By Richard Saintvilus
With shares of F5 Networks (FFIV) having traded as low $71 recently, I'm still trying to reconcile how the Street has waited this long to come to its senses. And with the stock so battered and bruised, Cisco (CSCO) and Oracle (ORCL) should be circling the skies waiting to pounce on F5's remains. But will they do it?
How Did We Get Here?
While F5's management has failed to produce the sort of leverage the company needed to grow margins and seize market share, all of the warnings signs of what's become of the company are there. Investors chose to ignore them while praying for a big payday that would never come.
What's more, given the weak carrier spending environment, the company's failure to properly diversify itself is now coming home to roost. So what's next? I don't see how F5 can recover from here. You think that's premature to say? But let's take a look back. Actually, I've been making these claims for almost a year.
Two months ago, while the stock was trading at $108, I told investors it was time to bail. But the Street had different ideas. I also issued a warning to investors as far back as last November after F5 missed on both top- and bottom-line estimates. We can go back even farther: Last July, I told investors to sell the stock and buy Cisco. Instead, investors were stuck, falling in love with F5's growth and cloud prospects. But management had not properly secured F5's position.
Bulls argued that the company was producing 20% revenue growth. While that was indeed impressive, the valuation wasn't, given F5's lack of enterprise leverage and over-reliance on carriers. Plus, F5 had lost its top sales executive, who left for rival Palo Alto Networks (PANW). At that point, F5's decline was just a matter of time. And with the competition ready to attack from multiple directions, margins were due to get squeezed.
Under New Management
What's interesting about F5 is that the company still has some very interesting assets. Unfortunately, current management has not figured out ways to realize that value. For instance, F5's dominance in the application deliver control (ADC) market, in which F5 has a 50% market share, was the reason why Cisco exited that business altogether. F5 actually beat Cisco at something. Unfortunately, F5 was unable to build on that.
Cisco, meanwhile, looked for other opportunities -- forming partnerships with the likes of Citrix (CTXS), which is second in the ADC market, to make up for Cisco's exit. But it's double-edged. While Citrix presents Cisco with supplemental ADC/enterprise leverage, these two are also direct competitors in several categories -- enterprise collaboration tools being one key area where Cisco's WebEx competes with Citrix's Go-To-Meeting.
Why Cisco Should Do This Deal
Today, Cisco needs Citrix's add-on benefits. But Cisco can't be comfortable. There's the risk that this marriage with Citrix can end in divorce. But why would Cisco want to remain in a position of need and grant Citrix such leverage? F5 is the solution. What's more, given that F5's services revenue is still growing at close to 30% rate means that F5 is actually outperforming not only Cisco, but also two of Cisco's chief rivals in Juniper (JNPR) and CheckPoint (CHKP).
So this deal makes sense on several levels. Plus, given F5's market cap of $5.7 billion, add a 22% premium and this deal would only cost Cisco $7 billion. At the most, it might reach $7.5 billion, which would only represent 16% of Cisco's $46 billion in cash. If you think this deal is too pricey, consider that Cisco has $12 billion in operating cash flow, and the company has figured out ways to store more cash each quarter.
Plus, management has to weigh the risk/reward of not doing this deal. The cloud market is expected to grow by $177 billion over the next two years. Besides, Cisco has already been investing in this area with recent buys like Meraki and Cariden. Meanwhile, F5 would help Cisco offset weakness in its core routing/switching hardware businesses, while also providing Cisco and extra advantage to tackle Riverbed (RVBD) in WAN Optimization. Essentially, the premium that Cisco would need to pay for F5 pales in comparison to the risk that exists if Cisco doesn't do this deal.
Oracle's Too Smart to Not See This
If Cisco passes on F5, Oracle shouldn't, especially since Oracle just paid a higher premium for Acme Packet (APKT) just to enter the session control delivery market. Essentially, Oracle just became a direct rival to not only Cisco, but Oracle now has extra cloud/enterprise assets to attack Citrix. What's more, Given Acme Packet's 40% share in the session border control market, Oracle has a way to leverage what it already does well -- manage and organize data.
Plus, there is an increase demand for service providers looking for ways to engage their customers more effectively, and Oracle now has Acme Packet's "Net-Net" line of products to effectively attack the enterprise in ways that Cisco did not anticipate. Although Cisco's recent acquisition for Intucell, which has solid self-optimized network capabilities, should help but it won't be enough -- not without F5.
Besides, even if Intucell or even BroadHop proved more fruitful than expected for Cisco, this advantage can easily be threatened with Oracle's expertise in software, which it can join with Acme Packet's hardware intelligence. Again, the key here is F5 and what it can bring to the table to Oracle should Cisco not jump in first. We know Cisco can make this deal happen tomorrow. But so can Oracle, which has $33 billion sitting on the books, with another $14 billion in operating cash flow. Again, it would cost Oracle $7.5 billion, which would represent only 22% of its cash.
The Value Proposition
Oracle's recent Q3 earnings, which the company missed on both top- and bottom-line estimates revealed how fragile its business can be, given the 2% decline in revenue. F5 would help Oracle solidify its position in the software-as-a-service environment, where Salesforce.com (CRM) has secured the lead. Oracle needs F5. With an acquisition, not only would Oracle have a lead in enterprise databases and Big Data, but given Acme Packet's 40% lead in SBC and F5's 50% share in ADC, Oracle's one-stop-shop enterprise objectives would be solidified, while making Oracle a "growth stock" again. The aggregate value of this "new Oracle" would command a 30% premium above Oracle's current share price. The stock could see $44 in less than 12 months.
Neither Salesforce.com, IBM, nor SAP would be able to compete. Meanwhile, Cisco, which has done its own study on global data traffic, can't ignore the advantages that F5 would present not only from a value perspective, but also strategically. While Cisco has done well, rebounding from previous mistakes, as with Oracle, Cisco would again become a growth company.
Plus, in some areas, Cisco could be a monopoly. But its Cisco's own market research that suggests that F5 is the ideal candidate. Given F5's lead in ADC, Cisco's could gain roughly 7 to 12 points in gross margin, effectively justifying $10 per share to Cisco's stock price in 12 months. Rivals like Riverbed, Juniper, and even Citrix would begin to feel a squeeze given Cisco's existing enterprise assets.
While F5's future seems to be in limbo, clearly this company still has the goods to deliver growth and leverage to an opportunistic company. From that standpoint, it may not yet be time to dump F5 shares at this point, especially given the recent declines. That said, absent some sort of an acquisition, the story has not changed. Leverage is still what's hurting this company.
While Cisco and Oracle are mulling this over, investors should not discount the idea that Citrix would also make an interesting acquirer. Citrix would have to raise the cash to do this deal, but F5 would immediately elevate Citrix to the top of the virtualization realm to dominate VMware (VMW) and Microsoft (MSFT). I've been right so far about my calls on F5. In that regard, I'll be surprised if this company remains an independent for the rest of the year.
Disclaimer: SaintsSense is a team of financial writers. This article was written by Richard Saintvilus, founder of SaintsSense. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.