A Look At NetApp's Key Challenges

Storage systems firm NetApp Inc. (NASDAQ: NTAP) faces key challenges amid competitive environment and customers shifting from traditional storage solutions.

Context Of Rating, Justifications

The company faces one of its biggest challenges in the form of fundamental technology shifts, including the emerging flash storage opportunity, software-defined storage and a shift to centralized intelligence in combination with low-cost, commodity hardware.

Meanwhile, competitive pressures dragged down NetApp's product gross margin for F16 by approximately 600 bps year-over-year primarily due to discounting and promotions, partially offset by lower material costs.

"We struggle to see a scenario, at least in the near term, where the company will find relief from these pricing dynamics," BMO Capital Markets analyst Jayson Noland wrote in a note.

"Though we remain positive on fundamental demand for Storage, our reseller surveys have suggested that the market has become incrementally more competitive as customers evaluate alternative architectures," Noland added.

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In addition, Noland said reseller feedback has been mixed in recent years.

"Some NetApp channel partners are experiencing less positive results relative to EMC and innovative start-ups. We don't expect a drastic deceleration in NetApp fundamentals, but our checks have trended less positive for a company that has historically been viewed in a very positive light by the channel," Noland highlighted.

Competition Encroaching

The analyst sees web-scale providers like Amazon.com, Inc. (NASDAQ: AMZN)'s Amazon Web Services (AWS) encroaching on "non-mission critical and cold data with appliance gateways and storage architectures that are proprietary in many cases."

"NetApp can sell to Cloud Service Providers like Verizon Terremark but a few high-profile Hyperscale providers don't buy Storage from traditional OEMs," Noland noted.

Further, the analyst continued that the company's virtualization efforts remain a positive, but without the tailwind. The analyst acknowledged NetApp's core competencies in NAS and iSCSI protocols, which positions the company to benefit from further adoption of server virtualization, unified storage and the shift toward 10G Ethernet infrastructure.

It's Not All Bad

"NetApp will continue to benefit from its large install base, but must innovate to position for large changes coming to the Storage market, in our opinion," Noland added.

Meanwhile, the analyst noted that the Sunnyvale, California-based NetApp has over 20 percent revenue exposure to Europe, which creates some additional risk to the first quarter.

Noland, who has a Neutral rating and $26 price target on NetApp stock, said cash flow generation and continued shareholder-friendly actions could help to support the stock despite fundamental challenges.

Shares of NetApp closed Monday's regular trading session 7.12 percent lower at $22.96. The stock has declined 14.55 percent this year.