What F5 Networks Needs to do in the Second Half

One of the hardest things to do in investing is to buy a stock that you know is out of fashion. With application delivery controller (ADC) specialist F5 Networks (NASDAQ: FFIV) you have a classic case of a technology company that is attractively valued, but seeing slowing growth.

Typically, the market doesn’t reward such companies, and you can find yourself waiting a long time for the market to come around to your view. On the other hand, if F5 can get back to growth the upside potential is significant.

F5 shifts

The recent third-quarter results were a return to form for F5 Networks:

• Revenues of $370 million vs. internal guidance of $355 million to $365 million

• Non-GAAP EPS of $1.12 vs. internal guidance of $1.06 to $1.09

• Fourth quarter (Q4) revenue guidance of $378 million to $388 million

• Q4 Non-GAAP EPS guidance of $1.17 to $1.20

The stock appreciated sharply on the back of the revenue and earnings beat, but you need to look at the numbers in the context of long-term trends. 

Source: F5 Networks accounts.

Growth is clearly slowing at F5 Networks, and the guidance for Q4 isn’t particularly positive, either. With that said, Q3 was a significant improvement over F5’s nightmare in Q2. Essentially, its telco service provider revenues made a bit of a comeback.

Source: F5 Networks presentations.

F5 wasn’t the only company to report some weakness with spending from telco service providers in the spring. Other IT companies such as Fortinet reported a similar story. The good news is that some of the deals that slipped over from Q2 were closed in Q3. In addition, its U.S. enterprise revenues were surprisingly strong, particularly in an earnings season where tech bellwethers Oracle and IBM gave disappointing results.

Growth prospects?

The real question for investors: Can F5 get out of its low-single-digit revenue-growth funk?

To do so, it must get product sales positive again. Representing 53% of total revenues, these sales declined 5% on the quarter, and are down 3.7% over the first three quarters. Indeed, on the conference call, F5’s management declared that generating product revenue growth would be its “No. 1 priority.” In the long term, its service revenues growth depends on getting more customers to install its products.

Moreover, there are other concerns with F5 Networks:

• The company has a dominant market share (over 50% according to most industry sources), so it will find it hard to grow by gaining market share from here.

• Citrix Systems (NASDAQ: CTXS) is growing its application delivery product NetScaler. Cisco Systems (which has discontinued investing in its ADC product) is recommending that its existing ADC customers integrate Netscaler.

• The ADC market may be maturing, and thus only capable of supporting low single-digit growth in future.

• F5 has significant revenues in the Governmental sector (see chart above), which may be challenged by austerity measures.

• F5 generates very high gross margins of 83%, which may come under threat if competition increases while the market matures.

• Smaller competitors like Radware (NASDAQ: RDWR) are also seeing weak conditions.

F5 described Citrix as its No. 1 competitor “by a mile”. In contrast to F5, Citrix recorded strong growth of 46% in its networking and cloud revenues in its recent quarter. Moreover, on its conference call, Citrix stated that NetScaler was the “major driver of growth in the quarter” for its networking division.

Not only does Citrix have the advantage of its relationship with Cisco Systems (as discussed above), but it also can bundle NetScaler with its market-leading desktop virtualization solutions. Indeed, it stated that this type of bundling deal was up 20% in the last quarter.

In comparison, Radware reported revenues and gross profits that were flat on the quarter. On its conference call, it stated that the underlying conditions were very good for the industry, but also talked of “some new platform pricing by some of the competitors that have simply brought down the average sale price.”  If Radware’s commentary is accurate, then competition is increasing, and Citrix appears to be the big winner in 2013.

The bottom line

In conclusion, F5 Networks reported a better quarter, and the return of telco spending is a good sign. In addition, its guidance looks a bit conservative. By my calculations, the company has generated more than $467 million in free cash flow over the last four quarters, which puts it on a free cash flow yield of nearly 7% as I write. This is a generous valuation, as it seems that the market is pricing in a significant amount of doubt over its future cash flow growth.

While the stock is undoubtedly cheap, my hunch is that it could remain so until F5 gets back to reporting growth in its product sales, and it’s hard to get too excited about the stock until it does so.