F5 Networks' (FFIV) big swoon in market cap last week wasn't pretty for any investor long the stock. One culprit was 1Q 2011 revenues falling short of street expectations, while other fingers pointed to short-sellers sniffing for blood as they emerged from hibernation. Or, perhaps as one analyst put it, investors simply woke-up in a cranky mood last Wednesday.
Regardless, the network/device space had been in the "clouds" since December and parabolic from the September lows. More importantly, FFIV outperformed the Amex Networking Index by some 130% in the past year (up to Wednesday's sell-off).
Based on our Merriam Report analysis of FFIV's Q4 2010 financials, it is likely investors and analysts may have been too optimistic going into Wednesday's announcement. We also thought CEO John McAdam did a respectable job of damage control in his recent appearance on CNBC. McAdam also said the company could have better communicated potential "softness" in the quarter. Yet we will cut him slack for that statement, because channel checks and vendor chats are what analysts get paid to do.
The questions now are: Do shares of FFIV look attractive at current levels, and how healthy is earnings quality following the earnings release for Q1 2011?
Let's start with cash-flow: Merriam Report signals for the period ending Dec. 2010 are bullish (both recent and confirmed). Dual cash-flow ratios are consistent and slightly above the median average for the seven quarters shown. Operating cash-flow (OCF) trends continue to strengthen and spreads between OCF and balance sheet cash-flow (BSCF) remain wide (an indication of healthy earnings quality, in our view).
However, the December period marks the first significant spike in BSCF (as a percentage of sales) during the seven quarters reviewed. While a one-time blip in BSCF doesn’t concern us, further increases in balance-sheet cash flows (as a percentage of sales) would be worrisome.
Revenue Metrics and Capital Productivity: Q1 2011 saw continued declines in R&D spending (as a percentage of sales) and a slight increase in Payables (as a percentage of sales), offset by improvements in Cost-of-Sales and SGA expenses. R&D spending is critical to future earnings growth, but with R&D spending currently at 12% of sales, the company is clearly committed to product innovation.
Improvements in inventory and capacity (P, P&E) returns were offset by modest declines in receivables (per dollar of sales). Receivables spiked 26% in the latest period (vs. a 5.6% rise in sales). Accounts payable in the last quarter rose 47% from the previous period.
Accruals: Another small chink in the armor of an otherwise decent Q1 performance is an incremental rise in accrual ratios during the past several periods. Although FFIV's accrual trend has not turned “officially” bearish (defined as +5 or more), rising accruals indicate that earnings could be increasingly supported by non-cash adjustments. A reversal of this trend in FFIV's use of accrual accounting (negative ratios are preferred) would only strengthen the earnings quality picture going forward.
Goodwill: Exponential declines in goodwill (as a percentage of equity and assets) suggest low impairment risk in the near-term. However, future acquisitions would likely change this outlook, and investors will want to keep an eye on goodwill and intangible asset trends going forward.
Conclusion: Based on MR analysis of financial statements for the seven quarters ending Dec. 31, 2010, we place an estimated fair-value on FFIV shares (adjusted for DSOs and payables) at $119.
Earnings quality is B-, but the company does have a healthy balance sheet, no long-term debt and over $5 a share in cash. FFIV is, in our view, well-managed and the company has evolved to be a major player in network delivery and platform performance products and services.
Takeover appeal: FFIV's application/delivery capabilities would make a nice fit for somebody wanting to integrate these tools into database functions. However, at current price-multiples to sales and cash flow, it's unlikely a potential suitor would pay much of a premium above FFIV's present market cap. Other issues that could potentially bog down a deal are recent declines in F5's earnings yield and rising price-to-free-cash flow ratios.
A potential acquirer would also have to weigh the benefit of leveraging its cost of capital against the possible risk of "future" equity getting clobbered by non-cash charges, impairment, etc. Low interest rates have allowed companies to tap the bond market and either pay down higher rate debt obligations or just pad their balance sheets with cash for a rainy day. If the acquirer were in the latter circumstances, it might not make sense to use cheap capital as "currency" to acquire inflated assets.
There is a huge difference between generating returns on equity and generating cash-flow in excess of your carrying costs. In some cases, it may be more advantageous to sit tight and wait until multiples pencil in to the future economic benefit and returns an acquisition would provide.
Investors and Traders: We believe a pull-back to the $90 area might provide value investors a decent entry point. Traders can likely make a few bucks on gap-fills, but a quick look at a three-month chart suggests a visit to the $100 area (or lower) isn't out of the question.
You can view our full report and analysis of FFIV here.
The problem with high-flyer momentum "darlings" is that valuations eventually get a reality check. David Clayton-Thomas sums it up eloquently in the jazzy Blood, Sweat & Tears song "Spinning Wheel": "What goes up must come down."
This is what happened to FFIV and others in the network space last week. Equity prices can and will fall faster than they rise.
Disclosure: None
