Weak macro conditions and the product portfolio transition impacted F5 Networks’ (NASDAQ:FFIV) growth momentum in fiscal 2013 (ending September’13). While economic uncertainty forced its customers to lower their spending, increasing competition led some to question the sustainability of F5’s growth rate and high margins over the long run. However, the company saw its growth accelerate in Q1 2014 as strong demand for its upgraded product portfolio, positive customer response to the recently introduced Synthesis architectural vision, and F5’s ‘Good, Better, Best’ pricing model (introduced in November 2013) led to strong sales across all geographic regions. The company witnessed a 2.8% sequential and 11.2% annual growth in its top line in Q1 2014.
F5 is set to announce its Q2 2014 earnings on April 23 and expects only a marginal increase in its top-line. While we agree that the weak macro environment will restrict its short-term growth, we believe in F5’s long term growth potential. Based on the rising demand for its new products, growing strength in its security offerings, and the building growth momentum with its Traffix Diameter solutions, F5 feels confident of witnessing continuous growth in its top line in fiscal 2014.
Our price estimate of $108 for F5 Networks is in line with its current market price. We will update our valuation after the Q2 2014 earnings release.
Growing Demand For New Products & Software To Help Retain F5’s Leadership In ADCs
The product refresh last year has significantly increased F5′s sales momentum. In Q3 2013, F5 completed the launch of what it claims to be the most significant product refresh in several years. It developed a range of new products and software solutions with an aim to boost demand and create new revenue growth opportunities. The new product line has equipped F5′s sales force and partner channel with the most functional and competitive ADC (Application Delivery Controller) solutions in the market. Already it accounts for the majority of the company’s ADC sales.
Though macro headwinds might restrict short-term growth, we think that the ADC market continues to have immense long term growth potential. It is estimated to grow at a CAGR of 7.07% through 2015.  F5 is one of the leading technology providers that optimizes the delivery of network-based applications and a leader in the ADC market with a market share in excess of 50%.
F5′s upgraded product portfolio has significantly expanded its addressable market and the company claims that it is witnessing record competitive win rates. At its investor meeting, 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.
At present, over 70% of the Fortune 50o companies are F5′s customers. 
Continued Expansion In The Security Market
With the explosion of data and processing required online, security has become a major concern for most enterprises, and thus, this is one segment bound to witness tremendous growth in the coming years. IDC estimates that companies around the world will spend $491 billion in 2014 for fixes and recovery from data breaches and malware, $127 billion in dealing with security issues and $364 billion dealing with data breaches. 
With its BIG-IP 11.1 software passing the ISCA Labs test for network firewalls, F5 entered the Internet firewall market in February 2012 and since then has expanded its security solution portfolio with the addition of new products. Its security portfolio solution has increased dramatically in the last few quarters. It acquired Israel based Versafe Ltd., a provider of web anti-fraud, anti-phishing, and anti-malware solutions in September 2013. The acquisition will help make F5’s security, access, and mobile solutions (including its Application Delivery Firewall solution) stronger.
With growing awareness of its security solutions in the market, F5 believes that this segment offers huge growth opportunity and expects the strong sale momentum to continue in fiscal 2014.
Gross Margins To Remain High
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 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. 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.Notes:
- Global Data Center Application Delivery Controller Market 2011-2015, Research And Markets, October 2012 [↩]
- Best- And Worst – Performing Cloud Computing Stocks March 24th To March 28th And Year-to-Date, Forbes, March 29, 2014 [↩]
- The Link between Pirated Software and Cybersecurity Breaches, March 2014 [↩]