Monday, December 10, 2012

Why I Bought More F5 Networks

F5 Networks (NASDAQ: FFIV) gave weaker than expected results and guidance, and the market did what the market does: immediately beat up the stock. In truth, it was hard to predict what the results would be, but the stock was cheap before the results and I think (despite the downgrade to earnings) it is even cheaper now. On balance, I think the stock is worth buying some more of, so I did. Here is why.

F5 Networks Results

A brief summary of the Q4 results.

  • Q4 Revenue of $362.6 million vs. estimates of $365.9 million
  • Q4 Non-GAAP EPS of 112c vs. estimates of 118c
  • Q1Revenue guidance of $363-370 million vs. estimates of $373.5 million
  • Q1 Non-GAAP EPS of 114-116c vs. estimates of 120c

So it’s a miss based on Wall Street estimates and also a downgrade to expectations. More importantly, it’s an earning miss based on F5’s own estimates. Back at the last results, it had forecast revenues of $360-370 million and non-GAAP EPS of 116c-118c.

There is no doubt that growth is slowing at F5, as evidenced by the downward movements in estimates. A chart of year on year revenue growth demonstrates this.

To put this into perspective, the forecast for Q1 2013 growth is for F5’s revenues to slow to 13.7% growth, and plenty of companies would give their back teeth for this kind of growth right now. On the other hand, there are some concerns over the composition of current earnings and the potential for disappointment in the future.

Telco Spending Weakening

In its commentary, F5’s management talked of a reluctance in customers to sign off larger deals ($1 million+) but did not highlight any particular weakness in any verticals on this front. However in terms of verticals there is a clear pattern emerging.

Telco spending has slowed in the second half, and this is in line with what has been reported elsewhere in the sector. For example, AT&T (NYSE: T) and Verizon (NYSE: VZ) have both been reducing capex expectations this year. For Verizon, it is part of the long term gameplan, and it has aggressively reduced spending plans over the last few years while AT&T could be under pressure to reduce spending as a consequence of a weaker macro environment. Verizon has largely rolled out its wireless networks and is trying to reduce capex as a percentage of revenues while AT&T seems to be shifting its spending to next generation networking.

The market was somewhat disappointed with F5’s telco performance because Riverbed (NASDAQ: RVBD) also has significant exposure to Telco and has very similar growth drivers to F5. Its results were fine, but this update from F5 suggests that things might not be so strong going forward. Riverbed’s relative strength is likely to be a consequence of its product transition causing a bottleneck of demand which is now being released.

F5’s in 2013?

Going forward, F5 declared that it expected sequential improvement in 2013 and its earnings to be back end loaded through the year. New launches and product refreshes are forecast to drive growth in the second half.  There is also a growth opportunity from its nascent data center security solution.

Moreover there is a significant growth opportunity from Cisco Systems (NASDAQ: CSCO), which is not investing in its application delivery controller (ADC) product. This is great news for F5 and, listening to the commentary, it doesn’t appear that any undue optimism was baked into F5’s forecast from this. In other words there is upside potential here. This development is also a statement that Cisco cannot compete with F5’s technology.

Here is how F5’s traditional sequential revenues move with the forecast for Q1 included.

The guidance for Q1 is a lot weaker than how revenues move sequentially for F5. In my view this is probably due to ongoing weakness in Telco plus the traditional reduction in Government spending.

Where Next For F5 Networks?

I think investors need to avoid the trap of letting short term market movements push them around. This company has just generated $465 million in free cash flow on a yearly basis. As I write this, the enterprise value is around $6.9 billion, so it has just generated 6.7% of this in free cash flow. Frankly the stock is cheap even with no growth assumed for 2013. Even if earnings growth forecasts (currently in the mid-teens) are lowered a bit, the stock will remain cheap. In terms of relative valuation, where do you find, say, a food company trading with double digit growth prospects?

No one likes holding stocks that are facing tough times, but based on this evaluation don't be surprised if F5 reports results in-line with expectations next time around and the stock soars. I bought some more.

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