F5 Networks: Multiple Contraction Storm Coming

Oct.24.13 | About: F5 Networks, (FFIV)

Mr. Goodshort: The reason I'm in town, in case you're wondering, is because of a Kansas City Shuffle.

Silly Momo: What's a Kansas City Shuffle?

Mr. Goodshort: A Kansas City Shuffle is when everybody thinks long, you go short.

Silly Momo: Never heard of it.

Mr. Goodshort: It's not something people hear about. Falls on deaf ears mostly. This particular one has been over four quarters in the making.

Sill Momo: Four quarters, huh?

Mr. Goodshort: No small matter. Requires a lot of planning. Involves a lot of people. People connected only by the slightest of events. Like whispers in the night, in that place that never forgets, even when the sell side analysts do. It starts with a stock.

-Lucky Number Selling

So, I was looking forward to F5's (NASDAQ:FFIV) earnings conference call last night because I was quite curious what they would have to say about fiscal 2014. For those of you not familiar with the name, I was early to spot F5's ADC product sales decline, and shorted the stock with some success in the back half of 2012. Since then the name has bounced around a bit. They were very weak early on in the year, thanks to a big product miss in q1, and have bounced back a good deal over the past quarter-and-a-half, thanks to a product refresh boost and an overall strong tech tape. The rebound caught my attention because I have a core thesis that F5's growth glory days are over, and that this is a $60-$70 stock. For those not familiar with the thesis, let's revisit it.

When I was shorting the stock north of $110, it was because I expected ADC's sales to slow. And slow they did. However, because this company has a very sizeable service revenue component, hitting overall revenue and EPS targets, thanks to lagging service revenue growth, was a non-issue for several quarters (anyone who has traded tech has seen this trap set and sprung on bulls many times). This made it an easy short because the evidence continued to mount that a day of reckoning was coming, but also a frustrating one because of the unwillingness of investors to throw in the towel on the stock until a headline miss went with the rapidly declining sequential product sales. Then in a span of a day or two, the 30% decline that was needed to get the shares to 'fair value' finally occurred. I stopped paying much attention to the name at that point until I saw the stock rebound on an uptick in product sales last quarter as well as solid guidance for the subsequent quarter.

Why you may ask?

Simple, because of the way service revenue lags product revenue, I expect F5 to have a tough 2014 when it comes to overall revenue growth. Basically, what insulated them and made them tough to short in 2012 will hurt them and make them easier to short going into 2014. So, while the stock experienced a temp rebound on a product uptick, I expect the multiple to quickly compress again as evidence of lackluster overall revenue growth presents itself.

A quick glance at the historical revenue growth rates should help make my point.

F5 Revenue

2010

2011

2012

2013

Product

28%

22%

12%

-2%

Services

23%

25%

23%

18%

Overall

26%

23%

16%

7%

Click to enlarge

As you can see, the declining growth trend here is pretty clear. What you should be asking yourself is what kind of service revenue comp will they be putting up in 2014. This is a question I hoped would be answered on the call as F5 typically gives preliminary annual guidance on the fiscal Q4 call, but that was not the case. Now in some instances, this is usually no big deal, but last night I assure you was not one of those instances. To illustrate, I have provided the guidance description from last night as well as last year.

Q4 2012 CC Revenue Guidance:

"For fiscal 2013, our general planning assumptions and expectations are as follows. We expect to see sequential revenue growth throughout the year with more robust product growth in the back half of the year, as demand builds related to our forthcoming product refresh and new security and service provider software modules."

Q4 2013 CC Revenue Guidance:

"Looking out to the year ahead, our general planning assumptions and expectations for the year are as follows: We believe the company-specific drivers, new products and expanding market opportunities that propelled our growth in the second half of fiscal 2013 position us to achieve year-over-year product revenue growth throughout fiscal 2014."

Hmm, it seems this year we just get product revenue guidance. What about the other 46% of the business? Well, one analyst was brave enough to seek some color on this issue during the call, but was promptly shot down by the CFO. See, management now wants you to focus on the fact that they are going to be all about getting product growth momentum going in 2014, and that they are willing to make some sacrifices to get there, notably, 175bps to 225 bps of gross service revenue margin decline. Yes, F5 will be spending more on consultants to help drive product revenue. Do the math on this and you are looking at roughly a 5% EPS headwind in 2014. Not exactly a disaster, but then again not good news either.

But here is what makes this all interesting.......

The Street Still Thinks this is a Growth Stock.

This is why last night's call was big on my radar, and why the stock which popped on a headline beat started fading faster than a new BlackBerry battery. Consensus estimates call for 13% EPS growth on the back 11.5% revenue growth. Not exactly gangbuster numbers, but after a 3% and 7% year, this would be a pretty decent re-acceleration. That of course is what struck me as odd, and why F5 jumped back on my short list. The likelihood of a meaningful uptick in overall revenue growth with the company having been milking a slowly diminishing services revenue tailwind was very low. You effectively would be banking on ADC product sales growing at a high double digit pace in 2014, and that's after two quarters of a refresh boost behind them. Add in the heavy US federal exposure, and the trend to SDN and you have two more secular product headwinds to deal with. Put this all together and you can conclude that consensus 2014 numbers will be coming down significantly.

But this must already be discounted in right?

Wrong. Knowing how the sell-side works, they will wait till F5's analyst day on November 14th, before they make major adjustments to their models even though those adjustments now appear to be pretty clear. Shave 100bps of gross margin and front end load that impact so Q1/Q2 EPS estimates are riskier while tailing off service revenue sequential growth throughout the year. Then maybe model something to the tune of mid-to-high single digit product revenue growth. All in all, what you should end up with here is a stock that should be trading in the low-to-mid teens on a non-GAAP EPS P/E multiple. You still have nice solid cash flow from the services business, but at the same time need to slap something more akin to a cash cow multiple on the whole thing as margin pressure and lackluster revenue growth become more of the norm. This get you to a stock that should be trading south of $70 before you think about a long position. I'd also add in on the call that they announced they will be providing less information on vertical sales as well as no longer regularly reporting a book-to-bill ratio. Management's reason for both is to reduce confusion, but realistically less information is never a good sign.

How to play this?

Short pre-market, and hopefully if it stays up before the open, buy November puts as you capture the analyst day (Nov 14) despite volatility getting crushed post results. The beauty of what is going on here is there is going to be some confusion, the type of which usually kills novice retail and tech 'perceived value' chasers, and you want to exploit that.

On a side note, I'd send thank you notes to any analyst that stays bullish because they will make it a lot easier for you to make money shorting the name over the next few weeks.

Starting with this guy...

F5 Networks reported very good results, says Cantor
After F5 Networks reported stronger-than-expected Q4 results, Cantor thinks the results "set the company apart from its peers." The firm thinks the company's new products are performing well, while it has several other growth drivers. Cantor keeps a $110 price target and Buy rating on the shares.

Disclosure: I am short FFIV. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.