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NetApp Inc. (NTAP - Snapshot Report) reported second quarter fiscal 2013 adjusted earnings per share (EPS) of 37 cents, which surpassed the Zacks Consensus Estimate of 33 cents. Adjusted EPS excludes amortization of intangible assets, acquisition-related expenses, non-cash interest expense as well as investments and tax gains, but includes stock-based compensation expenses. Shares leaped 10.21% in the after-hours reflecting better-than-expected results and outlook.

Revenue

NetApp reported second quarter revenues of $1.54 billion, up 2.3% from $1.51 billion in the year-ago quarter. Reported revenue was within the company’s guidance range of $1.50–$1.60 billion and in line with the Zacks Consensus Estimate. The year-over-year revenue improvement was mainly attributable to solid performances by Software and Services, partially offset by Product revenue. Currency fluctuations, however, pulled down revenue growth by 1.5%.

Geographically, revenue growth from America and Europe remained modest while revenue from Asia-Pacific grew 14.0%. Growth in America was mostly driven by the U.S. public sector.

Product revenues were $995.8 million in the quarter, down 2.0% from $1.02 billion reported in the year-ago quarter and accounted for about 64.6% of the total revenue. Despite the year-over-year decline, some positive factors were noticed. ONTAP 8 and clustered Data ONTAP witnessed increasing demand as the products are successfully helping customers to build agile data infrastructure environments with intelligent data management, utmost scalability, and non-stop operations.

Software Entitlement & Maintenance revenues were $219.4 million, up 10.8% from $198.0 million in the year-ago quarter. The segment’s revenues represented around 14.2% of the total revenue.

Service revenues were $326.0 million, up 11.3% from $292.8 million reported in the year-ago quarter. The segment accounted for 21.2% of the total revenue.

Operating Results

NetApp reported gross profit of $913.9 million, which inched up 0.1% year over year. Gross margin dropped 130 basis points (bps) year over year to 59.3%.

Total operating expenses increased 8.0% from the year-ago quarter to $778.6 million. This was mostly due to a 12.1% rise in research and development expenses. Operating income fell 29.7% from the year-ago quarter to $135.3 million. Operating margin was 8.8%, down from 12.8% in the year-ago quarter.

Net income on a GAAP basis was $109.6 million, or 30 cents per share, compared with $165.6 million, or 44 cents in the prior-year quarter. The quarter’s result was above the company guided range of 23-28 cents.

Excluding the above-mentioned special items, but including stock-based compensation, adjusted net income was $137.9 million or 37 cents per share, compared with $190.5 million or 51 cents a year ago.

Balance Sheet & Cash Flow

NetApp exited the quarter with cash, cash equivalents and investments of $5.57 billion, up from $5.44 billion in the previous quarter. Receivables were $615.0 million, up from $584.2 million a quarter ago. Inventories increased $9.5 million from the prior quarter to $213.2 million. The company bears no long-term debt. But 1.75% convertible senior notes amounting to $1.23 billion are due in 2013.

Cash generated from operations was $336.4 million compared with $229.2 million generated in the prior quarter. Capital expenditure in the quarter was $67.1 million, up from $61.9 million in the prior quarter.

NetApp repurchased roughly 6 million shares and ended the quarter with approximately 148 million remaining of its prior authorization. The company also announced the continuation of its share repurchase program with an additional authorization of $1.5 billion.

Guidance

For the third quarter of 2013, NetApp expects revenues in the range of $1.575 billion to $1.675 billion, representing 5.0% sequential growth and 4.0% year-over-year growth.

Non-GAAP gross margin is expected in the range of 60.0–61.0%, while non-GAAP operating margin is projected at roughly 15.0%. GAAP EPS is expected to range between 29 cents and 34 cents, while non-GAAP EPS is expected between 53 cents and 58 cents. The company estimates shares outstanding of approximately 365 million and a tax rate of 17.3%. The Zacks Consensus Estimates for the third quarter and fiscal 2013 are 38 cents and $1.45, respectively.

Our Take

The quarter’s results were decent with the bottom line surpassing the Zacks Consensus Estimate and the top line matching the same. Continuous margin contraction due to cost increases remained the main challenge. Keeping in mind the ongoing macro uncertainty caused by the European debt crisis and federal budget cuts, management guided a cautious third quarter.

But we believe that NetApp can witness strong product demand with its newly launched 3250 and 3220 platforms, the new series of midrange storage platforms.

Though new product refreshes, association with Cisco Systems Corp. (CSCO - Analyst Report) and VMware Inc. (VMW - Snapshot Report), and ramp of ONTAP 8.1 are positives, we believe that uncertain IT spending patterns and growth prospects of its archrival EMC Corp. (EMC - Analyst Report) may pose serious threats.

NetApp currently carries a Zacks #4 Rank (short-term Sell rating).

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