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Morningstar | All-Flash Arrays and Cloud Data Management Demand Position NetApp for Growth; Raising FVE to $60

Following a commendable turnaround, NetApp appears well-positioned to prosper in the short term through its leadership within nascent storage technology trends. In our view, NetApp's all-flash array products and cloud-based data management software will be highly demanded as IT teams upgrade to all-flash storage and shift an increasing quantity of workloads into clouds. However, we believe product substitutions will weigh on NetApp's long-term outlook. We are increasing our fair value estimate for NetApp to $60 per share from $35 as we maintain our no-moat and stable moat trend ratings. We caution investors to wait for a larger margin of safety before investing in NetApp.

NetApp's all-flash array product lines are attractive due to substantial latency improvements, reduced power consumption, higher capacity per size, and more software functionality versus incumbent storage technology. Although we expect NetApp to benefit from data center architects upgrading to flash, we caution that much larger brand-name competitors and white-box manufacturers will affect NetApp's long-term ability to demand a premium.

As cloud environments permeate the IT ecosystem, we posit that NetApp has wisely focused on software for data management across clouds. Although NetApp may not sell the hardware, the company's software is highly relevant to public and multicloud users. We like that NetApp has partnerships with hyperscale cloud providers and colocation data centers, as we believe NetApp's long-term vision is for its software to be the data management glue between on-premises and cloud data centers. However, we believe NetApp's early-mover advantage may be fleeting as hyperscale cloud providers develop similar solutions and competing data management tools proliferate. In our view, NetApp will remain a leader in private and on-premises storage management software, but we believe much-larger players and new entrants will make long-term growth markedly challenging.

NetApp is a leading provider of enterprise storage and data management solutions. It generates revenue by selling hardware and software term licenses in addition to support and maintenance contracts. New CEO leadership in 2015 prioritized a cloudcentric revamp of its operating system. Concurrent with a revitalized Ontap operating system, NetApp purchased SolidFire to penetrate the all-flash array market. We think these strategic imperatives have primed NetApp to prosper as IT teams adopt all-flash storage and migrate workloads to clouds. However, we have concerns that leading cloud vendors may eventually displace NetApp.

Enterprises have high demand for NetApp's all-flash array storage for on-premises and private cloud data centers. We expect all-flash storage to generate solid growth for NetApp into the next decade as IT teams upgrade to the faster, higher-capacity-per-size, and lower-power-consuming storage solution. Our opinion is that hyperscale cloud providers will use white-box storage, but enterprises will prefer industry-leading hardware brands, like NetApp, for on-premises and private clouds. In our view, NetApp's services and support are desired for nonpublic cloud environments. To capture a portion of the public cloud spending, we believe that NetApp's focus on cloud-based data management software has made it a viable solution within multicloud ecosystems.

NetApp aims to alleviate challenges associated with shifting data to public clouds via its hyperscale cloud provider and colocation data center partnerships. NetApp's software can hasten shifting workloads to public clouds and enterprises gain visibility, analytics, and data optimization possibilities. Since some workloads will not shift to public clouds because of latency, safety, or regulatory concerns, colocation partnerships provide enterprises with secure NetApp storage and the ability to use hyperscale providers' compute resources within a single site. NetApp is positioning itself to be a commonality for data management across the storage ecosystem. However, in our long-term view, we are concerned about market competitiveness and NetApp losing favor with hyperscale vendors.

Our forecast five-year revenue CAGR of 5% includes 6% to 7% annual growth through fiscal 2021 before slowing down toward 2% in fiscal 2023. We believe that all-flash arrays and hyperconverged infrastructure product adoption trends will spur short-term growth, but we expect growth to slow as the technologies become commonplace. In our view, market competitiveness should increase and ODM white-box offerings will weigh on branded hardware sales.

We model operating margin to expand to 21% of revenue in fiscal 2021 from 16% in fiscal 2018, but then decline back toward 16% by fiscal 2023. In the near term, we expect NetApp to benefit from favorable product selling prices and for gross margins to expand into the mid-60% range. Our expectation of NetApp shifting toward selling more recurring software revenue should increase profit margins. In our view, NetApp will benefit from being an early entrant into the all-flash array hardware and cloud-based data management software markets. Additionally, we posit that NetApp should gain operating leverage through its hyperscale and data center colocation partnerships. However, longer term, we expect that hyperscale providers may favor generic product offerings, cloud-based data management software to become more competitive, and the slowdown of the all-flash array refresh cycle to compress operating performance.