Wednesday, April 10, 2013

Is it Time to Buy F5 Networks?

F5 Networks $FFIV pre-announced results and delivered the kind of eye watering earnings miss that only small company technology investors can fully appreciate. In truth it was a pretty nasty miss on the top and bottom lines. As ever the market will react with a savage markdown and then start guessing at the causes. Is this an F5 issue or does is it an issue of broader based technology weakness?

F5 Networks Misses Estimates

In order to fully appreciate how bad this miss was it is worthwhile looking at what F5 said last time around. I’m going to highlight a few takeaways from the recent pre-announcement.

  • Q2 Revenues expected to be $350.2m vs. internal forecast of $370-380m

  • Non-GAAP EPS expected to be $1.06-1.07 vs. internal forecast of $1.21-1.24

  • Telco sales down sharply and below company guidance.There was broad based telco weakness and in North America in particular. F5 said the pipeline was there but deals failed to close at the rate it had expected.

  • US Federal Sales down significantly

  • Enterprise sales were described as being ‘okay’

  • Japan and Asia Pacific were ‘in line’

  • F5 is undergoing a product refresh

A graphical depiction of the effect on revenue growth.

To make matters worse a rival Application Delivery Controller (ADC) provider Radware $RDWR followed up by announcing that it would miss its own revenue guidance for the quarter by 8% and earnings by over 20%. So is that game over for the ADC market? Furthermore with industry forecasters putting F5’s market share at 50-60%, if the market is saturated then how does this speak to F5’s prospects?

F5’s Prospects

To answer this we have to delve into the detail of what happened and unfortunately it is not clear. Indeed Radware stated that EMEA and China were weaker than expected but described US sales as being ‘strong’. Note that this is almost a mirror image of what F5 said about its regions. I appreciate that F5’s sales are nearly 8x that of Radware’s (always view F5’s as more accurate) but this variance in regional performance does raise questions.

Furthermore as F5 has such a dominant market position it is somewhat susceptible to encroaching competition from Citrix Systems $CTXS and others. Indeed there has been some significant activity on that front. Late last year Cisco Systems $CSCO announced it wouldn’t be making new investments in its Application Control Engine (ACE) products and instead would be recommending and Citrix’s ADC NetScaler to its customers while integrating it into its network technology. It’s an expansion of its overall strategic partnership with Citrix.

Of course it also gives F5 opportunities and the company claimed that its rate of closure on the ACE contracts was better than the rest. This implies that this isn’t really a problem of the new customers and contracts that came up.

As for the ‘market saturation’ argument –and no doubt you will be hearing a lot more about this in the next few weeks- I’m not convinced. There may well be a short term affect as customers try and hold back on investment in technology that they feel they are well covered in (this is normal with all industry cycles) but, the truth is that the rise in bandwidth rich applications and, the need to move them around the net seamlessly and without degradation,  is still rising significantly. Hardly a day goes by without a corporation announcing significantly more investment in its e-commerce or social media strategy. Indeed F5 did say that the pipelines were there but they just couldn’t close them in the quarter.

So if it isn’t macro, new customers, or market saturation, then what is it?

What Went Wrong?

My best guess is this that it’s a combination of factors. To fully appreciate them it’s useful to go back to a breakdown of its key verticals.

  • The sequester looks like it had an effect on US Federal spending

  • The telco sector snapped back in Q1 from declining previously and has now fallen back again. This could be a case of the sales force bringing deals forward into Q1 and then management assuming a similar rate of deals would close in Q2.

  • F5 mentioned that the pipeline deals that didn’t close were with F5 customers and its possible that this is because Citrix and others are pushing for their solutions to be benchmarked against F5’s new products

  • In a tough environment customers may feel inclined to try and hold off spending when there are various options in front of them

In addition investors need to recall that product refresh cycles can have an effect. Indeed Riverbed Technology $RVBD had significant problems when it upgraded its product range only to see sales come back nicely. Sometimes product upgrades and refreshes give companies a reason to pause and assess options and Riverbed certainly saw that last year with its WAN optimization solutions. Would it be a surprise if a similar body of customers took the same approach with F5’s product refresh amidst competitors upping their competition? What is more disappointing is that F5 made some pretty positive noises about the new products in its last conference call.

In conclusion, I think this may well be a combination of the product refresh causing telco customers to pause, the sequester and a high market share which is attracting competition. We will get a clearer reading when F5 formally reports its earnings and when Citrix Systems discusses its ADC performance in the quarter. For now I think cautious investors may want to stay clear.

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