F5 Networks Takes Another Whirl In The Tech Spin-Cycle

By Stephen D. Simpson, CFA | April 05, 2013 AAA

Between earnings from the likes of Oracle (Nasdaq:ORCL) and TIBCO (Nasdaq:TIBX) and yesterday's negative guidance from F5 (Nasdaq:FFIV), I think it's safe to say that the tech spending market has cooled noticeably. Given the hype and hope that had been built into so many tech company valuations, that should probably have investors feeling at least a little uncomfortable now. While I am still a believer in F5, it's going to be tough to own tech stocks until there is a real sign of renewed momentum in the sector – likely a second-half event.

A Guidance Drop Delayed Is Still A Guidance Drop
Back in late January when F5 reported fourth quarter results, investors were cheered that management didn't lower guidance. As it turns out, that optimism was premature, as F5 pretty clearly had a rough first quarter to start the year.

Citing some weakness in Asia and very definite weakness in the North American Telco and government verticals, F5 took down its estimate for first quarter revenue by about 7% at the midpoint – from a range of $370 million to $380 million to about $350 million. Within that, it looks like product revenue fell about 10% from the year-ago period (and 9% sequentially), while service revenue improved 23% (and 1% sequentially). Although Telco and government verticals were weak, enterprise revenue held up pretty well and that offers some small comfort.

Probably Not Just An F5 Problem
Although a few analysts tried to pin this as an F5-specific issue, I'm not buying that. Fellow ADC equipment vendor Radware (Nasdaq:RDWR) followed F5 about half a day later with its own guidance warning on Friday morning, including a downward revenue revision of similar magnitude. So, we have two significant ADC players both taking down their revenue numbers by a high single digit percentage. What's more, given that F5's financial performance has generally followed the same path as companies like Oracle and VMware (NYSE:VMW), I think there's an argument to be made that there's still some real caution in the tech market that has carried over from the end of 2012.

If what F5 says about the Telco sector is representative, this isn't great news for Telco-exposed vendors like Juniper (Nasdaq:JNPR) or Ciena (Nasdaq:CIEN) either. Likewise, weak government spending could be a potential risk to Riverbed's (Nasdaq:RVBD) numbers. On the other hand, I'm not so sure that this represents a big risk to more focused secular growth stories like Aruba (Nasdaq:ARUN) or Palo Alto (Nasdaq:PANW), though both could be vulnerable to a sector/market-wide valuation revision.

Still Cause For Optimism?
Though I've been very reticent to pull the trigger given my worries about valuation and spending trends in the first half of 2013, I'm still a believer in F5. This quarter's performance (including that of Radware) certainly doesn't give me warm and fuzzy feelings about the ADC market. As a reminder, there's a pretty substantial bull-vs-bear battle as to whether the ADC market has matured to a point where meaningful growth is unlikely, highlighted by Cisco's (Nasdaq:CSCO) decision to bail out.

Although I do believe the ADC market is unlikely to show the same strong double-digit growth, I believe solid single-digit growth is still attainable. Likewise, I think F5 can reap the benefits of a product refresh cycle and displacement of old Cisco equipment. Last and by no means the least, F5 is also aggressively expanding into new markets like security and diameter signaling – while it's fair to note that there are few “second acts” in tech, this expansion into adjacent markets could give F5's growth further legs.

The Bottom Line
I have cut down my expectations for F5, and I'm now looking for long-term revenue growth of just under 10% and long-term free cash flow growth of 8%. If F5 can manage that level of growth, a fair value of nearly $110 is still credible (and the company has a cash-rich balance sheet). Of course, there are no guarantees that F5 will manage to deliver that sort of growth, so investors should not fool themselves regarding the risk here.

F5 is likely to go into Wall Street's penalty box, and this round of April earnings reports/revisions may take a lot of the steam out of the tech sector in general. As such, investors may see a whole new round of opportunities crop up, but those investors should also be wary. While the market may be about to create some opportunities, there is still risk that demand falls off still further and that today's buyers will need to have a strong stomach for the likely volatility this summer.

At the time of writing, Stephen Simpson owned shares of EMC, which is the majority owner of VMware.

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