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.

Key Earnings This Week

It's the heart of earning the earning season, and results are coming fast and furious. It's impossible to cover all the stocks, so I am going to pick out some of the more interesting companies that are expected to report. 

Tuesday
Affordable luxury company Coach's outlook on emerging-market spending will be closely followed, as it will attempt to regain market share from Michael Kors. LED manufacturer Cree will hope to report high growth in LED lighting sales, just as Acuity Brands did a few weeks ago.

Whirlpool will give an update on the market for appliances, as well as its margin-expansion plans. Tool maker Stanley Black and & Decker gave weak results, but it seems to be mainly a problem with a European acquisition in the security market. In other words, it shouldn't spell bad news for Whirlpool.

Numbers from human resource consulting firm Robert Half will be fascinating. The company's earnings have historically correlated with U.S. employment prospects, and conditions are getting steadily better in America. But what will it report on Europe?

WednesdayIt is a big day for aerospace, with Boeing and B/E Aerospace giving earnings. Other bellwethers giving numbers include AT&T and Caterpillar. However, the day belongs to the technology sector.

Citrix Systems (NASDAQ: CTXS  ) has already disappointed the market by pre-announcing third-quarter earnings significantly below its previous guidance. Revenue was light by $24 million, and investors will be keen to find out more when the full release is given. It will probably be less worrying if it came from its application delivery controller NetScaler. Citrix competes with ADC market leader F5 Networks (which also gives results on Wednesday), and some lumpiness NetScaler's growth will probably be forgiven.

However, if the shortfall came from Citrix's core desktop virtualization offering, then it could spell deeper underlying trouble. The key metric to follow is its product and license sales growth, particularly within mobile and desktop. Previously, Citrix management had been calling for an acceleration in mobile and desktop license sales, but are those plans still on track?

Data center provider Equinix's (NASDAQ: EQIX  ) share price has been weak amid fears of slowing growth. Previously, it reduced its forecast for growth in the second half, mentioned some softness in Germany, and admitted to longer sales cycles within its enterprise markets. All of the data center providers have been aggressively expanding capacity, and it's possible that they're starting to lose pricing power due to overcapacity.

The three key metrics to follow are its gross margins, client retention ratio, and its "adjusted discretionary free cash flow." The first two numbers are indicators of its pricing power and competitive positioning, and investors will not want to see them falling. The cited cash-flow measure helps gauge the underlying cash-flow generation in the company and is probably the best way to evaluate a company in a rapid expansionary phase.

The third featured tech stock is Fortinet (NASDAQ: FTNT  ) . It's hard to know what Fortinet will report, and the stock tends to be highly volatile over earnings. However, its guidance for the third quarter looks a bit cautious.

Source: Company accounts; author's estimates.

It is a competitive market, and rivals such as Check Point (which reported expectation beating results this morning) have new products out, while fast-growing newcomer Palo Alto Networks will be determined to expand its installed base. One thing to look out for will be how many larger deals ($500,000 or more) it reports in the quarter. This is a good indication of its ability to further expand outside of its core (small and medium-sized) business market.

ThursdayColgate-Palmolive and nutrition company Mead Johnson will update the market on the state of the emerging consumer. Other closely followed companies will include Microsoft and energy services company Flowserve. Investors in Zimmer will be cautiously awaiting results after Johnson & Johnson gave a disappointing outlook on pricing in its orthopedic solutions.

FridayFridays are relatively quiet, but the big earnings of the day will come from Procter & Gamble. In addition, Sherwin-Williams will update the market on the state of the painting and coating industry.

Citrix is Dealing Well With Changing Trends in IT

It helps to have powerful friends, and very few companies have allies as strong as IT virtualization specialist Citrix Systems (NASDAQ: CTXS  ) . With partners Cisco Systems (NASDAQ: CSCO  ) and Microsoft (NASDAQ: MSFT  ) helping to push some of Citrix's newer solutions, the company looks well-positioned to grow, even as its core desktop virtualization sales are slowing.

Citrix's changing end market

Desktop virtualization allows companies to centralize their application software management so that their hardware (PCs) become virtual devices. Installing new applications on a single central computer -- and having those changes instantly show up on every employee's PC -- makes managing IT infrastructure a lot easier for big companies.

The big story in computing over the last few years has been the shift from desktop PCs toward mobile devices and cloud-based solutions. This powerful trend has left some tech behemoths, like Microsoft and Intel (NASDAQ: INTC  ) , struggling to remain current.

Simply put, Microsoft's Windows has very low penetration on mobile devices. Meanwhile, Intel has been too slow to develop chips for the new ultra-mobile world, and the second half of 2013 is going to be an important period in its long-term plans. Within those six months, Intel is releasing a few new chips with which it is trying to establish a foothold in the ultra-mobile market.

All of this forms the basis for discussion of the challenges facing Citrix in 2013. If PCs are no longer the dominant force in computing, and Windows is no longer the default standard operating system, where does this leave Citrix's core desktop virtualization market?

XenMobile to the rescue

Citrix hasn't been slow to adjust to the changing reality. In the first quarter, it released its enterprise mobility solution, XenMobile. Unfortunately, it seems to have affected its growth pattern. Indeed, at the time of its first-quarter results, Citrix argued that the XenMobile release caused customers to delay orders as they assessed which type of solution was optimal. A chart of product revenue growth reveals how choppy the company's growth has been as a consequence.

Source: company accounts

Growth in products and licenses is the key to growth in the other revenue streams.

The second quarter saw an impressive bounce back in overall product and license sales growth. But within that, mobile and desktop only generated a 2% increase. So, even though mobile and desktop revenue actually rose 11%, Citrix's future growth is not assured.

However, on the conference call, management was keen to stress that: "...regarding mobile and desktop, I believe that the growth will accelerate as we look into Q3 and Q4. And that's a function largely of productivity starting to flatten out and mobile starting to ramp."

Desktop virtualization and application delivery controllers

Alongside the plan to push XenMobile -- which, by the company's own admission, is hurting its efforts to sell its stand-alone desktop solutions -- Citrix is also releasing its latest desktop virtualization solution, XenDesktop 7. Microsoft has a vested interest in helping this solution succeed because it brings Windows virtual desktop and apps under one structure, encouraging corporations to keep running Windows.

While XenMobile and the XenDesktop 7 are about generating future growth in mobile and desktop, the current star performer is Citrix's networking and cloud division. The latter grew revenue at a whopping 46% in the quarter, with product license revenues up 54%. In fact, the share of total revenues coming from networking and cloud solutions has risen from 16% in 2010 to around 22% so far this year.

Source: company accounts

The biggest contributor to growth in networking and cloud revenue came from Citrix's application delivery controller, or ADC, NetScaler. F5 Networks (NASDAQ: FFIV  )  is the global leader in this market, but Citrix's NetScaler has a couple of key advantages.

First, Citrix is able to include NetScaler as part of its virtualization offerings. Indeed, it announced that it signed 550 desktop virtualization orders in the quarter on this basis. Second, Cisco Systems is a key partner of Citrix, and since Cisco stopped investing in its own ADC (called ACE), the two companies have teamed up to sell NetScalers.

There is more growth to come. On the conference call, management argued that the replacement orders for Cisco's ACE only contributed a "minor amount" to the current results. In other words, Citrix still has a significant amount of Cisco's installed base of ACE customers to target in the future. Naturally, F5 will also fight hard for this business, but it's difficult to conclude that Citrix isn't taking market share at the moment.

The bottom line

Essentially, Citrix investors should be looking for a few things going forward:

• A strong return to mobile & desktop product license growth in the second half

• Ongoing sales execution from NetScaler

• Its partners, Cisco and Microsoft, continuing to integrate functionality with Citrix's solutions

The desktop virtualization market is far from dead, and still has some good growth catalysts. In addition, the changing tides in IT spending are about integrating solutions across multi-platforms, so Windows still has a key role to play. Meanwhile, XenMobile and NetScaler promise to offer alternative sources of growth.

Finally, Citrix's valuation does not look historically expensive.

CTXS Price to Cash Flow TTM data by YCharts

Provided it can execute on the above points, the analysts' consensus price target of $80 looks achievable. It's well worth a look.

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.

Palo Alto Networks Disappoints

The most surprising thing about Palo Alto Networks' (NYSE: PANW) recent results were that the market was surprised by them. In truth it has been a difficult first quarter for technology companies, and despite having defensive characteristics (IT security threats are definitely not going away) its sector hasn’t been oblivious to the difficulties. In summary Palo Alto missed estimates and guided lower than the market consensus with the usual concerns over Europe and Government coming to the fore.

Palo Alto gives little succor

Probably the most interesting aspect of these results was the timing. Its security rivals like Check Point Software (NASDAQ: CHKP) and Fortinet (NASDAQ: FTNT) had already given weaker than expected results amid talk of customer hesitancy (partly due to sequestration fears) and a faltering macro environment. If this was to prove temporary then we might have hoped that Palo Alto would report better conditions given that it is already June. Unfortunately it intimated that things got worse in April (the back end of its quarter), and performance in May was only ‘in line’ with its adjusted guidance.

Here is a chart of Palo Alto’s performance.

Note that product revenues saw a sequential decline in the quarter, and while the revenue guidance for Q4 of $106 million to $108 million implies a near 43% rise in revenues (at the mid-point), it is below the market estimates of $113.7 million. On such things do tech stocks soar and crash.

To put this into context, Fortinet had already warned, and as articulated in an article linked here, it will have to see a bounce back in the second half in order to hit even the lowered guidance. Palo Alto’s recent statements would not suggest that underlying conditions have improved much so I would suggest taking Fortinet’s word (that Q2 would be similar to Q1) at face value.

In addition Fortinet stated that its service provider revenues were weak in the quarter. This is a similar story to what F5 Networks (NASDAQ: FFIV) outlined over its application delivery controller based revenues too. The good news for Palo Alto is that, although it did see some ‘softness on its service provider based revenues, they do not make up a significant part of its overall revenues.

What caused the miss?

It is really about sequestration effects and Europe, specifically Southern and Central Europe. Palo Alto saw a $3 million-$4 million shortfall in sales from this region. Overall EMEA sales declined 4% on a sequential basis.  As for federal work the weakness seen was largely a consequence of sequestration effects. We can also see these effects on federal spending in a detailed look at F5 Networks' recent results.  With regards to F5 specifically, I note that Citrix Systems had a pretty good quarter with its rival product, and since F5 is undergoing a product refresh there may be other factors at play here.

With regards to competition there were a couple of interesting points made in the conference call. Firstly, Palo Alto’s management doesn’t feel that ‘bundling’ will get the job done anymore. I suspect this is a reference to competitors like Cisco Systems or Juniper Networks who may well try to include security solutions as part of their networking offerings. Indeed, Cisco’s security revenue growth turned negative in the last quarter.

Second, there were the usual references to beating out Check Point and others in the presentation. As a young and fast growing company we should expect Palo Alto to be replacing the installed base of competitors, but in retrospect Check Point’s recent results were relatively good, and there are some signs (average selling prices rising) that it is getting over the hump of convincing its customers to buy its upgraded products.

Where next?

It’s hard to be overly positive because it would have been useful if Palo Alto had reported better conditions in April/May but, the fact is that they did not. With that said the bullish case sees the sequestration effects as causing some short term reactions, much of which will be ironed out later in the year. Sequestration has its most obvious influence on public expenditure, but it will also affect the private sector because the former uses the latter. However, once the fear of the unknown recedes then companies like Palo Alto and Fortinet can hit their revised guidance.

The bearish case argues that these effects will continue to slowdown the IT market as the knock-on effects ripple through the economy and guidance will have to be lowered for many of these companies. Meanwhile the situation in Europe is hardly looking much better with sovereign debt issues remaining at the forefront of concerns.

Since we have never had sequestration before, it is hard to know which approach to take! My gut feeling is that things won’t get much worse. Unemployment is falling in the U.S., and growth is moderate but constant, while the housing market is picking up. F5 Networks has some uncertainty about it and Check Point needs to demonstrate it can get back to product revenue growth. However, if you are going to buy Palo Alto and Fortinet then this could be a decent time to start thinking about picking some of these names up.

Is Buying After a Tech Company Crashes a Good Idea?

It’s been an unusual earnings season so far. The market has kept moving higher even though many tech companies have warned. This can appear counter intuitive because tech is usually seen as a cyclical part of the economy. In other words, if tech is slowing down, then the economy will do too. Surely, if tech companies are warning, the market should be pricing in a slowing of growth rather than moving up in anticipation of stronger growth?

Pricing in a recovery?

One explanation for this is that the first quarter saw a weakness in technology spending which should be rectified in coming quarters. Indeed, I have suggested some reasons why this might be the case in an article linked here. If this argument is correct, then buying after the tech companies warn should be a good tactic. The chances are that expectations will have been lowered and the falls would have created some decent entry points.

In order to avoid the dangers of relying on anecdotal evidence and hearsay, I decided to take a bit of a methodological approach and see if the data supported the idea. 

The companies in this graph are those that warned or gave disappointing results in the current earnings season. They were garnered from the NYSE Arca Tech 100 Index. I have excluded biotech and focused on the IT hardware and software companies.

The blue lines are the stock’s performance since the day after the warning and the green lines are how they have performed against the S&P 500 since they warned. The data is current till April 20.

I think the evidence is pretty clear. Tech companies have tended to outperform the market since they warned. I appreciate that part of this effect might have been investors looking to buy stocks that looked ‘cheap’ in a rising market, but on the other hand, the evidence above is pretty broad based.

If I am right about this, then investors should start to look at potential tech company warnings as buying opportunities.

Who said what?

It’s time to look at a few of these companies to see what the specific issues were. This is useful because it helps us understand what is causing this effect.

I’m going to start with Oracle  and International Business Machines Oracle blamed its disappointing earnings on sales execution failures. This is partly a consequence of adding significant numbers of new salesmen and the inevitable disruption that this causes. In addition, its management argued that the pipeline was still in place, it was just that deals were not completed at the rate that they had expected. Oracle expects these issues to be ironed out ‘quick’ and argued that it wasn’t losing any market share.

Thinking longer term, Oracle does have question marks over some hardware product transitions and dealing with the affects that the shift to the cloud (Oracle still has substantive legacy software sales) will have on its revenue.

IBM delivered a very rare miss and I took it as an opportunity to buy some more. In a familiar refrain, it blamed sales execution but also managed to discuss the sequester, the change of Chinese leadership, the timing of Easter, and even the weather.

The good news is that -- just as Oracle did -- it argued that the pipeline hadn’t been reduced and deals weren’t lost to competition. It’s just that its sales guys just had a hard time closing deals in the quarter. The response was to do as IBM does and make some operational adjustments (workforce re-balancing) in the next quarter.

Citrix Systems also saw revenue and earnings come in lighter than expected. In addition, its Q2 earnings guidance was significantly below estimates. In actuality, it was a mixed quarter for Citrix. Its Netscaler product (an application delivery controller that competes with F5 Networks) saw good growth, but its core virtualization growth was disappointing. The latter has higher margins, so the net effect was to reduce expectations for overall margin growth in future.

It’s always worrying to see a company’s core activity slowing, but Citrix had a feasible excuse. It launched its XenMobile mobility solution in Q1 and it is entirely understandable if some of its customers may have decided to hold off purchases while they assess buying the new product. Again, Citrix outlined that its full year plans were ‘on-track’.

The bottom line

In conclusion, all three companies saw what looks like some temporary weakening caused by hesitation among customers rather than a reduction in overall spending plans. Although they all had their own reasons for disappointing, there was a common theme. All three saw their pipelines intact but customers exhibiting caution in their spending decisions. If this dissipates in future quarters (and it may do so after the media stops talking about the sequester) then buying these names, and others within technology, will prove to be a wise choice.