F5 to Retain its Growth Momentum in Q3’14

F5 Networks (NASDAQ:FFIV), a leading provider of technology that optimizes the delivery of network-based applications, will report its Q3 2014 earnings on July 23. At $420 million, the company’s Q2 2014 revenue came in above its target range, driven by rising customer adoption of its new product portfolio, the ‘Good, Better, Best’ pricing model, and the growing sales momentum of F5′s security and service provider business. Though F5 registered a marginal decline in its gross margin (82%), its GAAP earnings per share ($0.91) beat the company estimate. F5 expects revenue to increase by 17% (at the mid-point of its target range) and gross margin to remain flat in Q3 2014.

Based on the rising demand for its new products, growing strength in its security offerings, and the increasing growth momentum with its Traffix Diameter solutions, F5 feels confident of building on the growth momentum gained in the first two quarters of fiscal 2014 (ends with September). In 2014, the company claims that it will continue to introduce significant enhancements and world-leading technology in key growth areas   These include:   security, service providers and mobility, the cloud, orchestration, and software-defined application services.

Our price estimate of $109 for F5 Networks is in line with its current market price. We will update our valuation after the Q2 2014 earnings release.

See our complete analysis for F5 Networks here

Expanding Security Market Remains A Key Growth Driver

F5 entered the Internet firewall market in February 2012, with its BIG-IP 11.1 software passing the International Computer Security Association (ICSA) Labs test for network firewall. Since then the company has expanded its security solution portfolio with the addition of new products. It acquired Israel based Versafe Ltd., a provider of web anti-fraud, anti-phishing and anti-malware solutions in September 2013, enhancing F5’s security, access and mobile solutions.

In May 2014, F5 acquired Defense.Net, which further expanded its portfolio of security solutions for defense against Internet-based DDoS attacks on networks, data centers and applications. Defense.Net is a provider of cloud-based security services for protecting data centers and Internet applications from Distributed Denial-of-Service (DDoS) attacks, which makes a machine or network resource unavailable to its intended users. The combined portfolio of the two companies will provide customers with the most comprehensive hybrid DDoS solution.

With the growth of the Internet and rapid increase in the volume of traffic accessing applications, the DDoS attacks are becoming very common as cyber criminals find new ways to amplify their attacks. With an expanded product portfolio, F5 helps ensure that critical applications and networks are protected and available under the most demanding conditions, regardless of the volume, type or source of DDoS attack. Though the acquisition is not expected to have a material impact on F5’s operating results, it helps the company by increasing its competitiveness in the fast growing security market.

With increasing network complexity, reducing security risk is an important criteria for enterprises. Over the years, data theft technology has become more sophisticated and the global cyber-crime market is currently sized at $104 billion. ^[1] 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. ^[2]

The security market is highly competitive with players such as Cisco, McAfee, Palo Alto Networks, and others. Despite intense competition, F5 claims to be making significant progress in the market. Last quarter, F5 saw strong sales across its securities solutions portfolio, including Application Security Manager (ASM), Access Policy Manager (APM) and Advanced Firewall Manager (AFM). It had two multi-million dollar sales wins in the quarter as F5 solutions replaced existing competitors’ solutions. Also, a Tier 1 service provider purchased F5′s AFM firewalls to replace their existing traditional data center firewalls.

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 throughout fiscal 2014.

Good, Better, Best Offerings will Drive Software Sales

F5 introduced the ‘Good, Better, Best’ pricing model in November 2013 to help customers maximize their value of enterprise application delivery. The program helps customers select a platform that best fits the organizations’ needs, offering advanced traffic management, optimization and security services. The company claims that the model makes it easier to package its solutions together for the customer, giving them some incentive to add more modules.

F5 saw its revenue from the sale of software modules increase in Q2 2014, as a higher percentage of its customers purchased the ‘Better’ and ‘Best’ offerings. This was the first full quarter of the ‘Good, Better, Best’ market model and sales were up 83% compared to Q1 2014. 78% of the customers bought the ‘Best’ offering.

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.

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1. HP, F5 Networks Expand Web, Mobile Security Offerings, eWeek, September 17, 2013 [↩]
2. The Link between Pirated Software and Cybersecurity Breaches, March 2014 [↩]