F5 Networks (NASDAQ:FFIV) reported its fiscal fourth-quarter earnings last month. Despite a cautious spending environment, the company witnessed 7% quarter-over-quarter and 9% year-over-year growth. Due to a difficult macro environment, F5 posted negative revenue growth in the first half of fiscal 2013. However, with the completion of a product refresh in the fiscal third quarter, growth re-accelerated in the latter part of the year. For fiscal 2013 (September year end), F5’s revenue increased by 8% to $1.481 billion, compared to fiscal 2012. In addition to strong demand for its new products, the company benefited from rising strength in new and emerging markets. This helped improve F5’s gross margin to 83.1% in in the fourth quarter, compared to the prior year level of 82.7%.
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 key here is its software-intensive offering. 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. As we noted, 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.
Product Margins Remain Strong
Despite stiff competition in the industry, F5 expects product gross margins to remain strong in fiscal 2014. In the fiscal third quarter of 2013, F5 completed the launch of what it claims to be the most significant product refresh in several years and management strongly affirms its products’ competitiveness. The upgraded product portfolio has significantly expanded its addressable market and the company claims to be witnessing record competitive win rates. Additionally, 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.
F5 is also well-positioned to gain share in the $6.5 billion network security market. It entered the Internet firewall market in February 2012, and security modules now account for approximately 30% of F5’s total product revenue. With growing awareness of its security solutions in the market, the company expects the strong sales momentum to continue in fiscal 2014 as well.
We think that the increasing product revenue base will enable F5 to retain its product gross margins at the current level. Product sales accounts for over 50% of F5’s total revenue.
Rising Investment In Consulting Services Can Lower Margins
In its latest earnings call, F5 stated that it expects the rising investment in consulting services to lower overall gross margins by 0.5% to 1% over the course of fiscal 2014. Though services has a lower margin, it is still very profitable, generating a gross margin of 81.8% in the recently ended year. F5 currently derives 46% of its revenue from services, up from 42% an year ago, and we in our model the division accounts for 37% of the company’s valuation. The company indicates that its services business remains strong with high renewal rates and attach rates.
10% Downside If Gross Margins Decline To 70%
F5 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 into the customer base, 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.
In addition to rising competition, external factors like technological shifts or a change in price/performance preferences can lower F5’s gross margins in the future. Apart from 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 for smaller enterprises.
If F5’s product and service gross margin decline to 70% over our review period, there will be 10% downside to our current price estimate of $112.