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NetApp in the Spotlight for Shareholders

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Unable to up spending, companies will resort to better technology to cope with increasing volumes of data.

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It's not every day you can pick up shares in a top-drawer technology company at a reasonable price. But take a look at Network Appliance (NTAP). The data storage systems maker continues to deliver industry-beating growth, yet trading on a PE multiple of just 14 and a PEG of 0.8, the stock looks like good value. The shares have yet to catch up with the company's growth prospects.

Some might argue that the shares have run far enough. A year ago, they were priced at just over $14. Today they are trading for just over $33. But I'd say the shares have more steam left in them.

The company is grabbing market share away from IT giants Hewlett-Packard (HPQ) and Sun Microsystems, recently acquired by Oracle Corp (ORCL). The reason is because corporate customers like NetApp's external data storage systems, which are connected by network file servers instead of the more traditional route of attaching internal data storage devices directly to computer servers. This shifting preference in data storage technology is rapidly putting the market into the hands of the NetApp and its bigger rival, EMC Corp (EMC).

Even with EMC being the company to beat, NetApp is nicely positioned. Gross margins are holding up at around 65% and ought to stay that way for the foreseeable future. The company is concentrating not just on the boxes that store data, but also higher-margin software and virtual solutions that help companies manage their data.

Despite the economic slowdown, NetApp delivered yet another stellar set of earnings results last month. The company reported earnings of $108 million, or $0.40 EPS on $1,011.7 million revenue, well ahead of consensus Street expectations of $0.38 EPS and $954 million. The good news is that once corporate customers start loosening their purse strings, earnings growth should jump by an order of magnitude.

Even if its earnings outlook doesn't impress you, NetApp's free cash flow outlook should. Free cash flow last quarter was $145 million, or 14% of revenue. Due to an unusually big increase in accounts receivable last quarter, that number was well below the company's target range of 17% to 22%. Accounts receivables should remain relatively stable going forward, so free cash flow as a percent of revenue should bounce back to the target range next quarter. Remember, free cash flow growth is frequently a prelude to even stronger earnings growth.

On a free cash flow basis, NetApp looks undervalued. Let's say that NetApp produces $800 million in free cash in 2011, or about 18% of estimated revenues. With about $3.3 billion worth of cash and marketable securities on its balance sheet and about $1.1 billion in debt, NetApp's enterprise value is about $9.3 billion. That suggests the stock is trading at just 12 times free cash flow. A multiple of 17 to 20 times free cash flow -- which translates into share price of $36 to $43 -- probably better reflects NetApp's true worth.

The future looks bright for NetApp. The way I see it, companies will still need to find more effective ways of coping with the volumes of data they produce every day. Unable to up their spending at the same rate that their data volumes grow, companies will resort to better technology. Over the long haul, NetApp and its shareholders will be big beneficiaries.
No positions in stocks mentioned.
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