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NetApp new issue attractive relative to HPE

| June 19, 2020

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

The best relative offering in NTAP’s new deal, which priced in the middle of June, is the 5-year issue which remains attractive relative to both existing NTAP bonds and HPE. The new NTAP 5-year is trading at +145 bp – roughly 40 bp behind the NTAP 3.3% 2024 bonds – offering a steep curve for a 9 month extension. Furthermore, they are approximately +16 bp behind HPE 4.9% 2025s, a relationship that should reverse.

The historical relationship between NTAP 3.3% 2024 and HPE 4.65% 2024 bonds is highlighted in Exhibit 1. The median relationship has NTAP trading 55 bp through HPE, with NTAP currently trading roughly 17 bp through HPE. The credits are similarly rated with NTAP rated Baa2/BBB+ and HPE at Baa2/BBB/BBB+. Both credits have stable outlooks on their respective ratings.

Exhibit 1: NTAP vs. HPE historical spread performance

Source: Bloomberg TRACE, Amherst Pierpont Securities

Superior Balance Sheet Underscored by a Net Cash Position

NTAP boasts a very strong balance sheet, which is underscored by a net cash position. As of the most recent quarter (ended 4/24/20), NTAP was in a net cash position of approximately $1.0 billion. This compares favorably to HPE which is currently in a net debt position of roughly $12.7 billion. Furthermore NTAP ended the quarter with debt/EBITDA of 1.5x, which is over 2 turns better than HPE’s leverage ratio of 3.8x and over a turn better than its net leverage ratio of 2.7x. NTAP’s $2.0 billion deal is being used for general corporate purposes including the  repayment of 2021 debt ($500 million due 6/15/21) and its commercial paper balance of $523 million (as of 4/24/20). Given the size of the deal and already strong liquidity due to its cash position of $2.9 billion and untapped $1.0 billion revolver, NTAP may look to further reduce front end debt given the higher 3%+ coupon rates associated with that debt.  That said, leverage is not expected to increase much from the debt deal and management should remain in a sizeable net cash position. Additionally, while the company continues to pay a dividend, which consumed roughly 50% of FCF for fiscal 2020, management temporarily suspended share repurchases until they have a better sense of both the timing and magnitude of the broader economic recovery. That prudent step provides comfort that the new CFO, whom took the helm on 3/16/20, will continue with NTAP’s historical conservative policies.

Strong Free Cash Flow Despite Pandemic

NTAP’s margin profile is strong with an LTM EBITDA margin of 21.9%, 470 bp higher than HPE’s (17.2%). Street estimates have NTAP ending fiscal 2021 with and EBITDA margin of 22.3%, a 40 bp increase year-over-year. Additionally, NTAP’s business is much less capital intensive than HPE’s providing for an exceptional FCF/sales ratio of 17.3%. For fiscal 2021, free cash flow estimates are expected to decline slightly bringing FCF/sales to roughly 16.1%. HPE’s FCF/sales ratio is currently less than 1% and has not been higher than 6.2% in the past 5 years.

Agencies Affirm Ratings

Both Moody’s and S&P affirmed their ratings upon the deal announcement. Moody’s noted that their affirmation reflects their expectation that NTAP will maintain a conservative financial policy, which includes both a strong cash position and low leverage.  The agency also noted that its conservative financial profile helps to mitigate business risks associated with the enterprise storage and networked storage hardware markets.  The former is highly competitive while the latter has been declining due to cloud computing.  Despite the business risks coupled with the ongoing pandemic, Moody’s expects NTAP will continue to maintain its strong operating margins despite its forecast that revenues will decline by 3%-4% in fiscal 2021.  Moody’s believes revenues will rebound in fiscal 2022, with growth expectations of 3% for the year.

S&P also expects NTAP to remain in a net cash position which should provide for a good cushion to the agency’s downgrade threshold of 1.5x net leverage.  While S&P also expects sales in fiscal 2021 to decline with enterprise clients cutting back on IT spending due to the pandemic, they too believe that sales will return to growth in fiscal 2022.  S&P views NTAP as a “differentiated” player in the external storage market due to its all-flash and public/private cloud products.  NTAP maintains the number two position in terms of market share in the$25 billion external storage market behind Dell Technologies Inc. (DELL secured ratings – Baa3/BBB-/BBB-).

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