Time to Sell F5 Networks

by: Matt D'Alto
Reasons to sell (or sell-short) F5 Networks (NASDAQ:FFIV)
- Recent price $73.50
- $5.89B market capitalization
Recommendation: Long-only accounts should consider trimming/underweighting their FFIV positions into strength around the F3Q10 results (June 2010 quarter), especially above $70/share; trading/hedged accounts should consider shorting FFIV into strength leading into or after F3Q10 results and guidance.
Company Background
F5 Networks is a leading provider of technology hardware and software solutions that optimize the delivery of network-based applications as well as the security, performance, and availability of servers, data storage devices, and other network resources. FFIV's products sit in front of their customers' web/application servers, balancing application traffic, offloading non-core functionality where appropriate, improving network performance, and ultimately reducing the total server and technology expenditures for FFIV's customers.
FFIV is the best company at what they do with the best product suite on the market today. FFIV has seen a revival of growth over the last year from a new product and upgrade cycle in its core "BIG-IP" application delivery controller business, which makes up the majority of the company's revenues.
Business continues to be strong, but this is well known now by investors and has been well-telegraphed by management. In FFIV's fiscal 2Q2010 quarter (ending March 2010), management guided bullishly for sequential revenue growth for the rest of FY2010, with a book-to-bill greater than one entering F3Q2010.
So what's not to like, right? With this kind of market leadership and visibility, it is hard to deny that FFIV should have a solid quarter when they report in July. Odds are good that the guidance for the final September quarter will also be favorable as management promised for sequential revenue growth for the rest of this fiscal year.
Catalysts for Stock Depreciation/Multiple Contraction
Despite these positive factors, it will be hard for the stock to move to the next level and in fact may be at risk for profit-taking at its current valuation, for the following reasons:
1.) Sequential revenue growth, but how much and for how long? Investors' expectations for revenue growth have made a 180-degree turn from 18 months ago, when everyone thought FFIV's revenue growth would be at best low single-digits into infinity due to slowing product growth. Street analysts' expectations also have now become uniformly bullish, and assume FFIV will hit the upper end of FFIV's prior quarterly revenue guidance, and then grow sales 5.3% sequentially in F4Q2010. Management never committed to a specific sequential revenue growth target - just that it would grow sequentially. Even if they hit or exceed this number, there is no visibility yet from management on what revenue growth will look like in FY2011. The Street is already assuming 19% revenue growth on much tougher year-over-year comparables (see below). Knowing management, they will be conservative on the first cut of the new fiscal year's guidance parameters.
2.) Margins look unsustainable. In the last quarter, FFIV's gross and operating margins hit all-time highs for the company (80.7% and 32.2%, respectively). Again, this is a great achievement, but Street consensus is now baking in gross margins above 80% for the rest of this fiscal year and 79.9% averaging over the next 6 quarters - something the company has never done in its history. Also concerning is the Street already assumes operating margins will average 31.8% over the same 6 sequential quarters - again, a feat the company has never achieved. Maybe this is the new paradigm for the company, but more likely these estimates become an even harder hurdle knowing that FFIV will need to ramp expenses faster behind their recent rapid revenue growth to keep it going. Even well-managed expense control could easily result in historically excellent operating margins that are nonetheless below current lofty expectations.
3.) Geographically, there no room for error. All regions including Japan (which underperformed in the December 2009 quarter) showed strong sequential and year-over-year growth in the March 2010 quarter. Again, it is rare that all stars align so well for FFIV for multiple consecutive quarters. Sequential comparables will get much tougher now, and even one underperforming geography can now lead to some level of disappointment. It is worth noting that the EMEA region (mostly Europe, but includes Middle East and Africa) makes up over 20% of FFIV's revenues. Management has commented intra-quarter that they have not seen weakness in European markets. Nonetheless, this bears watching given most of FFIV's business is conducted through distributors, not direct sales, and one of FFIV's smaller competitors (Blue Coat Systems (NASDAQ:BCSI)) recently cited a poorer-than-expected outlook specifically due to European weakness.
4.) Near-term acquisition of FFIV seemingly less likely.FFIV's multiple has been the beneficiary of constant acquisition target rumors over the past year. Although FFIV is certainly a best-in-breed company, the list of potential acquirers has decreased and the deal pricing is now a significant hurdle versus a year ago because of FFIV's stock price appreciation. Hewlett Packard (NYSE:HPQ) was a constantly rumored acquirer of FFIV, but they now have their hands full integrating both 3Com (COMS) and PALM (PALM). Also, if FFIV were to be acquired, it would likely now have to be all-cash, as FFIV's lofty multiple makes an all- or part-stock bid highly dilutive/unattractive now. If anything, FFIV may more likely be the acquirer than the acquired now given their higher currency. Historically FFIV has been terrible at successfully integrating acquisitions.
5.) Balance sheet - yeah, it's great, but... Wall Street analysts like to couch FFIV's high valuation by excluding cash on their balance sheet to make the high P/E multiple more palatable. Conveniently, the Street is using a cash-per-share number that approaches $9/share as of FFIV's March 2010 quarter. However, analysts are using a numerator that incorrectly includes short- and long-term investments to get to the $711M in "cash". FFIV's latest 10K shows that $157M of long-term investments include municipal bonds and corporate bonds/notes with maturities between one and five years away - hardly what most would consider cash. Another $174M of this $711M is also munis and corporates with less than one year maturities - also questionable. There is another $143M of U.S. government securities in this $711M bucket, and while safer these also have maturities between one and five years, and will fluctuate in value. The conclusion is it is hard to put much faith in the ex-cash valuations the Street uses to justify FFIV's valuation premium since much of the cash value fluctuates as investments are marked-to-market every quarter.
Also, days sales outstanding (DSOs) in the latest quarter was 39. This metric historically hovers in the mid-50s for FFIV, and management has guided to such in the recent past. The sudden improvement in DSOs, while a good thing otherwise, likely represents unusual pull-forward of recognized revenues from larger deal sizes and/or customers, rather than a sustainable improvement in payment speeds. A return back to more normalized DSO levels seems more likely than not, and is a potential risk to estimates going forward.
6.) "Mo-mo money" has no patience. There is a lot of momentum technology investor money "hiding" in FFIV because, unlike many of its communication equipment and technology sector peers, the chart technically has not yet "broken." This leaves the stock highly susceptible to even minor issues/concerns that could derail this momentum growth story very quickly.
7.) Valuation is not factoring in tougher comparisons.Year-over-year comparisons will get much more difficult entering FY2011. Even with a continued strong (albeit well underway now) product upgrade cycle and data center consolidation spending, FFIV will probably be able to muster, at best, 20% year-over-year revenue growth in FY2011. That is a very respectable number for sure on a tough comp, but FFIV stock already trades at 27x FY2011 consensus earnings expectations which assume 19% revenue growth next year with near-peak gross and operating margins baked into the earnings expectations. FFIV also trades at 7.8x LTM sales. Even the best communication equipment companies rarely can string together this kind of sequential fundamental improvement over such a relatively long period of time and thus maintain such a valuation premium. Some multiple compression seems likely here.
Also, technology stocks often stop outperforming when the second derivative of growth (macro or micro) slows. It is increasingly likely that FFIV is in the midst of peaking growth and margins for the company, probably at the same time as the overall macro economy here in the U.S. and abroad. The stock market will be appropriately forward-looking if this is the case.
Consider Pairing Up CSCO Long/FFIV Short
If you want communications equipment and/or technology exposure, consider Cisco (NASDAQ:CSCO) over FFIV on the long side, and/or pair an FFIV short with a CSCO long to hedge potential macro risks. On a relative valuation basis, CSCO trades at 12.5x forward earnings estimates and at 3.4x P/S (i.e., less than 1/2 of the multiple of FFIV). With CSCO you're only sacrificing a few percentage points of growth over the next 12-18 months relative to FFIV based on current Street consensus, but getting a much less-loved stock with similarly strong fundamental characteristics at a much better valuation. If you prefer to hold your long position in FFIV, you can also buy FFIV Oct. 65 put options to protect your profits without selling your stock.
Disclosure: Short FFIV, Long CSCO