Sunday, September 2, 2012

F5 Networks Equity Research

In a final proof that investors really are not willing to hold a stock for more than five minutes these days, F5 Networks $FFIV was sent sharply higher even though it warned of a cautious spending environment and gave guidance below analyst estimates. The market was probably anticipating a whole lot worse and no one seems to have any patience with holding stocks if there is any kind of tangential negativity around them right now. Indeed, stocks catering to proprietary technology spending have been subject to no end of negative sentiment recently.
Perhaps investors can now start to remember that value does actually matter!


Why F5 Networks is Less Vulnerable in a Slowdown

What makes this company attractive is that it has secular growth drivers that give it some insulation from the ravages of a weak technology spending environment. For the uninitiated, 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.

In other words, every time you see a kid holding something electronic whilst surfing or watching a video stream, it's good for F5.

CEOs maybe keen to cut back on certain areas of spending, but investing in mobile apps and taking advantage of mobile traffic growth is not one of them. You only have to look at how Google $GOOG  is restructuring its business in order to monetize mobile through search and ad placement. The shift to mobile internet usage is tangible and companies won’t stop spending in this as it is a secular trend.

The need for corporations to engage with social networks and other virtual environments is also seen as being a secular shift in how companies do business. Similarly, the demand for bandwidth is creating consolidation and security issues at data centers. All of these things play into F5’s strengths.

So What Happened With The Results and Guidance?
After fellow networking play Acme Packet $APKT gave horrible results and guidance, the market was understandably nervous about F5's upcoming results. However, I think there is a strong case to be made for the former being too optimistic in its previous outlook and operating in some difficult end markets. F5's results were nothing like as bad.

The Q3 results were pretty much in-line but the guidance was a little weak relative to analyst expectations and historical trading patterns. Analysts had forecast revenues of $377m and EPS of $1.24 for Q4 but F5 guided towards $360-370m and EPS of $1.16-$1.19. No matter, the stock went higher as investors breathed a sigh of relief. Historically the guidance was a bit weak too.
Here is how F5’s sequential growth rates have moved in the past.




The Q4 guidance is notably lower than it has been in recent years and is only slightly above what the company recorded in Q4 2008. But so what?

Unless you believe that we are heading into another global recession this sort of optic should not scare investors too much. After all, the weakened guidance of $360-370m in revenues still implies a 16% growth.


Weakness Was Macro Based Not Industry

One surprising aspect of these results was that F5's management reported that they saw caution across a broad base of sectors rather than in any specific vertical. This is somewhat surprising given the weakness in telco spending that saw many others.  There was a decline in the telco sector but this was as expected following a very strong quarter previously. I would have expected worse from the Telco sector. Again, this suggests that F5 are relatively less vulnerable.

I’ve broken down the industry verticals for the last two quarters.

SectorQ2 Revenue ShareQ3 Revenue Share
Telco27%22%
Technology19%16%
Financial16%23%
Government12%12%

As for the European exposure, F5 said a similar thing to what Check Point $CHKP talked about recently. Europe is a wide and varied region and different countries have considerably different prospects. Generally speaking the North is doing ok but the South is struggling.  In any case, Europe only makes up 21% of current revenues with the Americas contributing 57%.

Incidentally, Check Point is a good company to reference because it competes with F5’s nascent data center security business. The former recently gave a decent set of results too.


Where Next for F5 Networks?

On a PE basis this stock is obviously very expensive and it is easy to dismiss it on that basis. However, the company generates large amounts of cash flows ($440m in free cash flow on a trailing basis) and earnings are somewhat unrepresentative of the true value because the profit and loss sheet contains significant non-cash items (stock options). In addition, a lot of its sales get booked as deferred revenues and then get recognized in time. Product revenues actually grew 15.4% in this quarter so the underlying picture remains sound.

I think the stock is attractive at this price but be prepared for volatility and lots of it!