F5 Networks (NASDAQ:FFIV) is one of the leading technology providers that optimizes the delivery of network-based applications. The company closed its fiscal 2012 with 20% higher revenues, but its growth rate slowed to 7.6% in fiscal 2013 (ended September 30, 2013) on account of weak macro conditions. It witnessed negative growth in the first half of fiscal 2013, but saw its growth re-accelerate in the latter part of the year with the completion of a major product refresh in the third quarter.
Nevertheless, F5’s stock price is down by more than 20% year to date. We believe that the decline in its stock value is a combination of macro and internal factors. While the economic uncertainty has forced its customers to lower their spending, increasing competition has led some to question the sustainability of F5’s growth rate and high margins over the long run. Slowing growth in the Application Delivery Controller (ADC) market is another important factor contributing to the negative sentiment around F5’s stock.
Our price estimate of $112 for F5 Networks is at a significant premium to the current market price of $81. While we agree that the weak macro environment can restrict its short term growth, we believe in F5’s long term growth potential. In this article we discuss the growth potential of the ADC market and why we think F5 remains a strong player in the industry.
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Slowing Growth In The ADC Market?
ADCs simplify both the management of data centers and the delivery of resources across diverse networks. They also enable applications to perform faster. While the ADC market witnessed a double-digit growth in 2012, some research firms believe that the growth will 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, and we believe that, being the market leader, F5 will benefit from this trend. 
Here are some of the factors driving demand for ADCs:
– Growing network traffic: With increasing worldwide Internet penetration, global IP traffic has increased eight-fold over the past five years and is estimated to grow at a CAGR of 29% from 2011 to 2016. Enterprise Internet traffic is expected to grow at an annual rate of 18%.  Cisco estimates Internet traffic to grow at 40% annually. 
– 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 computing and storage services, to lower their capital and operating costs. 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. 
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 dominates the high-end market but does not have a very large (less than 20%) market share in virtual ADCs. However, F5’s partnership with VMware can help expand its presence in virtual ADCs.
Additionally, many argue that a physical and virtual ADC can coexist and needn’t necessarily be an either/or option. Moreover, though virtual ADCs are comparatively lower priced than traditional ADCs, the latter is better suited to manage large amounts of application connections and data. (Read: Physical or Virtual ADC: An Either/Or Choice?)
F5 Networks Is A Leader In Traditional ADCs
F5 designs and sells ADCs, and the core function of its products is load-balancing data that distributes Internet traffic evenly across multiple servers in a data center (either physical servers or virtual machines). F5 is a leader in the ADC market with a market share in excess of 50%.
F5 recently completed the launch of what it describes as the most significant product refresh in several years. The company developed a range of new products and software solutions with features intended to boost demand and create new revenue growth. The upgraded product portfolio has significantly expanded F5′s addressable market and the company reports that it is 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.
At its investor meet, 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 its market position.
F5 is confident that demand for its products will conitinue to accelerate, driven by: 1) continuing advances in the capability of its hardware and software; 2) increaseing market penetration in emerging markets only now adopting the technology; 3) continuing replacement of aging Cisco ACE infrastructure; and 4) Upgrades within its own installed base. Its book-to-bill ratio (ratio of orders received to units shipped and billed) in Q4 2013 was greater than 1.0x, and the company claims to be seeing an uptick in million-dollar-plus deals, which had been shrinking since the last few quarters.
Competition From Citrix Is A Big Threat
Though it continues to dominate the ADC market, F5′s 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 19.0% during the same period.  Citrix is gaining share on account of two factors –
– Partnership with Cisco: 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. Citrix claims that it has managed to transition a number of former Cisco ADC customers to its systems.
However, in its earnings call, F5 announced that its has recorded over 900 ACE replacement project wins in fiscal 2013. In Q4 2013, new business accounted for 47% and existing business for 53% of F5′s sales as compared to 40% and 60% a year ago, respectively. The ACE opportunity accounts for a majority of the new business.
– Citrix’s virtualization offering: Virtualization is a fast growing sub-segment of ADC and Citrix is a leading player in the market. Virtual ADCs are much cheaper, costing only one-third of traditional ADCs, which make them an attractive option for the lower-end market. 
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).Notes:
- A Fable of Three Networking Insects, The Motley Fool, May 17, 2013 [↩]
- Global Data Center Application Delivery Controller Market 2011-2015, Research And Markets, October 2012 [↩]
- Cisco Visual Networking Index: Forecast and Methodology, 2011-2016 [↩]
- F5 Networks a Buy on Growth and Profits, InvestorPlace, November 19, 2013 [↩]
- More Predictions on the Huge Growth of Cloud Computing, Wall Street Journal, April 21, 2011 [↩]
- Is F5 Networks’ Fumble a Buying opportunity?, The Motley Fool, April 10, 2013 [↩]
- F5 Networks On Its Heels, But Hasn’t Fallen Down Yet, Investopedia, June 3, 2013 [↩]