NetApp to Acquire Data Domain: Can it Castrate this Bull?

Some folks I know on Wall Street started shorting Data Domain stock late last year and were very happy until today. Actually, they’re still pretty happy, just not giddy like they were in March when the stock bottomed. As you can see from the chart below, DDUP has outperformed its peers in the past three months and will now spike close to the buyout price.

Relative Comparison

Relative Comparison

In after hours trading, DDUP is approaching the announced buyout price of $25, a nearly 40% premium over yesterday’s close. That’s at or near it’s 52-week high, which is pretty astounding.

I think this is a brilliantly timed move for Data Domain at a great price for the firm. The company is broadly considered the leader in the data de-duplication space but could see the writing on the wall. Larger established companies including EMC and IBM had made their moves to attack and smaller companies were perfecting the formula to compete. Rather than fighting a multi-front war, Data Domain found an eager buyer in NetApp with more resources to do battle.

I like the deal for Data Domain but I don’t like the price NetApp paid, which I guess means on balance I don’t like the deal. Here’s my understanding:

  • NetApp will pay nearly $1.5B for Data Domain (net of Data Domain’s cash).
  • The transaction is expected to close within 60-120 days.
  • About $700M of the price will be paid in cash, the rest in NetApp stock.
  • Data Domain will be organized as a product group within NetApp.
  • NetApp expects the deal to be accretive over the next twelve months.

NetApp is trading at 1.7X trailing revenue and Data Domain 5.5X trailing revenue (at the presumed closing price). Combined, the company will have a valuation of roughly $7.24B with Data Domain’s piece accounting for 20% of the value of the combined entity. That’s assuming the merged company can command a blended valuation that preserves Data Domain’s valuation. I don’t think this is likely and because the deal involves approximately $700M in cold hard cash, the risks are higher. As Al Shugart said many times: “Cash is more important than your mother– especially in a downturn.”

For an acquirer, I prefer transactions where the acquiring company’s multiple is higher than the acquiree’s and the acquired revenue translates into an immediate valuation bump at the aquiring company’s inflated multiple. This type of transaction creates an instant ROI from a valuation standpoint. Is this a sure-fire recipe for success. No. And can firms succeed in acquiring companies without this blueprint. Yes– IBM does it all the time. But NetApp doesn’t have IBM’s track record of accomplishment when it comes to acquisitions.

Regardless, NetApp will argue that the growth prospects of a combined firm will lift NetApp’s blended value over the long term but of course that’ s not a certainty by any means and in my view it’s unlikely.

The Good

Here’s my thinking on this deal. I like the fact that Data Domain is teaming with a company that has a much larger portfolio with a set of data reduction technologies including primary data de-duplication, compression and now data de-duplication for disk based backup. EMC’s mantra of ‘de-dupe is a feature, not a product’ rings true although I like to think of data reduction techniques as a storage service, not a feature. NetApp, of all the companies Wikibon follows is one of the most closely aligned to the vision of enabling storage services for applications.

The vision goes something like this. NetApp can extract data reduction IP from its expanded technology base and apply it broadly across its portfolio. If NetApp can architect a solution where various data reduction technologies (in-line, post-process, compression, single instancing, etc.) all speak the same language the company can implement a vast array of data reduction services that optimize storage efficiency and data movement across tiers.

Data Domain never could have achieved this vision as an independent company in the near-to-mid term. For NetApp, Data Domain fills a gap and while there’s some product overlap it’s not enormous. As well, NetApp has fantastic integration with major applications (e.g. Exchange) and is well-positioned to advance a new agenda with Data Domain assets.

The Bad

This vision will take forever to execute. Meanwhile, IBM with Diligent and TSM; and EMC with Avamar and Quantum are further down the path. This will lower the time to value for NetApp which I’m defining as the valuation being incremental (i.e. 1+1 > 2).

(Please see 5/21 Update below).

The Ugly

Data Domain was trapped. It was a point product company in a market that was becoming increasingly competitive with large firms (EMC, IBM) making significant progress and smaller firms such as Falconstor, Commvault and others sharpening their knives. In many respects, NetApp is trapped too. As I’ve described in previous posts I think EMC, at $15B in revenue is getting squeezed by the forces in the IT industry (consumerization, consolidation, etc). If weren’t for VMware the company would be in deep strategic trouble.

Where’s that leave NetApp? Even with Data Domain it leaves them in a room with the walls closing in. As the traditional data center stack consolidates (Oracle/Sun, HP/EDS, EMC/VMware, etc) one has to question if a $1.5B investment in a data centere market that isn’t really growing (at the TAM level) is the right move. The answer is yes, only if NetApp can gain dramatic share against the likes of IBM, HP, Oracle, EMC and to a certain extent, Microsoft and Cisco.

Currently, NetApp lacks a clear strategy for so-called cloud computing and it doesn’t have a big play in the information management space other than as a focused infrastructure player. Two years ago I would have advocated this type of singular focus but in today’s consolidating market, integrated stacks and services are becoming more desirable competitive weapons.

For the record, NetApp would almost assuredly disagree with this assertion and has a strong track record of doing the impossible.

What’s Next?

Can NetApp aquire and grow its way out of this shrinking room? Maybe, but if I were in NetApp’s shoes I’d be looking for ways to tap consumer markets through storage  services. I’d also be looking to solve the huge problem of unstructured data management.

Alas, for NetApp the $1.5B bull is out of his pen and it’s time to break out the dull pocket knife. Do it right and you’ll have a better animal – just don’t get kicked in the head.

5/21 Update

NetApp’s strong quarterly earnings combined with the fact that the DDUP acquisition is expected to be accretive in a reasonable timeframe boosted the company’s stock today. Investors were encouraged by the 34% year on year revenue growth posted by NetApp and substantially higher earnings growth (50%+). How can you not be in this climate? The stock’s rise today, while most likely attributable to NetApp’s strong earnings is a clear indication that the street likes the Data Domain deal better than I do.

While management indicated visibility is poor for both NetApp and Data Domain, it’s  clear that NetApp is gaining significant share in the storage market. EMC’s revenue in its core storage business was down substantially in its first quarter. Some of this can be attributed to timing but you can’t ignore the fact that NetApp’s revenue grew nearly 5X faster than VMware’s, one of EMC’s hottest growth prospects.

In addition, NetApp CEO Dan Warmenhoven in his remarks yesterday indicated that grand software integration visions such as the one described above are not in the cards. The company is clearly focused on getting a fast ROI from its acquisition and letting customers sort out integration challenges later. Given the premium NetApp paid for DDUP I don’t think this is the wrong near term strategy to get a faster payback.

With this approach, however, customers may find that data proliferation is occuring faster than data reduction over the long haul and they may be left wondering what to do with all these de-duped silos.


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