F5 Networks (FFIV) has successfully built itself as the leader in the delivery of network-based applications, data storage devices and other network resources. Its strong financial performance is a testament to its superiority among the software vendors. It generates high returns on capital based on its high-margin businesses and stable revenue streams. I believe that its strong competitive advantage is high switching costs of its customers from its Application Delivery Network (ADN) services. ADN is a suite of technologies that can perform complex tasks like data traffic management, Web application security, protocol optimization and data center load balancing. This is the niche where F5 Network has entrenched competitive position. This segment has been the major growth drivers of the company as it commands more than 50% of the market.
Blue Ocean: Small Niche Player in the Enterprise Market
The Blue Ocean Strategy was conceived in 2005 in the field of corporate strategy. The book believes that high growth and profits can be achieved through creation of new demand in an uncontested market space rather than competing head-to-head with other suppliers in the industry. Such is the case of F5 Network. It did not compete head on with giants Cisco (CSCO), IBM (IBM) and Juniper Network (JNPR) in the enterprise market. It focused on a smaller niche that would have not significant impact on their profitability. As it executed its ADN services, clients begin to realize the improved performance with their Web 2.0 applications and traditional applications from vendors such as Microsoft (MSFT) and Oracle (ORCL). The key was better execution and focus, leaving the networking giants behind the game.
It has kept its competitors at bay for a while now. Juniper has partnered with Riverbed (RVBD) to provide competitive solutions to enterprises and clients. Separately, both Cisco and SAP are joining forces to improve their capabilities in the Application Networking space. Despite these efforts, F5 Network's market share has remained stable.
F5 Network spends significant resources to provide its clients with templates and guides that are specific to a particular software application. These guides provide instructions for the deployment process of its products. The company regularly updates these guides to support new software versions. In my view, clients who use these guides to manage F5's products will be reluctant to change vendors for future deployments or capacity expansions. Its user community portal, DevCentral, complements its services. The portal provides customer access to a large database of custom configuration and scripting templates. Thus, its competitors are having a hard time snatching up market share from F5 Network.
Competitive Advantage Translates to Better Financial Track Record
For the last 10 years, revenues have grown from $108 million to $1.15 billion. This translates to a growth of 26% a year. Its operating margins have significantly improved from negative 8.8% in 2002 to 30.4% in 2011. The strong operating margins signaled that the company has reached its operating scale. Additionally, customers purchase high-margin service contracts that allow for upgrades, hardware maintenance and support. Going forward, I see that operating margins will remain steady (i.e., operating margins higher than 30%). However, there will still be competitive forces that will bring its operating margins lower.
In contrast, Cisco's revenues have grown from $18 billion in 2002 to $43 billion in 2011. This translates to a 10-year average growth rate of 6.84%. Its operating margins have increased from 15% to 17%. On the other hand, Juniper has revenues of $23 million in 2005 to $726 million in 2011. Over this period, revenues have grown by 51% year. Its operating margins have also improved from negative 74% in 2005 to 12% in 2011.
Moving forward, I expect that F5 will have relatively better financial track record. Analysts expect the company to earn $4.44 per share this year. This translates to a growth of 17% compared to the same period last year. For the next 5 years, the company is forecasted to grow its earnings by 19% a year. Meanwhile, Cisco and Juniper have growth rates of 8% and 14%, respectively.
The enterprise market also appears to face significant tailwinds. The growing adoption of advanced video communications will fuel drive the industry's growth. The industry also faces strong prospects from enterprises moving into cloud based services and storages. Cloud providers are currently building large virtualized data centers to host changing mix of on-demand resources. Its clients are deploying F5's products to shift traffic quickly and easily with their own internal resources and cloud. Overall, F5 seems to be a beneficiary from these developments.
F5's Valuations Suggest Sustained Double-Digit Growth
While the company's strong competitive advantage can sustain its current financial performance, I believe that its valuations appear fairly valued. It is currently trading at 28 times earnings. Over the last 5 years, the company has an average price earnings ratio of 38 times. On a historical basis, its valuation does not appear overheated. However, the stock is trading relatively higher compared to other networking stocks.
For example, networking giant Cisco appears to offer value at first glance. Cisco trades at 12 times earnings on an 8% earnings growth rate. Meanwhile, Juniper trades at 38 times earnings with growth expectations of 14%. In terms of price over growth ratio, FFIV offers relative better value compared to its peers. FFIV has price over growth ratio of around 1.01 times, lower than Juniper and Cisco. Juniper trades at 1.69 times and Cisco is valued at 1.10 times.
Investors should only be concerned whether growth rates are sustainable or not. The current valuation suggests that earnings growth will be at more than 15%. The recent earnings report validated these assumptions. The quarterly earnings report points to a growth of 20% compared to the same period last year. While investors should be concerned of a lower outlook for the succeeding quarter, any pullbacks should be viewed as a good entry opportunity.