F5 Networks (NASDAQ:FFIV), one of the leading technology providers that optimizes the delivery of network-based applications, will report its Q1 2014 earnings on January 22. While the company closed its fiscal 2012 with 20% higher revenues, its growth rate slowed to 7.6% in fiscal 2013 (ended September 30, 2013). Experiencing a difficult macro environment, F5 witnessed negative growth in the first half of fiscal 2013. However, with the completion of its product refresh in Q3 2013, it saw its growth re-accelerate in the latter part of the year. The first-quarter consensus revenue estimate of $396 million, representing growth of 8% over the prior year, should offer a good start to the year.
F5′s book-to-bill ratio (ratio of orders received to units shipped and billed) in Q4 2013 was greater than one, and the company claims to be seeing an uptick in million-dollar-plus deals, which had been shrinking over the last few quarters. Though F5 expects its revenue to remain flat in Q1 2014, we believe its growth will re-accelerate in 2014 and beyond. We think that the upgraded product portfolio, increasing Cisco (NASDAQ:CSCO) ACE replacement, and a strong sales force will help accelerate F5′s product demand in the future. The company has consistent margins, a solid balance sheet with strong cash generation and no debt.
Our price estimate of $112 for F5 Networks is at a 15% premium to the current market price of $98.
New Product Platforms to Accelerate Growth
In Q3 2013, F5 completed the launch of what it claims to be the most significant product refresh in several years. It developed a range of new products and software solutions with an aim to boost demand and create new revenue growth opportunities. New platforms include a high-end VIPRION 8-slot chassis and a new range of appliances, the BIG-IP 2000, 4000, 5000, 7000 and 10000 Series. F5 also introduced the largest portfolio of software virtualization products and a new centralized management platform, BIG-IQ.
The upgraded product portfolio has significantly expanded F5′s addressable market and the company claims to be witnessing record competitive win rates. Additionally, it completed its acquisition of LineRate Systems in February this year which it believes will broaden its application-focused ADC solutions and advance its leadership in ADCs.
F5 is also well-positioned to gain share in the $6.5 billion network security market. It entered the Internet firewall market in February 2012, and security modules now account for approximately 30% of F5′s total product revenue. With growing awareness of its security solutions in the market, the company expects the strong sales momentum to continue in fiscal 2014 as well.
F5 Gains By Replacing Cisco’s ACE Products
In 2012, rival firm Cisco announced its decision to exit the ADC (Application Delivery Controller) market after losing more than 50% of its market share to F5 and Citrix. F5 is the market leader in ADC solutions and the segment accounts for close to 60% of its total product revenues. F5 has scored big product wins by replacing some of Cisco ACE (Application Control Engine) products in large customer accounts in the last few quarters.
In its last earnings call, F5 announced that it recorded over 900 ACE replacement project wins in fiscal 2013. In Q4 2013, new business accounted for 47% and existing business for 53% of F5′s sales as compared to 40% and 60% a year ago, respectively. The ACE opportunity accounts for a majority of the new business.
The ACE installed base is over $1 billion but F5′s target market is much larger. In addition to replacing Cisco’s existing solutions, F5 has the added opportunity of providing customers additional functionality including security, access control and application acceleration.  Though Citrix remains a big threat for F5, we believe the latter will continue to retain its dominance in the ADC market.
Gross Margins To Remain High
At present, F5 enjoys a very high gross margin, which increased by over five percentage points from 2006 to 2013 (from 77.7% to 82.9% ). In addition to strong demand for its new products, the rising demand from new and emerging markets helped improve F5′s gross margin to 83.1% in in Q4 2013, compared to the prior year level of 82.7%. The company expects that the updated product portfolio will help re-accelerate its top line growth in fiscal 2014 and is confident of maintaining its product gross margin around the current level. However, it does expect a slight decline in service gross margins in the future. Service revenues were 46% of the total in fiscal 2013.
We expect F5′s gross margins to remain around the current level for the rest of our review period. Despite intensifying competition, F5′s recent product upgrade and its building sales momentum in new markets will help drive revenue growth. F5 drives technological differentiation through the software that is installed on the hardware that it sells. Given this differentiation, revenue growth should help offset the modest attrition in service margins. (Read: F5′s Profitability to Remain Strong Despite Slightly Lower Service Margins)
- F5 Networks Management Discusses Q4 2013 Results – Earnings Call Transcript, Seeking Alpha, October 23, 2013
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