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Summary

  • The fundamentals of the business are solid with revenues and cash flows growing in the mid-teens.
  • At an enterprise value of 15 times 2014's EBITDA, shares of F5 aren't cheap.
  • The technicals suggest accumulating shares with the MACD providing a fresh buy signal.

F5 Networks, Inc. (NASDAQ:FFIV) reported solid fiscal second quarter results as revenues for the first six months of the year increased 15.5%, and GAAP diluted EPS for the same period increased 6.5%. EPS grew at a slower rate than revenues partly because of increasing head count, and currency headwinds. For the full year, I am expecting 15% revenue growth with 7.4% EPS growth.

Going into the fiscal first quarter, I thought management was guiding too conservatively; that thought turned out to be correct. The firm is producing double-digit growth on the BIG-IP 5000 and 7000 series refreshes. Application delivery is an area that I am bullish on, and with VMware (NYSE:VMW) and Cisco (NASDAQ:CSCO) as technology partners, F5 is well positioned to compete with Citrix (NASDAQ:CTXS). Additionally, the company has an installed base comprising of large enterprises.

At the current share price, F5 is overvalued based on the base case scenario, but undervalued based on the optimistic scenario, which suggests a relatively small margin of safety. Also, the firm is trading at an enterprise value of 15 times 2014's EBITDA with growth opportunities representing 62% of the current share price. Simply stated, shares of F5 aren't cheap. But based on the fundamentals, I would accumulate shares at more reasonable prices.

Recent Developments

  1. F5 acquired Defense.Net, Inc., which was a privately held provider of cloud-based security services for protecting data centers and Internet applications from distributed denial-of-service attacks. The acquisition is not expected to have a material impact on F5's operating results.
  2. Traffix Signaling Delivery Controller has successfully achieved Cisco compatibility certification with Cisco Unified Computing System Manager.
  3. F5 announced extended capabilities for OpenStack public, private, and hybrid cloud solutions, allowing customers to quickly deploy and orchestrate F5 application delivery services in OpenStack environments.
  4. The VIPRION 2200 chassis is generally available now.

Analyst's Note

F5 Networks, Inc. develops, markets, and sells application delivery networking products that optimize the security, performance, and availability of network applications, servers, and storage systems.

For the year ending (in thousands of dollars):

2013-09

2014-09E

As % of total 2014 revenues

United States

777,516

886,368

52%

Other

74,391

88,525

5%

Total Americas

851,907

974,894

57%

EMEA

327,109

392,531

23%

Japan

83,051

97,170

6%

Asia Pacific

219,247

238,979

14%

Total Revenues

1,481,314

1,703,573

For fiscal 2014, I'm forecasting $1.7 billion of total revenues. Japan, EMEA, and Other are forecasted to drive revenues growth during this fiscal year. If the current trend continues, Asia Pacific would become a smaller portion of total revenues and EMEA would become a larger portion of total revenues. Revenues generated outside of the Americas appear likely to comprise 50% of total revenues within the next few years. There isn't sufficient disclosure to determine the impact of the changing geographic mix on the consolidated operating margin.

For the year ending (in thousands of dollars except per share data):

2013-09

2014-09E

Total net revenues

1,481,314

1,703,573

Gross profit

1,228,267

1,402,467

Operating income

430,818

465,501

Net income

277,314

294,841

Diluted EPS

$3.50

$3.76

Sales of the core ADN products are anticipated to drive 15% total net revenues growth in fiscal 2014. Revenues from Services are expected to be 47% of total net revenues, which is up from 37% in fiscal 2011. The incremental investments are expected to adversely impact the profitability margins during the current fiscal year with gross margin down to 82% from 83% the prior year, and operating income down to 27% from 29% the prior year. The contribution from non-operating income is likely to be smaller in fiscal 2014 than in fiscal 2013, and that combines with a higher effective tax rate to reduce the net profit margin to 17% from 19% the prior year. Combined with a 1% reduction in diluted shares, GAAP diluted EPS is expected to increase 7.4%.

Turning to the financial position, F5 is liquid with a strong solvency position. Since the end of 2011, there was about a $250 million increase in goodwill, which suggests that the firm is employing a growth through acquisition strategy. The share repurchases are expected to increase the asset turnover during this fiscal year. And total deferred revenue is expected to top $600 million at the end of this fiscal year.

At the year ending (in thousands of dollars):

2013-09

2014-09E

Current deferred revenue

421,429

497,286

Deferred revenue, long-term

109,944

127,535

For fiscal 2014, I'm expecting cash flow from operations of $562 million with $541 million of free cash flow to the firm and equity. The share repurchases are anticipated to total $500 million during fiscal 2014. Free cash flow to the firm and equity is expected to grow 14.5% Y/Y.

The excess return on equity, in my opinion, will be 10%. Consequently, F5 is expected to create shareholder value during this fiscal year. That comes with cash flows and revenue growth in the mid-teens. Overall, the fundamentals of the company appear solid.

Portfolio & Valuation

(click to enlarge)

F5 is in a bull market of primary degree and intermediate-term-bear market. Based purely on technicals, the play is to accumulate on dips. Additionally, the MACD crossing the signal line from below is a "buy signal."

Monthly expected return

Quarterly expected return

Quarterly standard deviation of returns

Sharpe ratio

2.51%

7.54%

22%

0.30

Estimated intrinsic values

Forward multiplier model valuations

Forward multiplier model valuations ex-cash

Optimistic

$123.14

P/E: 29.11

27.25

Base case

$90.74

P/S: 5.04

4.72

Pessimistic

$58.33

P/BV: 5.55

5.20

Current price

$109.57

P/CFO: 15.27

14.29

Based on the fundamentals of the firm, shares of F5 are overvalued. The return generating ability of the firm doesn't justify the current valuation. Additionally, F5 is trading at 27 times fiscal 2014's diluted EPS excluding cash, which isn't cheap. Lastly, the EPS growth rate doesn't justify the premium (~60%) relative to the S&P 500.

General Risks

  1. The share price is likely to remain volatile and investors could lose a portion or all of their investment.
  2. Investors should judge the suitability of an investment in F5 Networks in light of their own unique circumstances.
  3. This section does not contain all risks related to an investment in F5 Networks.
  4. A decline in the global economic growth rate and/or a decline in the pace of economic growth in the United States could adversely impact the results of operations and the share price.
  5. Cyclicality in IT expenditure may affect the performance.
  6. The technology industry is characterized by rapid technological change, which could materially adversely impact the results of operations.
  7. Competition in product development and pricing could adversely impact performance.
  8. Incorrect forecasts of customer demand could adversely impact the results of operations.
  9. Higher interest rates may reduce demand for F5 Networks' offerings and negatively impact the results of operations and the share price.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

Source: Why I Will Accumulate F5 Networks At More Reasonable Prices