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.

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.