Sterne Agee analysts Alex Kurtz, Amelia Harris and Craig Jones lower estimates and price target for NetApp Inc. (NASDAQ:NTAP) as competitive headwinds set in.

NetApp

After additional analysis of the NetApp Inc. (NASDAQ:NTAP) channel and new associated competitive threats in North America, we are lowering our estimates to reflect branded product growth of 1.4% and 1.0% for FY2014 and FY2015. We expect the stock to underperform in the near term relative to its peer group but with estimates now widely reset and new products to be launched later this year we could see some sentiment improving as we move into early summer and thus retain our Neutral rating. $36 PT.

Channel analysis suggest more headwinds

An analysis of the N.A. NetApp Channel suggests increased mind share among new competitive vendors such as Nimble, Nutanix, Pure, and Tintri to name a few. Specifically, we reviewed ~75 of NetApp Inc. (NASDAQ:NTAP)’s top two tiers of North American Value Added Resellers (VAR) and found that at least 25% are now selling one of these brands, up from likely less than 10% two years ago. This is further supported by our 4Q13 IT VAR Survey of 30 NA resellers that also highlighted the potential impact from new competition. (See charts later in the report.) The other new dynamic we would highlight through recent checks with larger VARs is the accelerated move by EMC Corporation (NYSE:EMC) to funnel more traditional “Direct” business to the Channel (in effect creating additional pressure for mind-share at these VARs for NetApp).

Consensus estimates have begun to incorporate

This Given the channel feedback and analysis on NetApp Inc. (NASDAQ:NTAP), we are now assuming branded product growth rates of 1.4%, 1.0%, and 2.2% in FY2014, FY2015, and FY2016. On a comparative basis, we are modeling EMC Product Growth rates of 4.0%, 1.6%, and 3.7% in CY2013, CY2014, and CY2015 and -2%, -2%, and 1.6% for NetApp. A key delta is the growth of new emerging technologies for EMC Corporation (NYSE:EMC) outside of VNX and VMAX. Consensus estimates are now at -2.8% and 2.0% Y/Y product growth for FY2014 and FY2015, down from 6.6% and 4.8% prior to the October 2013 quarter, suggesting the big cuts have happened.

NetApp’s FlashRay could help but most likely a CY2015 event

Discussions with NetApp partners that have spent time with early beta units of FlashRay are encouraged about the product and the integration into ONTAP. If we see one key differentiation with the upcoming FlashRay product (launch in mid CY2014), it is the ability to distinguish itself from smaller flash start-ups that cannot offer customers a fully integrated solution (FlashRay to FAS). That said, this year will be a pipeline building period with any incremental growth next year in our view.

Lowering estimates

We are now forecasting FY2014, FY2015, and FY2016 non-GAAP EPS of $2.74, $2.94, and $3.18 from $2.74, $3.03, and $3.29.

Valuation and outlook

We are lowering our multiple by a point to 8.5x CY2014 EPS Adjusted Cash to yield a new PT of $36 (down from $38). This compares to our 11x multiple for Brocade Communications Systems, Inc. (NASDAQ:BRCD) and 13x for EMC Corporation (NYSE:EMC) (adjusted for net cash). We would suggest these companies, along with Cisco Systems, Inc. (NASDAQ:CSCO), have additional opportunities for growth outside their core platforms and as such should enjoy a higher multiple to reflect those incremental growth markets.

Changes to competitive dynamics lead to new headwinds

Our proprietary analysis of NetApp channel partners, specifically their top VAR tiers (Star and Platinum), highlights changes that we believe are beginning to impact the company’s branded product growth rates that we are modeling of 1.4%, 1.0%, and 2.2% in FY2014, FY2015, and FY2016. We analyzed ~75 of NetApp’s top partners and found that 30% are now selling at least one alternative new brand (Nimble, Nutanix, Pure, Tintri and Violin Memory), and of those resellers, 23% are now selling at least two brands. We believe these percentages are up from likely 10% about two years ago. These partner tiers require annual revenue of at least $1 million and can scale at the high end to over $20 million with the larger resellers.

The other key issue and feedback we have received in our most recent discussions with larger Storage VARs is what appears to be an accelerated move by EMC, in some instances, to shift revenue from its Direct sales efforts to the Channel. Why this is relevant is that historically NetApp’s value proposition was to target the Channel that would often be experiencing some confrontation with EMC’s sales organization. While its a qualitative assessment, it appears that EMC is accelerating this shift in the last 12 months. (NetApp drives 83% of its revenue through the Channel; EMC does not regularly disclose this but we would estimate the number of “authentic” Channel revenue is likely closer to 60%.) The other nuance we have picked up is that EMC is driving portions of its Enterprise customer business to these larger VARs (the crown jewels for EMC).

Why does this matter? If NetApp Inc. (NASDAQ:NTAP) is to remain relevant on a national level, it needs these larger VARs and now it appears EMC is looking to further penetrate these relationships by moving larger deals through the Channel. Again, these are qualitative assessments on our part but in our view, a change in course for EMC (as a competitive move and potentially a way to lower its cost of sales over the longer term).

Our thesis on these data points and how it impacts NetApp Inc. (NASDAQ:NTAP) shares: The historical bull argument for the stock is that NetApp should outgrow the market and/or EMC and these new data points (new competition, EMC acting differently in the Channel) challenge this view. Other secular headwinds such as Public Cloud computing and VMware, Inc. (NYSE:VMW)’s move into the low-mid range Storage market with vSAN from VMware also muddy the waters in our view.

We would remind investors that the issue with Channel partners is not always about revenue shift among vendors (although this is the ultimate outcome) but rather the allocation of technical resources between vendors. We would estimate that in aggregate Nimble, Pure, Tintri, Nutanix, and Violin Memory are approaching $300-$400M in annual revenue, with at least 75% of that number flowing through the Channel, growing over the next couple of year to $500 million. This can quickly be the difference for NetApp growing product revenue at 1% vs. 4%.