F5 Networks (NASDAQ:FFIV), a leading provider of technology that optimizes the delivery of network-based applications, reported another quarter of strong sales in Q3 2014 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. At $440 million, revenue came in ahead of company guidance and increased 5% sequentially and 19% annually. F5 witnessed strong sequential and annual growth in both products and services. The Americas, EMEA and APAC all recorded double-digit annual sales bookings growth, while Japan was down due to a number of significant orders slipping into Q4 2014. At $1.05 and $1.39, F5’s GAAP and non-GAAP EPS were above its expected range.
The solid revenue growth and profitability in Q3 2014 was driven by strong uptake of F5’s expanding array of systems and application services. The company claims to have experienced a very strong increase in its business pipeline in Q3 which it believes will translate into growth in the current quarter as well as fiscal 2015. As drivers of F5’s future growth, we see: 1) continued strength in sales of F5’s security solutions, 2) the ‘Good, Better, Best’ bundling options, 3) rising momentum with Cisco ACE replacement opportunities, and 3) a general trend toward broader adoption of its full solution portfolio by large enterprises, service providers and government customers.
F5 intends to continue introducing significant enhancements and world leading technology in its key focus areas, which include security, the service provider and mobility markets, as well as the cloud and software defined data center architectures. The company plans to make infrastructure investments in additional data centers and security operation centers to ensure growth in its cloud-based opportunities, including Defense.Net, Versafe and general F5 as a service solutions. As part of this effort, it plans to recruit an additional 125 employees to its team in Q4 2014.
Our price estimate of $109 for F5 Networks is in line with its current market price. We are in the process of updating our valuation for the company.
Security Business Is A Huge Growth Driver
F5 reported strong sales across its securities solutions portfolio including Application Security Manager (ASM), Access Policy Manager (APM) and Advanced Firewall Manager (AFM). It also started to win sales of its new Secure Web Gateway solution last quarter.
With increasing network complexity, reducing security risk is an important criterium for enterprises. Over the years, data theft technology has become more sophisticated and the global cyber-crime market is currently sized at $104 billion.  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. 
Since its entry in the Internet firewall market in February 2012, F5 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. Last quarter, it closed its acquisition of Defense.Net, which is a provider of cloud-based security services for protecting data centers and Internet applications from Distributed Denial-of-Service (DDoS) attacks. DDoS attacks bombard servers with access requests, making them unavailable to its intended users. The combined portfolio of the F5 and Defence.Net 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.
F5 will deliver another major revision of TMOS (Alpine release) in the near future. The TMOS Alpine release includes approximately 124 new features with over 50 new features for security. Examples of new security functionality includes good integration of the Versafe module on BIG-IP for native deployment of WebSafe anti-fraud and detection services, centralized management support for ASM and BIG-IQ, more GI firewall support for AFM, including significant new centralized management capabilities and BIG-IQ. 
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 the next few quarter.
Good, Better, Best Offerings Drives Software Sales
Q3 2014 was the first two quarter-over-quarter comparison of sales of F5’s ‘Good, Better, Best’ bundles. The company continued to experience strong momentum with a 49% sequential increase in the ‘Good, Better, Best’ bundles, with 73% of the customers opting for the ‘Best’ solutions. F5 claims that sales of these bundles now account for a significant percentage of its overall quarterly 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.
Cisco ACE Replacements Provides Added Growth Opportunity
In 2012, rival firm Cisco announced its decision to exit the ADC market after losing more than 50% of its market share to F5 and Citrix. F5 has scored big product wins by replacing some of Cisco ACE products in large customer accounts since then. The company claims that the competitive win rates continue to be extremely high, at over 90%. The ACE installed base is over $1 billion, but F5′s target market is much larger. In addition to replacing Cisco’s existing solutions, F5 has the added opportunity of providing customers additional functionality including security, access control and application acceleration.
F5 recorded 900 ACE replacement project wins in fiscal 2013 and believes that the Cisco ACE install base continues to be a significant replacement opportunity for it, at least for 2 years. The Cisco ACE replacement opportunities were another strong growth driver for F5 in Q3 2014. F5 claims that customers continue to take the opportunity to add additional functionality, such as its ASM and/or the AFM security modules when they implement the new F5 solutions.
Q4 2014 Guidance
- Revenue in the range of $453 million to $463 million.
- GAAP gross margin to remain in the 82% range. Non-GAAP gross margin at around 83.5%.
- GAAP operating expenses in the range of $232 million to $240 million.
- GAAP and non-GAAP effective tax rate of 38% and 35.5%.
- GAAP and non-GAAP EPS target of $1.15 to $1.18 and $1.46 to $1.49, respectively.Notes:
- HP, F5 Networks Expand Web, Mobile Security Offerings, eWeek, September 17, 2013 [↩]
- The Link between Pirated Software and Cybersecurity Breaches, March 2014 [↩]
- F5 Networks’ (FFIV) CEO John McAdam on Q3 2014 Results – Earnings Call Transcript, Seeking Alpha, July 23, 2014 [↩]