F5 Networks - Siren Or Solid Play?

By Stephen D. Simpson, CFA | August 24, 2012 AAA

While other tech stocks like Cisco (Nasdaq:CSCO) or EMC (NYSE:EMC) look cheaper by many metrics, I've had a fondness for F5 (Nasdaq:FFIV) for some time now. Here is a good example of where a value investor can get badly burned - F5 looks underpriced today and offers the sort of growth value investors don't often get to enjoy, but there are more than a few yellow flashing lights. So is F5 all that it seems, or is this a siren trying to lure investors toward the rocks?

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Is There Ever Just One Cut?
Like many tech companies, F5 announced June quarter results that were "meet and lower" instead of the "beat and raise" that investors look for with growth stories. Of course, there were plenty of valid reasons for the revision - Europe and Asia continue to struggle, while carriers/service providers have yet to return to the market in force. What's more, the company's management didn't back away from its longer-term goal of 20% growth.

Unfortunately, more could be in store. While Cisco did report relatively solid earnings and analysts did revise numbers up, how much of that was due to truly better end-market conditions as opposed to carefully managed expectations and/or the impact of share buybacks? With Chinese economic data looking soft and economists openly worrying about Germany, this may not be the last time F5 has to revise down.

SEE: A Breakdown Of Stock Buybacks

Competition - There's Plenty of It
F5 not only has to worry about the health of the end markets it serves, but also its competitors. Cisco is a well-known threat, though the company really hasn't shown that it has anything in ADC or security that F5 can't handle. Likewise, while the Juniper (Nasdaq:JNPR) and Riverbed (Nasdaq:RVBD) tie-up may be a long-range threat, IP partnerships like this don't often work as well as advertised.

There are other threats to consider as well. Citrix (Nasdaq:CTXS) and A10 seem more willing to compete on price, leaving a premium-priced vendor like F5 vulnerable to channel checks that suggest they're losing business (more of a threat to perception than total revenue, but still a threat). Then there's Radware (Nasdaq:RDWR), with its decision to build an ADC business around offering multiple form factors.

By no means is this a winner-take-all market (EMC has done quite well despite multiple competitors in storage), but again it's a question of optics. If F5 has a challenging quarter or two, but Radware appears to be growing better, how much pressure does that put on F5's multiple and investor sentiment?

Promising Markets on Deck
Of course, F5 isn't just an ADC company anymore. The biggest near-term opportunities would look to be in security and diameter signaling, even if there will be competition here as well.

On the security side, while Palo Alto (NYSE:PANW) has been getting a lot of attention for its next-gen firewall technology, I'm not sure it's an "either-or" proposition. I'm no security expert, but it seems as though F5's building around inbound security that protects data centers and enterprises from events like denial-of-service attacks, while Palo Alto seems more focused on things such as traditional threat blocking and ID/access control. That's not to say that there isn't overlap, but rather just that there can be room for both to a certain extent.

As for diameter signaling, I would think this is a good play on the rise of smart devices. With the IMS demands that smartphones and tablets make on a network (accessing apps, downloading data, etc.), it would seem that the explosion of usage here ought to create quite a lot of diameter, signaling controller demand for network operators.

The Bottom Line
I'm all too aware of how wanting to like a stock can lead an investor to rose-colored vision and excessive optimism. I'm also all too aware of how the markets can abandon a high-multiple, high-growth story like F5 during a rout and rack up 40 to 50% losses in just a few months. All of that said, and with admitted worries about another meet-and-lower quarter for September, I'm getting an itchy trigger finger here.

SEE: 5 Must-Have Metrics For Value Investors

Right now, I'm looking for F5 to post mid-teens revenue growth out through 2017, with a gradual (and slight) erosion in free cash flow conversion. Overall, I'm looking for low-teens free cash flow growth for the next decade - a very aggressive expectation, I'll admit, but not unreasonable when compared to what companies like Cisco and EMC did during their growth phases. Factor that all in and fair value appears to be north of $130. By no means is this a widows and orphans stock, but sometimes even a value investor needs to take on some risk in the pursuit of growth and capital gains.

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

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