An Ill Wind Blows At F5 Networks

By Stephen D. Simpson, CFA | October 25, 2012 AAA

Sometimes the stocks that you don't buy shape your portfolio returns as much as the ones you do buy. That feels true for me right now, as holding off on buying F5 Networks (Nasdaq:FFIV) seems to have spared me a pretty negative reaction to these fiscal fourth quarter results. Although I still believe in the growth story at F5, it's hard to deny that there are more risks and challenges now than over the past year or two.

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Not a Big Miss, but One Data Point Looks Especially Worrisome
F5 reported 15% revenue growth from last year, but only about 3% growth from the fiscal third (June) quarter. That was only about a 1% miss, but F5 saw product revenue growth decline to only a 6% increase from last year and a 1% increase from last quarter - the lowest growth rates since the 2009 recession. Service revenue saved the day, growing 30% and 5% for the quarter. F5 saw meaningful slowdowns in the teleco and large enterprise verticals. Unlike IBM (NYSE:IBM) and Juniper (NYSE:JNPR), F5 saw pretty solid strength in its business with the federal government, but I would be concerned about the sustainability of this performance.

Margins were OK. Gross margin improved about a half-point from last year and worsened slightly from the third quarter. Operating leverage was a little soft, as operating income rose a little less than 13% from last year and less than 2% from the prior quarter. Unlike some other tech vendors, F5 didn't curtail sales/marketing spending quite as much this quarter.

SEE: Zooming In On Net Operating Income

Can F5 Re-light the Rocket?
I would think even the most ardent F5 bulls would agree that single-digit product revenue growth is not going to get the job done, considering the valuation on these shares. The biggest question for management going into 2013, then, is whether it can reignite growth (and if so, by how much). On the one hand, the company does have a significant product refresh cycle coming in the next year. The company is also ramping up its efforts in security (90% growth in this fiscal year, making up about 7% of product revenue) and diameter routing. Cisco (Nasdaq:CSCO) has also deprioritized F5's core ADC market, and it's unclear whether a partnership between Cisco and Citrix (Nasdaq:CTXS) is really going to be much of a threat to F5.

On the other hand, F5's large share in ADC probably precludes significant additional share gains. At the same time, it's increasingly questionable as to whether the underlying ADC market growth can support the sort of growth F5 needs to validate, or "grow into" its valuation. And while I don't think companies such as Citrix or Radware (Nasdaq:RDWR) are huge threats at this point, F5 hardly needs more competition. There's also a valid question as to whether the company's diversification efforts will pay off and boost/sustain the growth rate. Relatively few companies succeed in more than one line of business, and it's not as though security is an easy market to target, with relatively new companies such as Palo Alto (Nasdaq:PANW) and Fortinet (Nasdaq:FTNT) already fighting it out with more established names such as Check Point (Nasdaq:CHKP).

The Bottom Line
If the macro environment stays tough well into 2013, it will be difficult for F5 to make a lot of progress with product growth, and there would likely be further pressure on margins and multiples. Admittedly, that's true for most tech hardware companies, but the valuations on companies such as F5 and Palo Alto make it a relatively greater risk than for companies such as Check Point and Cisco.

While some analysts are starting to turn on F5, I find it curious that they are making big cuts to F5's projected free cash flow (FCF) margin. Few analysts discuss their cash flow modeling (it often seems to be more of an afterthought or side-effect to their income statement models), but it would seem that there are expectations for much more capex spending and much less deferred revenue contributions - even though F5 continues to grow its service business more quickly than expected.
I find it hard to go along with those estimates calling for a big decline in free cash flow conversion. That said, I recognize that my estimate of high single-digit free cash flow growth will be too aggressive if F5 cannot find new growth markets beyond ADC. Right now, those numbers translate into F5 delivering just over $4 billion in revenue and $1 billion in free cash flow in a decade, against $1.4 billion and under $500 million in this last fiscal year. That's a lot of expected growth, but F5 shares are meaningfully undervalued if they can deliver; even mid-single-digit cash flow growth would support a triple-digit price target today.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

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