F5 Networks (NASDAQ:FFIV) designs and sells application delivery controllers (ADC), a hardware appliance used in data centers. Its products simplify the management of data centers and delivery of services across diverse resources. Despite a sluggish macro environment, the company closed its fiscal 2012 with $1.38 billion in revenues, marking a 20% increase over 2011. F5 has had consistent operating margins, a solid balance sheet with strong cash generation, and no debt. (Read Q1 2013 Earnings Article: F5′s New Products Will Help Restore Growth Momentum)
F5 Networks’ stock price has declined from $138 in April 2012 to the current level of $93. However, keeping in mind the robust pipeline of future sales opportunities, we continue to believe in its strong fundamentals. We think that the decline in stock price is more on account of macro concerns and continue to believe in the long-term growth prospects of the company.
Here we provide a quick snapshot of the important segments that contribute to F5′s business and the key trends that could help drive the stock in the future.
What are the important segments that contribute to F5′s business?
The core function of F5′s products is load-balancing that distributes internet traffic evenly across multiple servers in a date center (either physical servers or virtual machines), making them look like a single device. F5′s BIG-IP product family represents the majority of its sales and supports a growing number of features and functions available as software modules and standalone applications. TMOS is the application that runs on the BIG-IP platform. F5′s products and services are purchased by a wide variety of enterprises in technology, telecommunications, financial services, transportation, education, manufacturing, healthcare and the government sectors.
F5 Networks earned close to $1.5 billion in revenues in calender year 2012 and earned approximately 83% gross profit and 30% operating margin on the same. It incurs low capital expenditure (3% of gross profits) as its software is its primary product. With 15% R&D and 40% selling and administrative expenses as a percentage gross profit, F5 devotes a significant amount of resources on developing and marketing new software and products.
We divide F5′s business into the following key segments:
1. Application Delivery Network
Application delivery networking (ADN) involves managing, inspecting, modifying, redirecting and securing of application traffic between servers. The basic function of ADN includes load-balancing and monitoring the performance of servers and applications. ADN accounts for over 56% of F5′s overall revenue and the company earns 84% gross margins in this segment.
On account of rising internet traffic, data center virtualization and growth in cloud computing, the ADN market is estimated to increase from close to $3 billion in 2012 to over $7 billion by 2019.
F5 has a strong customer focus and has developed technology partnerships and alliances with major application vendors, including Oracle and SAP. The company also works closely with two major server virtualization vendors, Microsoft and VMware, to help its customers get the most out of their virtualization deployments.
Accounting for more than 25% of the market, F5 Networks is a dominant player in the application delivery network market. With a number of leading technology partners, strong application and feature-rich products and a dedicated sales and distribution channel, we expect F5′s market share to increase over our review period.
2. Installation, Consulting & Other Services
F5 also offers a wide range of support services that include installation, phone support, hardware repair and replacement, software updates, consulting and training services. F5’s technical support staff is strategically located in regional service centers to support its global customer base. Its customers typically purchase a one-year maintenance contract which entitles them to an array of services provided by F5’s technical support team.
Services account for close to 42% of F5′s overall revenue and the gross margins are the same (84%) as the ADN segment. We forecast services revenue to grow at the same rate as that of product revenue as services are linked to maintenance contracts sold along with the products.
3. File Storage Virtualization
In most big organizations, data is stored on local file servers, which are difficult to manage, costly to maintain and generally underutilized. Such centralized storage of files can slow access for remote users and applications. F5’s ARX product family of file virtualization solutions represents a unique set of capabilities that optimize the performance and utilization of network attached storage systems.
F5 derives less than 2% of its revenue from file storage virtualization products and earns 82% margins in this segment. We forecast revenues to increase at a steady pace over our review period.
As data in enterprise spread across multiple data centers located in different geographies, it becomes increasingly important for them to implement solutions for tiering of data so that the most important data can be accessed with a minimum delay. F5′s products provide automatic tiering of data that enables enterprises to save both on IT overhead as well as cost of access.
Current Trends That Favorably Impact F5′s Growth
Growing internet traffic: With increasing worldwide internet penetration, the global IP traffic has increased eightfold over the past 5 years and is estimated to grow at a CAGR of 29% from 2011 to 2016.  There is a growing adoption of advanced video communications in the enterprise segment which will fuel growth in enterprise traffic. Enterprise internet traffic is expected to grow at an annual rate of 18%. ((Cisco Visual Networking Index: Forecast and Methodology, 2011-2016))
Shift to cloud-based services and data center virtualization: As organizations transform their own data centers, they are increasingly turning to external third-party cloud providers for services and storage to lower their capital and operating costs. To accommodate the dynamic needs of their clients, cloud providers are building large virtualized data centers to host a constantly changing mix of on-demand resources. Research firm Forrester projects the global market for cloud computing to increase from $41 billion in 2011 to $241 billion by 2020. 
Our price estimate of $130 for F5 Networks is at a significant premium to the current market price.Notes:
- Cisco Visual Networking Index: Forecast and Methodology, 2011-2016 [↩]
- More Predictions on the Huge Growth of Cloud Computing, Wall Street Journal, April 21, 2011 [↩]