Did NetApp over-pay buying SolidFire for $870 million?

Did NetApp pay too much for all-flash array vendor SolidFire?

Its latest results prompted financial analysts to update their clients on NetApp’s finances and one* included SolidFire revenues for the four fiscal 2018 quarters. They were $36.3m, $23.5m, $25m and $46m; a total of $130.8m for the year.

NetApp paid $870m for SolidFire in late 2015. A $130.8m run rate is 15 per cent of that, seemingly a not bad return. But that is not the actual return, because the actual return on the SolidFire investment is the profit on that $130.8m.

What is it?

We don’t know, as NetApp doesn’t reveal that information. However it does reveal its own revenues and profits, and the profit can be presented as a percentage of its revenues.

In NetApp’s fiscal 2018 quarters its profits as a percentage of its revenues were 9.92, 12.32, -33.29 and 16.52. That negative third quarter numberwas caused by US tax law changes.

Let’s ignore that number and use the other three to calculate NetApp’s average profit percentage for the year. It comes to 12.92 per cent.

We can apply that to the SolidFire revenues to work out a notional SolidFire profit for the year; $16.9m.

That is 1.94 per cent of the SolidFire acquisition cost. In other words, $870m was invested and is getting a 1.94 per cent return. Is this good or bad?

We understand, simplistically, that a business can evaluate an internal rate of return on investment by comparing it to their internal cost of raising cash, the weighted average cost of capital (WACC). That would be the cost of raising the $870m in this case.

Another way if looking at it is to use an internal rate of return (IRR) and saying that returns acquisition investments must be higher than an IRR threshold level.

If an acquisition brings in more than the WACC or IRR then it is a reasonable deal. Some business sources suggest a large and mature company could have a 7 or 8 per cent WACC.

A venture capitalist company might have a 50 per cent WACC while a private equity concern might have a 35 per cent one; both representing a risk premium, with the VC investment risk being higher than the private equity level.

We could class NetApp as a large and mature company. It seems unlikely that a SolidFire return on investment of 1.94 per cent would exceed NetApp’s WACC or IRR percentage.

Therefore, on the basis of the calculations and assumptions above, NetApp overpaid for SolidFire.

Does this argument stand up?

William Blair analyst Jason Ader said: “Your math makes sense. But I would note that a big reason in my mind for the SolidFire acquisition was to get their hands on its HCI tech, which at the time of the deal, was still under development. While NetApp HCI is still small revenue for NetApp today, it could be much more significant over time, which could help justify the purchase price.”

*Wells Fargo senior analyst Aaron Rakers.

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