Factors That Could Lower Our Valuation For F5 Networks

After witnessing fifteen consecutive quarters of revenue growth, F5 Networks (NASDAQ:FFIV) saw a 4% sequential decline in its Q2 2013 revenues on account of sharp decline in earnings from telecommunication customers and the U.S. federal government. However, the company bounced back in Q3 2013 on account of strong growth from the U.S. and as its customers adopted its new product portfolio.

F5’s stock price has declined by more than 20% in the last year on account of slowing growth. The company believes that its competitiveness in the market remains intact and blames the weak macro condition for the slowdown. Despite lower revenue growth it has had consistent operating margins, a solid balance sheet with strong cash generation and no debt.

Though F5 does not anticipate a material change in the macro environment in the near term, it expects its product portfolio upgrade in the last two quarters to help it grow despite continuing softness in the global economy. We believe that F5’s upgraded product portfolio combined with a strong salesforce will help re-accelerate demand for its products in the future.

Our price estimate of $112 for F5 is at a significant premium to the current market price. In this article we explore various factors that can lower our valuation for F5 Networks.

See our complete analysis for F5 Networks here

Slowing Growth In The ADC Market: 10% Downside

While the ADC market witnessed a double-digit growth in 2012, some research firms believe that the market is maturing and growth will slow down to as low as 2% this year. ^[1] ADC simplifies the management of data centers, delivery of resources across diverse resources and enables applications to perform faster.

F5 designs and sells ADC and the core function of its products is load-balancing that distributes Internet traffic evenly across multiple servers in a data center (either physical servers or virtual machines), making them look like a single device. With a 59% contribution to its total revenues in 2012, F5 remains the market leader in ADCs. F5 is majorly dependent on the sale of its ADC products and will continue growing, as long as their is a robust demand for ADCs in the networking market.

Though macro headwinds might restrict short term growth, we think that the ADC market continues to have immense long term growth potential backed by rising network traffic and increasing shift to cloud-based services and data virtualization. The ADC market is estimated to grow at a CAGR of 7.07% through 2015, and we believe that being the market leader F5 will benefit from this trend. ^[2]

If the ADC market grows at a slower pace than we anticipate and the Application Delivery Market (ADN) only reaches $5 billion by the end of our review period, there will be a 10% downside to our price estimate for F5.

Increasing Competition From Citrix Can Limit F5’s Growth In The ADC Market: >10% Downside

Though F5 continues to dominate the ADC market, its market share in the segment declined from 58.1% in 2011 to 55.6% in 2012, while that of its closest competitor Citrix increased from 17.3% to 19% during the same period. ^[3] While F5’s growth has slowed in recent quarters, Citrix recorded strong growth of 46% in its networking and cloud revenues in its recent quarter.

Citrix and Cisco have partnerships in various areas of data center and virtual desktop infrastructure. The two companies recently entered into a new collaboration to integrate Citrix’s NetScaler ADC with various Cisco network and security technologies. Cisco also agreed to recommend Citrix’s NetScaler as an ADC alternative to its customers. Cisco exited the ADC market last year after losing more than 50% of its market share to F5 and Citrix. Citrix claims that it has managed to transition a number of former Cisco ADC customers to its systems.

Additionally, Citrix is a leading player in the virtualization space, a fast growing sub-segment of ADC. Virtual ADCs are much cheaper, costing only one-third of traditional ADCs, which make them an attractive option for the lower-end market. ^[4]

In addition to Citrix, F5 also competes against start-up firm A10 Networks (6.2% market share) and other smaller players such as Riverbed Technology (NASDAQ: RVBD), Radware (NASDAQ: RDWR) and Brocade (NASDAQ: BRCD). In addition to some of the larger players like Cisco, Juniper and Citrix, F5 also competes against new entrants such as Palo Alto Networks, Fortinet and Sourcefire in the ADN market.

Nonetheless, F5 claims to have scored big product wins by replacing some of Cisco ACE products in large customer accounts and has a strong pipeline of similar opportunities. In addition to replacing Cisco’s existing solutions, F5 has the added opportunity of providing customers additional functionality like DDoS prevention and application security solutions. Thus, we believe that the company will manage to retain its leadership in the ADC market.

However, if F5 looses some market share to Citrix or other players in the market and its market share in ADN declines to 20%, it will lower our valuation for F5 by more than 10%.

F5 May Not Be Able To Sustain Its High Gross Margins: 10% Downside

Historically, F5 has enjoyed very high gross margins and the same could come under pressure as competition intensifies. The company is facing competitive pressure from potentially lower cost software based solutions from Citrix. Falling ADC prices over the years have attracted small and medium sized businesses as well as large enterprises and service providers, driving growth in the market. In order to face Citrix’s growing threat and retain its leadership in ADCs, F5 might have to lower its prices to spur demand which can put pressure on margins.

If F5’s gross margins drops down to 65% over our review period our price estimate will decline by approximately 10%.

Understand How a Company’s Products Impact its Stock Price at Trefis

1. A Fable of Three Networking Insects, The Motley Fool, May 17, 2013 [↩]
2. Global Data Center Application Delivery Controller Market 2011-2015, Research And Markets, October 2012 [↩]
3. Is F5 Networks’ Fumble a Buying opportunity?, The Motley Fool, April 10, 2013 [↩]
4. F5 Networks On Its Heels, But Hasn’t Fallen Down Yet, Investopedia, June 3, 2013 [↩]