Tuesday, June 26, 2012

F5 Networks Being Unfairly Marked Down?

F5 Network $FFIV gave results and cheered the market. The Nasdaq needed this after the recent sell-offs in tech bellwethers $IBM, Intel $INTC and Qualcomm.

For those not acquainted with F5, it is one of those sexy stocks associated with cloud computing growth and the inexorable rise of bandwidth usage. In short, F5 ensures that the delivery of applications is not degraded when they are moved from one server to another.

Clearly, the need for faster connectivity to access information in the cloud has led to significant growth in bandwidth demand. Similarly, the proliferation of bandwidth-rich video and increasing penetration of smart phones are creating bandwidth demand.

The market was apprehensive coming into these results and, for good reason. However, F5 ‘beat’ on revenue and generated strong earnings. F5’s cautious management did no more than guide their midpoint slightly below market estimates.

F5 Networks Stock Earnings Beat

First off, a pretty good set of Q2 results and guidance for Q3
  • Revenue of $339.6m vs. estimates of $335.3m
  • EPS of $1.12 vs. estimates of $1.07
  • EPS Q3 guidance of $1.12-1.14 vs. estimates of $1.14
  • Q3 Revenue guidance of $350-355m vs. estimates of $355
The book to bill was affirmed at higher than one and, management has some exciting things to say about growth in data center firewalls. This is not an area that F5 are traditionally associated with but positive noises were made about competing with Juniper $JNPR in particular but, also Cisco $CSCO and Check Point.

Indeed, Juniper appears to be assailed from all directions at the moment, not least from Cisco within core internet networking solutions. As for F5 and data center firewalls, it is already seen as a ‘meaningful revenue generator’, and management sounded bullish about the expanding opportunity.

Perhaps what was surprising about the results was the broad-based strength. Americas revenue was up 21%, with EMEA not far behind, coming in at a 19% increase. APAC increased 24%. When asked by analysts, the management affirmed that Europe was doing consistently well and broad based in its growth too. Moreover, Government did well with US Federal (about half total Government numbers) spending showing a slight improvement. Otherwise, worldwide Government revenue was flat.

No matter, F5 tends to be quite diversified in its industry verticals. For example, here is a breakdown of Q2’s major verticals:

VerticalPercentage of Q2 Revenues
Telco27%
Financial16%
Technology19%
Government12%

Telco was unusually strong this quarter. In the next quarter, financials are expected to be up and, Telco down from these percentages. From a historical perspective, these numbers are quite low for financials but, I got the impression that management felt this was just due to natural lumpiness in ordering. Going forward, F5 expects North American enterprise spending to improve whilst Technology is seen as tracking a bit lower.

One interesting piece of ‘color’ was that two distributors now account for over 10% of revenue generation. Namely, Avnet $AVT with 16.6% and, Ingram Micro $IM. This implies that Avnet and Ingram are very useful barometers for how F5 Networks are doing in the quarter. I would suggest listening in on their conference calls and presentations in order to get an early ‘read’ on how F5 might do.

F5 Growth Prospects and Evaluation

This report is going to confirm that F5 are firing on all cylinders and, with the management talking of sequential revenue growth through 2012, there is little not to like about the stock. As ever, with technology darlings, the stock price can run away from the fundamentals when it is fuelled by momentum and investor sentiment. So is F5 overpriced?

The short answer is no and here is why
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Firstly, the drivers for the company are largely secular in nature and are being promulgated by technology shifts. Secondly, F5 is a company that has always been highly cash generative and has demonstrated that it can both grow gross margins and, free cash flow as it expands revenues. Thirdly, there is upside from data center firewall security. And finally, I think that the current evaluation can cope with any disappointments from European enterprise or worldwide Government.

Here is a graph of how F5 is tracking in terms of sequential revenue growth.



Note how the estimated numbers for 2012 are forecast to track last years. Who said equities analysts don’t work hard!

Looking back at the last few years, F5 tends to turn around 33% of its revenues, into free cash flow. So, a simplistic assumption of hitting analyst forecasts of $1.39bn and $1.65bn to Sep 2012 and 2013 respectively would see free cash flow (FCF) of around $459 and, $545m. Interpolating, gives $507m estimated for the next four quarters out.

I like to value companies in terms of Enterprise Value (EV). Now, if you, conservatively, want to pay a forward FCF/EV of around 5% for a company that is generating high teens revenue growth, than this would give you a target of $10.14bn in EV which is around $135. A typically looser estimate of 4.5% would give you a target price of $149.

I would be inclined to be a bit looser with F5 in terms of valuation but, a bit tighter with regards to risk.

Frankly, I don’t think that the pressures in Government spending are going to abate. In fact, in the US they could strengthen because the US hasn’t really done anything about cutting its debt or deficit levels. However, I am aware that F5’s solutions are mission critical and they are largely secular.

Therefore, I wouldn’t be surprised to see some downgrading of forecasts for certain verticals within F5’s markets. This wouldn’t be a disaster, because recall that we are talking about marginal movements in revenues. In addition, most forecasters are certainly not foreseeing a recession, but the potential for disappointment remains.

I would conservatively reduce revenue forecasts by 5% and, based on the assumptions above, this would still give a range of $128-141 as a target price, pending on which stance you want to take on the stock. And, more importantly, how you might tolerate the stock price reaction to any future short term negative news.