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.

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.

Oracle's Results Reveal Tech Weakness

The last thing the tech market needed right now was a disappointing set of earnings from Oracle (NASDAQ: ORCL), but unfortunately that is exactly what it got. It would be an understatement to say that it has been a difficult 2013 so far for the tech industry and these numbers will do little to assuage many fears. But what do they mean for Oracle and how do they relate to the rest of the tech world?

Oracle disappoints, again

Looking back at an analysis of the previous quarter’s earnings Oracle missed its own guidance and this quarter saw some key numbers coming in at the low end. For example Oracle had forecast 1-4% overall revenue growth (they came in at 2% in constant currency), new software license and cloud subscription growth was forecast to come in with 1-11% growth (the result was 2% growth). The one ‘bright’ spot was that hardware systems product growth was forecast to be negative 12-22% and came in at the high end with a negative 12%.

Clearly the numbers came in towards the bottom of the guidance ranges. All of which is somewhat disappointing given that many investors have been hoping for a second quarter (2Q)  bounce back. Last time around Oracle blamed some sales execution issues and the timing of the sequester. However it calmed investors by describing its pipeline as being up and, claimed that the issue was really about the timing and execution of deal closure.

Well it was a different story this time around with sales execution quoted as improving ‘significantly’ and economic weakness cited in a few areas like Brazil, China and Australia. Moreover, transaction sizes were described as being smaller (a sign of economic pressure).

The good news from a geographic perspective was that its US and EMEA performance were as expected with 4% and 5% new license growth respectively. The problem was with Asia-Pacific down 7%. This is a worrying sign for the industry because many technology companies are relying on Asia for growth.

What the industry is saying

As a bellwether Oracle’s results will be closely watched and those of us hoping for some sort of confirmation of a return to better days would have been disappointed. In a sense it is a mere continuation of what we have been seeing elsewhere. For example, Palo Alto Networks (NYSE: PANW) recently reported results. It missed estimates and guided lower than the market consensus for the next quarter. Although Palo Alto is in a different area (IT security), I found its results interesting because other companies in the sector had previously reported weakness in April. Unfortunately Palo Alto came out and confirmed that conditions in May were only ‘in line’ with the reduced expectations created by a weak April. Another indication of weakness and it appears to be linear.

One interesting aspect of Palo Alto is that its telco service provider revenues do not make up a significant part of its revenues. This is in contrast with other tech companies like say F5 Networks and Fortinet. These companies missed estimates and disappointed with guidance. Both cited weakness in their service provider verticals and this may well continue into the current quarter. On the other hand Palo Alto's results are more indicative of the wider tech spending environment and investors will need to hear some more positive noises from bellwethers like IBM and Oracle before feeling very confident with Palo Alto.

Moreover Oracle is facing some operational challenges as it shifts revenues towards cloud-based solutions. It described its SaaS (software as a service) based revenues as having a $1 billion run rate. This is fine but to put it into context its full year revenues are closer to $37 billion. In addition some cloud-based companies like Rackspace Hosting (NYSE: RAX) have reported some weakness as enterprises still seem keen to use any excuse to withhold IT spending. In fact in its last quarter it declared that its revenue per server declined to $1,308 from $1,310 last year. This is not a good sign for a company supposed to be in a high growth phase. In Rackspace’s case it was partly due to customers delaying purchases of legacy systems while they appraised its new OpenStack public cloud offering. Rackspace also has increasing competition from the likes of Amazon Web Services (who has been cutting prices) and I take this to be another sign that conditions have weakened in technology in 2013.

With regards to Oracle’s direct competitors like IBM (NYSE: IBM) and SAP (NYSE: SAP), these results are obviously not great news and they got marked down in sympathy. Moreover Larry Ellison was quite candid on his view that SAP’s Hana database was ‘virtually never’ seen in the market and even referenced some large German industrial companies that had bought Oracle’s rival Exadata database machine in order to run SAP’s applications. He also suggested that Hana could never successfully compete with Exadata. Frankly there is no love lost between SAP and Oracle, even when it comes to yachting, and this sort of comment has been heard before. Moreover I think SAP’s investors can take some heart from the fact that EMEA (its core market) was a bit stronger than expected for Oracle.

As for IBM, Oracle’s report was a bit worrying. It pretty much reported a similar story to Oracle last time around by blaming things like sales execution, the sequester, the weather and even the change in the Chinese Government. Will it do the same this time? It’s hard to tell but IBM didn’t lower its full-year forecast last time around and announced it would take some workflow rebalancing in Q2. All of which will put some pressure on it to deliver in the current quarter. As for the issue with the Chinese Government, did we see signs of this in the weak results that Oracle just reported?

Where next for Oracle?

The positives in this report were that the transition to new hardware product systems is going a bit better than expected and the US and Europe are doing okay. In a sense it is another story of current macro weakness amidst ongoing change in Oracle’s business as it shifts to cloud based solutions and new hardware products.

In the last quarter it made sense to pick up some Oracle stock after disappointing results and I wouldn’t be surprised if the same applies this time too. The stock trades on an enterprise value to EBITDA multiple of just 7.4 and generates huge amounts of cash flow that currently represent over 10% of its enterprise value. On a value basis the stock looks cheap and I wouldn't be surprised to see Oracle increasing its returns to shareholders in future. It looks a good long term hold but be prepared for volatility as the tech spending environment still looks a little weak this year.

Do Ciena's Results Mean its ok to Buy Telco Again?

It would probably be an understatement to say that it has been a difficult earnings season for companies selling into the telco service providers. After hopes of a second half recovery in 2012 were dashed by a second half slowdown the idea was that pick-up would be pushed into 2013. So far it hasn’t worked out like that. Indeed a host of companies have warned and lowered guidance and even companies who don’t exclusively service the sector like Fortinet or F5 Networks (NASDAQ: FFIV) have cited specific weakness from their service provider verticals.

With that said, what is the market to make of the recent sterling results from Ciena Corp (NASDAQ: CIEN)?  Does its earnings beat and guidance raise mean that telco spending is back?

Is it the industry or is it Ciena?

Answering this question requires an understanding of where the industry and Ciena has come from. My view is that it is more about Ciena than being a general signal that telco spending has recovered. On the evidence so far, the indications are that telco spending is weaker but Ciena is benefiting from some favorable trends in the industry. Investors in the industry would be well advised to try and stay stock specific.

I discussed Ciena in an article earlier this year linked here, and many of the markers that they company laid out then came into fruition in the latest set of results. Therefore these results were really a continuation of positive trends identified by the company. For example in the last conference call it outlined that its Q1 was back-end loaded and Q4 had seen record orders. Clearly that momentum continued into Q2. In addition the product mix is getting better for gross margins too. Its lower margin solutions are in optical transport, and they dropped as a share of revenues from 17.7% to 11.3% in Q1 as overall revenues rose 6.3%. Meanwhile its gross margins improved to 41.2% from 38.2%, and it believes it can hit mid-40’s margins in the future.

What is going right?

The key to the results is that the service providers are expanding expenditures on newer technologies like 40G and 100G high speed Ethernet networking and Optical Transport Networks (OTN). The share of Ciena’s revenues from 40G and 100G rose to 70% from 60% in the previous quarter. Meanwhile its management spoke to 100G and OTN spending being in the first to second innings of a multi-year expansion.

Essentially telcos are having to adjust to huge growth in areas like cloud computing and mobility, which are creating huge increases in data volumes. Furthermore as the switch to wireless from wireline spending gathers apace and 4G/LTE rollouts increase we can only expect more of this. The question is this; if all these issues are coming together then why hasn’t overall telco spending strengthened?

I’ve discussed the capital expenditure plans of AT&T (NYSE: T) and Verizon (NYSE: VZ) in specific articles linked here and here. With regards to AT&T, it disappointed the industry by announcing that its capital spending plans for 2014 & 2015 would be cut by $2 billion respectively so they would now lie at around $20 billion in each year. This sounds like bad news but it was because it got better deployment from its current 4G/LTE rollout and was actually ahead of its plans to deploy 300 million 4G/LTE points of presence by 2014. Again it outlined its shift in spending towards high bandwidth capability and corporate mobility. Good news for Ciena, not so good for legacy technology providers.

Similarly, Verizon talked of caution among its enterprise customers and continued its ongoing drive to reduce CapEx as a share of revenue figure. In a sense Verizon can do this because it began rolling out its 4G/LTE network around five years ago. But as with AT&T, its smartphone penetration rates were higher than expected, with significantly increased amounts of data now being carried on its 4G/LTE network. The pressure to invest in higher bandwidth solutions in order to meet this demand is ongoing. Again Ciena is well placed.

What is going wrong?

Ciena certainly did report strong growth from the big two Tier 1 US carriers. In addition its management stated its international backlog was good too. All of which is fine, but it doesn’t explain why everyone else was so weak in the quarter. Granted plenty of other companies have substantive legacy technology solutions (Ciena is positioned for newer technologies) and no doubt they suffered as a consequence.

But what of something like F5 Networks? They offer application delivery controllers, which ensure applications get moved around networks safely and efficiently. Demand for such products should surely increase in line with the trends discussed above. The fact that it didn’t and other companies reported weak telco based sales is an indication of how easily telcos can shift their approaches to spending. Indeed, Ciena could even see some of this in future quarters. F5 has its own question marks with a product refresh and increasing competition but there is no doubt that its telco vertical was weak.

The bottom line

In conclusion, I think that these results were more about Ciena then the industry. Its long-term outlook is good, but don’t be surprised if there are some bumps along the way. As for the legacy technology providers, this is not necessarily a good report and it is still too early to conclude that the much-awaited pickup in telco spending is coming soon.

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.

Will Fortinet Hit Guidance This Year?

A few weeks ago IT security company Fortinet $FTNT helped kick off a pretty dismal reporting season for technology by pre-announcing a weak set of results. Since then a plethora of other companies have reported and given a myriad set of reasons and excuses for missing. I think it’s fair to conclude that there was a marked reluctance among business to sign off on large tech deals in the quarter. Given that this could be temporary, is it now time to start buying these names?  And with Fortinet, what does its new guidance entail for 2013?

Fortinet Updates the Market

Before going into the color I want to outline the full year guidance changes.

The guidance changes are pretty significant but I think that if they are hit then Fortinet will be higher by the end of the year. As I write the Enterprise Value of the stock is around $2.4 billion. I’ve followed this stock for a while and never seen it trading on a forward free cash flow over enterprise value (FCF/EV) of around (145/2400)=6%. The reason I highlight this metric is to compare it with very low Government bond yields.

It is arguably cheap on this basis alone. Furthermore consider the new guidance was based on a continuation of the weak trends in Q1 continuing in Q2 and most notably coming from U.S. service providers. So if you think this weakness will prove temporary then there could be upside to come. On the other hand my concern is that the guidance appears to imply some pretty optimistic assumptions for the second half.

Is Fortinet’s Guidance Achievable?

Consider that Q2 revenues were guided towards $143 million at the mid-point with $135.8 million reported already for Q1. This makes $278.8 million for H1 but the full year guidance is for $600 million. In order to see what this implies I have included the Q2 guidance plus my guesstimates for what Q3 and Q4 are implied to be. 

I’ve assumed that Q4 will contribute 28.3% of revenues as it has done in the last three years. The Q3 and Q4 numbers are my estimates.

As you can see the implication is for a pretty concerted resumption to growth in the second half and I’m not entirely clear how this can be accepted categorically given the weakness in H2.

Furthermore here is how these numbers look on a sequential basis.

From this graph it looks like the Q3 and Q4 assumptions are for ‘same again’ sequential growth. Fortinet may well do this but given that Q1 & Q2 are notably weaker it does seem to imply a return to better conditions.

Why Was the Q2 Guidance So Weak?

I must confess I was hoping a bit more from Fortinet than it gave in Q2 guidance. If you go back to the analysis of the Q1 results there were three reasons given for the billings miss of around $12 million. Fortinet attributed $6-9m to service providers, Latin America missed by $4-6m and there was an inventory shortage (due to product refresh) which caused a $2 million-4 million miss.  The last two issues were believed to have been able to rectify in the short/medium term thanks to new management and better execution, with the service provider issue being more problematic.   However in the latest statement Fortinet basically said that conditions remained the same in Q2 as Q1. Rather confusingly Fortinet cited challenges in Europe even though a few weeks ago it said Europe was only a bit weaker.

With regards the telco service providers, there can be little doubt that they have been reluctant to spend. F5 Networks $FFIV also reported very weak numbers from its key telco vertical . My suspicion with F5 is that its problems are a combination of weak telco spending, the success of Citrix Systems with its rival Netscaler product and the difficulties in protecting its dominant market position within the application delivery controller market. For F5 and Fortinet the following graph of the latter’s deal breakdown reveals a lot.

I think there is a case for a ‘budget flush’ in Q4 which caused some overdue optimism and lets recall that the previous quarter contained worries over the fiscal cliff while Q1 saw a lot of attention over the sequester. Telco customers tend to do large deals and it wouldn’t surprise if this boils down to a few deals that didn’t close in Q1. So will future quarters bounce back?

The Competitive Environment?

Looking back at the recent results in the quarter I thought Check Point Software (NASDAQ: CHKP) reported a mixed set of results. While Check Point probably needs to generate some product and license sales growth to truly convince, in the light of what the rest of the industry has reported its results are starting to look good. The good news is that yearly comparisons are likely to get easier going forward even if the company doesn't seem to ready to shake off its 'cash flow now but investors wont see any of it' image.

Amongst the discussion of the deal commentary it mentioned winning a seven figure contract with U.S. wire based carrier and replacing Palo Alto Networks (NYSE: PANW) as a consequence. In addition it won a large U.S. deal with a global retailer and beat out Check Point, Palo Alto, Juniper and Cisco in the process. These sorts of wins (and other large deals cited in the commentary) are actually quite impressive because Fortinet is coming from a position as being known as primarily a SMB focused company.

For Palo Alto this sort of thing must be a concern because as a young and fast growing company (with an evaluation top match) it is not a good thing to see others replacing it with security solutions. It has a lot of expectations built into its evaluation. Moreover its solutions are not known for offering a value proposition so given any kind of discounting in the industry it could see its margins cut.

F5 only has security as a very small part of its revenues (and only really in the data center) but many of its customers are in common with these companies and if CFO's have decided to 'go slow' then it will get hit accordingly. My only concern with F5 as a recovery play is that it is undergoing a product refresh which might take a quarter or two to fully filter in. We shall see.

Is Fortinet Worth Buying Now?

As the charts indicate the guidance assumes somewhat of a bounce back in the second half and there are some internal opportunities (Latin American leadership and inventory shortages) which can be rectified but the key issue will be with telco spending.

The good news is that we can keep an eye elsewhere at what other companies are seeing. It has been a miserable reporting season for most companies selling into them and cautious investors might want to wait until one or two companies with telco exposure start saying better things.

Fortinet Starting to Look Interesting

We are very early into earnings season but already two leading tech companies have reported weaker earnings thanks to a reluctance among telco service providers to close deals. F5 Networks $FFIV previously disappointed and now it’s the turn of Fortinet $FTNT to warn over missing estimates.

Fortinet Warns in Q1

The preliminary announcement of results brought with it some disappointing expectations.

• Total billings expected to be $147-149 million vs. internal guidance of $158-162 million

• Total revenue expected to be $134-136 million vs. internal guidance of $138-141 million

The billings miss of $12 million (at the mid-points) was blamed on three factors. In the commentary around the results the managements claimed that $6-9 million was due to the service provider segement, Latin America missed by $4-6 million, and there was an inventory shortage due to a product transition, which caused a $2-4 million miss.

The Good News First

Firstly, the inventory shortage issue was forecast to be rectified within a quarter so we can expect some of those billings to come back. Secondly, the geographic performance was mixed. Latin American weakness was put down to some local macroeconomic issues, although there is a new sales management in place there expected to improve performance going forward. Europe was cited as being weaker, but not by much, and a large deal is expected to close soon. Fortinet had has some issues with China previously, but that region was declared ‘back on track,’ and Asia was strong in general with Japan surprisingly good.

Thirdly, the really good bit of news was that US enterprise based spending did well in the quarter. This nicely mirrors what F5 Networks said over this segment of its sales too. This is heartening because it implies that this is not really a US macro issue. I’m glad that Fortinet confirmed this, because the view from F5 is somewhat obscured by the fact that it is undergoing a product refresh right now.

And Now the Bad News

The bad news is that, just as F5 Networks did, Fortinet argued that the telco service providers were determined to prove themselves villains in the quarter. Almost word for word, Fortinet repeated the mantra that F5 had earlier argued. My interpretation of the commentary runs a bit like this: yes there are large deals out there, no they weren’t closed with others due to competition, yes we think we can close them in the future, but no we can’t be sure when the telcos will do this… and I doubt they are both lying!

In the case of F5 it is a bit more obscure because of the product refresh and its dominant market position (50-60%) in its core application delivery controller (ADC) market. Moreover, Cisco Systems $CSCO has pulled out of investing in its ADC, so it is reasonable to expect F5 to be winning some new business there. Similarly, with Fortinet there is the fear that its weakness is being caused by Cisco bundling security solutions with its core networking equipment to the telcos and undercutting other players. However, there was no indication of this from F5 or from Fortinet.

Instead, there appears to be a shift in service provider spending towards more cautious piecemeal spending. Indeed, Fortinet spoke of one large customer that changed from a ‘capex to an opex’ based approach and decided to shift the purchasing over multiple quarters rather than buy with one large deal.

All of this resulted in a nasty sequential drop in Fortinet’s revenues:

And there can be few guarantees that this will recover in time.

Where Next for Fortinet?

It’s a nasty miss, but I think there is some cause for optimism here. Firstly, if we go back to what Fortinet reported last time we can see that it was a strong quarter that involved a significant amount of larger deals being won.

And since the telco deals that missed in Q1 tended to be larger deals, perhaps the Q4 performance is a sign that there was a budget flush in that quarter? Similarly, I note F5 reported a strong quarter from telco in its Q1 only to disappoint in Q2. A royal budget flush? I’m wondering out loud what this might mean for Cisco’s forthcoming results.

If this turns out to be the case then the weakness within the service provider segment may be incrementally graduated into forecasts over the full year as both companies get over the effects of the change in purchasing patterns by the telcos. Furthermore, if US enterprises are still spending then the economy can’t be in that bad shape.

As I write, Fortinet is trading on a current FCF/EV yield of just over 5% and is on track (in a bad quarter) to generate 8% year on year billings growth with revenue up 15% for Q1. That is not bad at all, although cautious investors (like me) will want to listen to what the Tier 1 service providers say about their spending plans in the forthcoming results. Provided their outlooks are okay, I think Fortinet is worth a close look down here.

Weakness in European Technology Spending?

It’s been a good week for technology in general but three stocks stand out as being the big losers. Fortinet $FTNT , Riverbed $RVBD and, F5 Networks $FFIV have all seen significant declines. Why?

These companies have been written about on EarningsView. For example, Blue Coat Earnings Write Up , F5 Networks Growth Looks Solid , Fortinet Delivers Strong Results

What all three have in common is that they all reported weaker spending in technology in Europe and were on evaluations that appeared ‘stretched’ to say the least. I’ve decided to go through the conference calls and see what each said about Europe.

Company	European Commentary
F5 Networks	‘We have taken a fairly conservative forecast in terms of Q4 for EMEA as well. So, we are not looking for much growth sequentially there at all’…    …‘much like last quarter we saw weakness in some of the more macro affected economies in EMEA. Germany wasn’t great, UK wasn’t great. But the rest of the country did pretty well, excuse me, rest of the theater did pretty well.’
Riverbed Technology	‘Sales in EMEA were weaker than expected.. ..we attribute the softness both to the environment and our own execution’…  …‘Looking at Europe specifically, the weakness was in a surprising place, which is our central region headquartered in Germany, and Germany is supposed to have one of the stronger European economies. So that's what tells me there was some execution problem there.’
Fortinet	‘In terms of geographic breakdown of the billings growth Americas was at 32%, EMEA 2% and APAC 41% compared to Q2 2010. While Americas and APAC had very strong quarters, softness in EMEA from a macro perspective as well as timing of some of our large transactions resulted in lower billings growth for this region in this quarter. However, pipelines remain strong and we do expect to resume good growth in EMEA during Q3 and the balance of the second half.’…  …’ I don’t think it's totally ourselves, but what I’ve heard from some others that EMEA was, there was a little bit of malaise in EMEA, but that’s not an excuse, we think we will do better’

All three companies are leaders within their respective niches in technology and signs of weakness should be taken seriously. F5 Networks is a leader in application delivery networking, Riverbed is the top firm in the WAN (Wide Area Network) Optimization market and Fortinet is a global leader in UTM (Unified Threat Management) which is security solution primarily offered to small and medium sized enterprises.

European Macro Economic Woes Weighing on Technology

There is no doubt that firms in Europe have somewhat slowed purchasing decisions in response to fears over the macro environment and in particular European peripheral Sovereign Debt. I suspect this is a late quarter event because surveys up to June were indicating conditions that were holding up quite well in Europe. For example, here is the Optimism Index from Duke/Fuqua School of Business CFO Survey for June

Business Optimism Duke CFO Survey

Moreover, with regards to Riverbed we could be seeing the results of competitive pressures from the restructuring at rival WAN Optimization firm Blue Coat Systems International $BCSI. It will be worth seeing the results of Blue Coat because that company’s restructuring has been a long time coming.

Sovereign Debt Issues or Evaluation

I suspect, assuming a successful resolution of the European debt issues (Italy is the key) that these companies could report some upside surprise in EMEA revenues in the second half. So does this sell off in the stocks create a buying opportunity?

I’m not so sure and this view is principally due to the current evaluations. All of them looked stretched and were priced to perfection. In these cases, the slightest disappointment will see the stock price take a substantial hit. Even given the disappointing statements on Europe, these companies beat estimates and guidance was hardly weak, but it still leaves them on high evaluations.

Co	Stock Price	Q EPS Est	Q EPS Act	Next Q Guidance vs. Analyst Est	Current PE	Forward PE
F5 Networks	$101.5	91c	97c	97-99c vs. 98c	30.1x	28.7x
Riverbed	$32.3	21c	21c	21-22c vs. 23c	44.9x	36.3x
Fortinet	$21.3	8c	9c	9-10c vs. 9c	76x	59.2x

Frankly, I think the disappointment over the European statements is sending a warning over how highly rated these companies are. They are all attractive but, for now, these evaluations look a bit rich for me.