F5 Networks (NASDAQ:FFIV) is the market leader in Application Delivery Controllers (ADC), and the segment accounts for close to 60% of it total product revenues. An ADC simplifies the management of data centers, delivery of resources across diverse platforms and enables applications to perform faster. The core function of F5’s products is load-balancing that distributes Internet traffic evenly across multiple servers in a data center (either physical servers or virtual machines).
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After growing at a strong pace for many years, the ADC market is believed to have slowed down this year. Though macro headwinds might restrict short term growth, we think that the ADC market continues to have immense long term growth potential and will remain an important revenue driver for F5.
Last year, rival firm Cisco announced its decision to exit the ADC market after losing more than 50% of its market share to F5 and Citrix. Cisco’s ADC market share is estimated to have declined from 22.5% in 2009 to 11% by November 2012. ((F5 Networks And Citrix Systems Benefit From Cisco’s ACE Exit, Seeking Alpha, September 24, 2012)) Though it will continue to sell and service its existing customers, Cisco will no longer develop its ACE load-balancer technology in the future.
Despite Cisco’s partnership with Citrix where Cisco recommends Citrix’s NetScaler to customers as an ADC alternative, F5 claims that it has won a number of big Cisco clients and has a rich pipeline of similar deals for the future. While we agree that rising competition and lower industry growth can limit F5’s future growth, we believe that the company can manage to retain its dominance in the ADC market.
What Are The Factors Driving Growth In The ADC Market?
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% this year.  Despite a possible slowdown in the short term, we think that the market continues to have immense long term growth potential as ADCs remains an important tool for managing data network traffic. Market research firm Dell’Oro predicts the ADC market to increase from $1.6 billion in 2012 to $2 billion by 2016. 
Here are some of the factors driving demand for ADCs:
– Growing network traffic: With increasing worldwide Internet penetration, the global IP traffic has increased eightfold 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%. 
– 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 services and storage 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 growth at the high-end segment has somewhat stagnated, there is increasing demand from the lower-end customers who are turning towards virtual ADCs. Virtual appliances currently represent only 8% of the ADC market but the proportion is slated to rise in the future. Revenue from virtual appliances is estimated to increase from $50 million in 2011 to $500 million by 2016. 
Why Citrix Remains 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% during the same period.  Citrix is gaining share on account of two factors –
1. 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.
2. 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).
F5 Will Retain Its Leadership In The ADC Market
In its recent earnings call transcript, F5 declared that it has scored big product wins by replacing some of Cisco ACE products in large customer accounts and has a strong pipeline of similar opportunities. In addition to replacing Cisco’s existing solutions, F5 has the added opportunity of providing customers additional functionality like DDoS prevention and application security solutions.
In the last few quarters, F5 has been working on the most significant product refresh in several years. It launched a range of new products and software solutions this year. We believe that the new product portfolio will better equip F5 to exploit Cisco’s customers. In addition to a strong product portfolio, F5 offers Cisco customers a 25% discount on integration services.
Cisco’s exit has opened up additional revenue opportunities for existing players in the ADC market. Replacing Cisco’s ACE solutions represent a significant portion of F5’s deal pipeline. We believe that F5′s competitiveness in the market remains intact and it would earn higher ADC product revenue in the future.
Our price estimate of $114 for F5 Networks is at a considerable premium to the current market price.Notes:
- A Fable of Three Networking Insects, The Motley Fool, May 17, 2013 [↩]
- F5 Networks And Citrix Systems Benefit From Cisco’s ACE Exit, Seeking Alpha, September 24, 2012 [↩]
- Cisco Visual Networking Index: Forecast and Methodology, 2011-2016 [↩]
- More Predictions on the Huge Growth of Cloud Computing, Wall Street Journal, April 21, 2011 [↩]
- Cisco Ending ADC Business, Ceding Market to F5, Citrix, Riverbed, eWeek, September 20, 2012 [↩]
- 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 [↩]