Monday, November 4, 2013

F5 Networks Offers Confusing Guidance

It's been an unusually volatile year for technology companies, and the fun isn't over yet. The latest tech company to give varied results and guidance is application delivery controller provider F5 Networks (NASDAQ: FFIV  ) . In short, the company pleased the market by getting back to product sales growth, but its guidance and outlook were somewhat disappointing.

F5 Networks' volatile year

F5 ends its financial year in September, and its fourth quarter results told a tale of two varying halves. Moreover, its guidance left more questions than answers.

  • Fourth-quarter revenues of $395.3 million vs. guidance of $378 million to $388 million

  • Non-GAAP EPS of $1.26 vs. internal guidance of $1.17 to $1.20

  • First-quarter 2014 revenue guidance of $390 million to $400 million

  • First-quarter non-GAAP EPS guidance of $1.17 to $1.20

While the fourth-quarter results were a handsome beat, the guidance is either excessively conservative or hints at some potential disappointment in future. The following chart demonstrates the welcome return to product sales growth (something that F5 previously highlighted as its “No. 1 priority”). It also shows the growth deceleration in the first half vs. a recovery in the second.

Source: Company presentations, Author's analysis.

Service growth slowing in 2014 for F5 Networks?

 As the chart suggests, services growth tends to lag product sales growth (which is why the latter is so important) and you need to put this into the context of F5's guidance for the next quarter. I have a few points on this issue.

First, at the mid-point F5 is guiding toward revenue of $395 million, however its management stated this on the conference call:

We would expect to see product revenue growth year-on-year each quarter next year.

Its product revenue growth in the last quarter was 1.2%, and if you assume it’s the same again in the next quarter its product revenues will be $207.2 million. This implies that its service revenues will be around $187.8 million, meaning that its service revenue growth will slow to 16.9% in the first quarter. Visualize that on the chart above to see the deceleration.

Second, the estimate for first quarter revenue growth of 8.1% looks reasonable in the chart above. However, you need to put into the context of sequential growth. In fact, the sequential guidance for the first quarter is the weakest for the last seven years excluding the 2009 recession.

Source: Company presentations, Author's analysis.

Frankly, either the guidance is excessively conservative or F5's second-half momentum is going to slow going into 2014.

Citrix Systems, Radware and Cisco

Overall it's been a disappointing year for F5, particularly as it started the year with three key tailwinds. First, it's starting to see traction with its data center security solutions, disclosing that 30% of its product sales last year were made with a security solution included. Second, Cisco (NASDAQ: CSCO) announced last year that it would cease new investment in its application delivery controller product called ACE. Instead, it intended to work with F5's chief rival Citrix Systems (NASDAQ: CTXS) and recommend Citrix's NetScaler product.

F5 obviously has an opportunity to replace legacy ACE systems. Indeed, it announced that it won over 900 ACE replacement projects in its financial year, and argued that the ACE market represented a 'two to three year market' opportunity.

The third tailwind was the launch of what F5 called its “largest appliance product refresh ever.” Unfortunately, sometimes when technology companies launch new products it can cause some short-term purchasing delays. Customers may want to hold off purchasing the older products, yet wait to assess the new products. In fact, F5 argued that this was partly the cause of the slowdown in the first half. However, if this is the case then why is the sequential guidance for the next quarter so weak?

Furthermore, Citrix just reported that for its ADC NetScaler:

The cloud and Internet segment was slower than expected due to the timing of large orders and coming off such a strong growth quarter in June.

Another ADC company Radware has been arguing that there has been a reset of pricing at the low end of the ADC market in recent quarters, even while it confirmed that it continued 'to see activities of customers replacing Cisco ACE'.

Where next for F5 Networks?

 In summary, despite the three tailwinds for F5 discussed above, there is evidence that its market conditions got tougher this year. Indeed, the company forecast a possible 50 to 100 basis point drop in gross margins next year, due to the need to invest in lower margin consulting services. Although, this doesn't imply a drop in product sales margins, all investors will really care about is the impact on its bottom line.

All told, F5 is an attractive stock if you think the guidance is too conservative. It may well turn out to be, but there are enough question marks to cause a bit of discretion over the stock.

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