Weak macro conditions and the product portfolio transition impacted F5 Networks (NASDAQ:FFIV) growth momentum last year. While economic uncertainty forced its customers to lower their spending, increasing competition led some to question the sustainability of F5′s growth rate and high margins over the long run — factors that negatively impacted its stock price. However, the strong demand for F5′s upgraded product portfolio, positive customer response to the recently introduced Synthesis architectural vision and F5′s ‘Good, Better, Best’ pricing model (introduced in November 2013) led to strong sales across all geographies in Q1 2014. (Read our earnings article) F5 Networks has seen its stock price increase by approximately 20% year to date as the strong results last quarter renewed investor confidence in the company.
Our price estimate of $108 for F5 Networks is now in line with its current market price. Though the weak macro environment might restrict F5′s short-term growth, we believe in the company’s long-term growth potential. Below are key factors that support our belief.
The ADC Market Remains Strong; F5 Is A Leader In Traditional ADCs
ADCs simplify the management of data centers, delivery of resources across diverse networks and enable applications to perform faster. While the ADC market witnessed a double-digit growth in 2012, some research firms predicted the growth to slow down to as low as 2% in 2013. Though macro headwinds might restrict short-term growth, we think that the ADC market continues to have immense long term growth potential. The ADC market is estimated to grow at a CAGR of 7.07% through 2015.
F5 is one of the leading technology providers that optimizes the delivery of network-based applications and a leader in the ADC market with a market share in excess of 50%. However, while F5 dominates the high-end market, it does not have a very large (less than 20%) market share in virtual ADCs. Though ADCs are still important in managing data network traffic, growth at the high-end of the market has stagnated and lower-end customers are turning to virtual ADCs.
F5′s partnership with VMware (NYSE:VMW) could help expand its presence in virtual ADCs. Also, although virtual ADCs are comparatively lower priced than traditional ADCs, the latter is better suited to manage large amounts of application connections and data.
F5′s upgraded product portfolio has significantly expanded its addressable market and the company reports that it is witnessing record competitive win rates. At its investor meeting, F5 mentioned that its installed base of users has a relatively older suite of ADCs in place; ranging from three to six years of service and even longer in some cases. That means a refresh cycle has just begun gaining traction. A second wave of new software and hardware solutions, which offer new features across all product categories, will be released in the second half of 2014.
Enriched product capabilities should continue to drive growth and strengthen F5′s market position. F5 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. At present, over 70% of the Fortune 500 companies are F5′s customers.
Continued Expansion In The Security Market
With the explosion of data and processing required online, security has become a major concern for most enterprises, and thus, this is one segment bound to witness tremendous growth in the coming years. IDC estimates that companies around the world will spend $491 billion in 2014 for fixes and recovery from data breaches and malware, $127 billion in dealing with security issues and $364 billion dealing with data breaches.
With its BIG-IP 11.1 software passing the ISCA Labs test for network firewalls, F5 entered the Internet firewall market in February 2012 and since then has expanded its security solution portfolio with the addition of new products. Its security portfolio solution has increased dramatically in the last few quarters. It acquired Israel based Versafe Ltd., a provider of web anti-fraud, anti-phishing and anti-malware solutions in September 2013. Offering advanced web and mobile protection solutions, Versafe provides a comprehensive real-time detection and protection for every user, device and browser. The acquisition will help make the company’s security, access and mobile solutions (including its Application Delivery Firewall solution) stronger. F5 is building out two world-class security operations centers in Seattle and Tel Aviv to support the new online security service from its Versafe acquisition.
With growing awareness of its security solutions in the market, F5 believes that this segment offers huge growth opportunity and expects the strong sale momentum to continue in fiscal 2014.
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%). 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.
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