Do NetApp Inc's $1.2 Billion Share Buybacks Make Sense?

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It might seem logical that a high margin data storage company like NetApp would return capital to shareholders via share buybacks. The reason for this logic is because large disk storage as a business has suffered in recent years due to the rise of cheaper alternatives, like cloud storage. However, given the possibility for NetApp to see accelerated revenue growth in the near future, investors might be best served if the company avoids future buybacks, at least for now, and focus on the better growth opportunities that lie ahead. 

NetApp's buyback effect
For the last three fiscal years, NetApp's revenue growth has been essentially stagnant, hovering between $6.2 billion and $6.3 billion. Without growth, NetApp has hardly been considered a Wall Street darling. Therefore, with operating margins north of 13%, NetApp has employed a rather aggressive buyback policy, purchasing $1.2 billion worth of stock during the last 12 months, and $1.68 billion in 2013. The effects of these buybacks are obvious. 

NTAP Chart

NTAP data by YCharts

Since the start of 2012, NetApp's stock price has risen 9.4%, meanwhile its market capitalization has actually decreased 2.5%. The reason for this disconnect is the company's buyback program, which reduces NetApp's total shares 

How NetApp can increase shareholder value, faster
Considering the stock gains that NetApp's buybacks have produced, it might sound preposterous to suggest that ending the program would be in the best interests of shareholders. However, as seen below, NetApp's stock has significantly underperformed the S&P 500 since January 2012. This essentially proves that Wall Street places an emphasis on growth, and stocks with better fundamental growth perform better than those lacking.

^SPX Chart

^SPX data by YCharts

All things considered, the outlook for worldwide external disk storage systems has improved a bit. During the first and second quarter of this year revenue fell 5.2% and 1.4%, respectively for the industry. While losses are never good, the performance in both quarters represents a major improvement from the year-over-year losses of the respective periods in 2013. Therefore, NetApp has opportunities to find growth in its core business looking ahead, which actually increased 1% year-over-year during NetApp's second quarter, outperforming the overall industry. However, NetApp's most significant growth driver, which could add value to its stock, has nothing to do with physical storage drives.

The FlashRay advantage
After many months of anticipation, NetApp's all-flash product, conveniently called FlashRay, recently began shipping. FlashRay is unlike anything that NetApp has ever developed, because it's not actually a physical disk intended for storage, but rather utilizes the cloud and other technologies. Reportedly, FlashRay has 20 times the performance of traditional hard disk drive storage systems, and includes integrated file and volume management, complete data management, and application integration features. Hence, it is built for the enterprise customer.

That said, NetApp is by no means the first player to enter flash storage. In fact, companies have raced to enter the space due to its year-over-year growth of nearly 50%. Therefore, NetApp must compete with the likes of EMC and IBM, with the former being the market leader following its acquisition of XtremIO last year.

However, FlashRay has the opportunity to be a market leader in this fast-growing space, which is where the company's decision to buy back shares aggressively becomes unwise. While competitors have chosen to enter flash storage through acquisitions, NetApp is the first company to actually build its own flash product ecosystem from the ground up.

According to NetApp's former Vice President, Brian Pawlowski, "acquired flash technologies might have scale-out capabilities, but lack management integration when combined with an existing network of storage products." Essentially, FlashRay is built to interact, and work with NetApp's existing line of physical storage disks, having complete synergies with the company's storage ecosystem. In essence, this level of cohesiveness cannot be created with acquired technology, giving NetApp a distinct advantage in a fast-growing business.

Foolish Thoughts
Buybacks are great for shareholders, especially when there are no better ways to add shareholder value. The problem with NetApp's buyback is that FlashRay could be a real blockbuster product, but the company faces stiff competition against peers that have invested billions of dollars to acquire and market their respective flash technologies.

That said, NetApp is no longer a company without growth prospects, meaning it's no longer a company that should buyback shares as aggressively. Instead, NetApp's best approach is becoming the leader in all flash storage technologies, and creating revenue growth, not buying back stock.

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The article Do NetApp Inc's $1.2 Billion Share Buybacks Make Sense? originally appeared on

Brian Nichols owns shares of Apple. The Motley Fool recommends Apple. The Motley Fool owns shares of Apple, 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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