F5 Networks On Its Heels, But Hasn't Fallen Down Yet

By Stephen D. Simpson, CFA | June 03, 2013 AAA

There are only a handful of tech companies that aren't seeing significant pressure on their revenue growth these days, so in that respect F5 (Nasdaq:FFIV) is in good company. What's more troubling about F5, though, is the prospect that the company's core market (and its position within that market) has begun to fade significantly. Although F5 is cash-rich and has opportunities to reignite growth with new products for new markets, investors need to appreciate the risk that growth stagnates during this reconstruction period and that valuation alone won't be enough to support the stock.

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The Luster Of ADC Is Fading At An Increasing Rate
F5 is still the leader in the application delivery controller (ADC) market, but that leadership position is looking less and less impressive. While ADCs are still important tools in managing data network traffic, growth at the high-end has stagnated, while lower-end customers turn to virtual ADCs where F5 holds much less share.

All the while, Citrix (Nasdaq:CTXS) is becoming an increasing threat to F5. For starters, Citrix is benefiting from its partnership with Cisco (Nasdaq:CSCO) and successfully transitioning former Cisco ADC customers to its systems, even though F5 management is also claiming good success in converting Cisco customers. To that end, while different analysts have reported different figures for ADC market share, there seems to be a general consensus that F5 lost share in 2012 and now holds a share somewhere in the low 40%'s. Citrix has won almost all of that (with its share now in the low 20%s). While privately-held A10 Networks is also growing, smaller rivals like Radware (Nasdaq:RDWR), Brocade (Nasdaq:BRCD) and Riverbed (Nasdaq:RVBD) don't seem to be gaining much momentum.

Citrix is problematic for at least two reasons. First, Citrix can (and does) bundle its ADC products with its popular virtualization offerings. While F5 can somewhat answer this with its partnership with VMware (NYSE:VMW) it's certainly not the same. Citrix has also proven adept at advancing virtual ADC technology, so much so that it is estimated to have about half the market (while F5 is below 20% share). With virtual ADCs sometimes costing as little as one-third of traditional ADCs, it can be a compelling threat on the lower end of the business, where F5 is often too feature-heavy (and/or expensive) for what the customers need.

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Still Waiting For That Second Act To Start
Every successful tech company eventually faces a point where the market in which it grew to prominence no longer has the growth characteristics to take it much further. Perhaps it's early to say that about the ADC market, but I don't think so.

Certainly there is more that F5 can do with ADCs. New products will support more modules, and F5 is looking to modules like application firewall and policy enforcement software to take advantage of growth in security and toll-free mobile data, respectively. The trouble is, though, that these products are likely more appealing to higher-end customers and that's where rivals like Check Point (Nasdaq:CHKP) and Palo Alto (Nasdaq:PANW) answer with purpose-built high-performance products of their own.

As I've said before, markets like security and storage can add some juice back to F5's ADC prospects, and although Citrix has the early lead in virtual ADCs, I wouldn't rule out a competitive response from F5. Additionally, there are potential “second act products” like diameter routing to consider, though Oracle (Nasdaq:ORCL) (through its acquisition of Acme Packet) is not a rival to take lightly, nor incumbent Tekelec.

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The Bottom Line
My biggest fear on F5 is that the core high-end ADC market is close to saturation, and that F5 will find it difficult to do more than refresh its installed base with future product cycles. At the same time, I worry that the combination of virtual ADCs and the migration of smaller businesses towards options like Amazon's (Nasdaq:AMZN) AWS will hollow out the medium-sized and small-business market segments.

As a result, I've cut back my growth estimates pretty substantially. I'm now looking for revenue growth of 7% and free cash flow growth of about 5% (these are 10-year CAGRs). Interestingly, that still points to a fair value of about $100, or about $85 excluding all of F5's net cash. Consequently, I have to say that the market really has soured on F5 – so much so that I'm still somewhat bullish on the stock. While I do worry that F5 is dead money for the next couple of quarters (absent a big recovery in market share/product revenue growth) and I'm aware that value arguments seldom work in tech, this company (and these shares) isn't done yet.

At the time of writing, Stephen D. Simpson owned shares of VMware.

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