The underperformance of F5 Networks (FFIV) vs. the S&P 500 over the past year, and current relatively low valuation on the stock, does raise the question whether F5 has become inexpensive enough to buy. Specifically, F5 had declined about 35% over the past 12 months while the S&P 500 has risen 11%. In addition, the stock is trading at a forward four quarter P/E multiple of about 16x, which is near the bottom of the three year historical range of about 15x-40x.
While the valuation analysis make the stock tempting, given that the company remains the market leader with over 50% market share in the Application Delivery Controller (ADC) market, I think it is best to stay on the sidelines for now and see how the next quarter or two transpire for the company, as I think it is possible that revenue estimates for the company may be subject to some downward revisions. The rationale behind my thought process is as follows:
1. Book To Bill Trends - F5 has shown a book to bill of below 1 in two of the past three quarters it has reported. This is not desirable for growth stocks. This suggests that product backlog is not expanding and makes the company more reliant on bookings within the current quarter to achieve its financial guidance for the March quarter and street estimates for the June quarter.
2. Product Revenue Growth Decelerating - In the past five quarters, F5's product revenue growth has been 15%, 18%, 16%, 6% and 4% respectively. The recent deceleration is concerning, especially since Cisco has exited the ADC market in September 2012, which should have opened up more of the market for F5.
3. Slowing Technology Vertical Concerning - F5 has seen low year over year growth in its Technology vertical for the past five quarters with reported year over year growth of -3%, -3%, -9%, 3% and -13% respectively. While the numbers are certainly a concern, the underlying potential reason for the weak performance is more of a concern. Specifically, F5's management honestly discussed on their last analyst call that the performance of this vertical has been impacted by some new architectural approaches by a couple of their larger customers in this segment. The reason this is a potential concern is that the larger customers in this vertical tend to be large cloud operators in the class of Facebook (FB), Amazon (AMZN), Google (GOOG), etc. If large innovative cloud operators are starting to use their own organic approaches to ADCs, that could be irreversible, diminish the future growth rate of the ADC market and reduce valuation investors are willing to pay for F5. In a broader sense, F5 is now being perceived as being at risk to the emerging trend of Software Defined Networking (SDN), where applications like load balancing and ADCs may be virtualized via software applications developed by companies other than F5.
4. LTE Spending Lumpy - F5 benefited in the December 2011, March 2012 and June 2012 quarters from initial strong spending by US operators on their LTE build-outs. Growth in their telecom vertical showed year over year growth ranging from 27% to 65% during these three quarters. In the last two quarters, however, growth has slowed and was -16% in September 2012 and 13% in December 2012. While the LTE market is still in the early innings globally, F5 is awaiting for broader build-outs of LTE to re-accelerate growth in this vertical. Thus, this is likely to be a temporary issue for F5, but one that in combination with the other points above could make the March and June quarters a bit challenging for the company.
5. Expansion into Security Competitive - F5 is seeking to expand its addressable market beyond ADCs by adding security features and modules to its platforms. There is certainly merit to this strategy given the high margin nature of security appliance and software revenues, the potential for F5 to leverage its installed base of ADCs and the complementary nature of security software to the ADC market. In fact this week, we saw security firewall company Fortinet acquire a start-up company in the ADC market called Coyote Point. The convergence of some elements of the security and ADC market is now catching some momentum, and will likely even garner more momentum as the market moves to an SDN framework a few years out. For F5, however, the jury is still out on how well they will execute on their security strategy. The security market is already very competitive and the venture capital community continues to fund new security start-ups. Thus, my view is that the security initiative is a smart one for F5, but one that is not likely to impact financial results in the March and June quarters. If F5 demonstrates success in rapidly expanding its security business in the next year, this would likely be a catalyst for expanding the valuation metrics of the company and lead to better stock performance.
Additional disclosure: My firm, NT Advisors LLC, provides consulting and advisory services to the technology, venture capital and private equity industries.