Did F5 Networks Overpay To Acquire Shape Security?

F5 Networks (NYSE: FFIV) recently announced that it has entered into an agreement to acquire Shape Security – a security company that protects the websites and mobile apps of some of the world’s largest enterprises from various types of fraud and cybercrime. Notably, F5 will shell out $1 billion to acquire Shape Security – a figure that represents a Price-to-Sales (P/S) multiple of 14.3x for the target company, which is nearly 4 times F5’s estimated FY’20 P/S multiple of 3.6x. The deal is expected to close in March 2020, and F5 is expected to fund the transaction through cash on its balance sheet and a $400 million unsecured term loan.

This is the most expensive acquisition in F5’s history and we believe the acquisition will weigh on the company’s earnings in the near term but is likely to boost F5’s growth in the long term. Trefis quantifies the impact of the Shape acquisition on F5’s operating metrics in the scenario-based dashboard How Much Could F5 Networks Be Worth Post It’s Shape Security Acquisition? Besides detailing the rationale behind the acquisition, we arrive at the potential upside to F5’s stock as a direct result of the acquisition.

#1. F5’s Acquisition of Shape Could Add Additional $140 Million To F5’s Application Revenues By FY’21

• Shape is a leader in fraud and abuse prevention and is likely to add a new dimension to F5’s portfolio of application services which is helpful in protecting customers’ digital experiences.
• The acquisition will accelerate F5’s growth momentum and is likely to double F5’s addressable market in the security business.
• Post its completion in March 2020, Shape Security will be integrated with F5’s software’s business under the Application Delivery Network segment.
• Notably, Software revenues are approximately 25% ($250 million) of the company’s Application delivery revenues.
• We assume that the acquisition will boost the company’s software revenues by 35% and 60% in 2020 and 2021, respectively. As a result, Shape is expected to add around $140 million to F5’s software business over 2020-2021, helping F5’s application revenues to cross $1.16 billion in FY’21.

#2. However, Additional Expenses of ~$115 Million Are Expected To Be Incurred Due To Shape Integration

• Purchase accounting adjustments and anticipated one-time expenses related to the transaction and integration are likely to weigh on the company’s earnings in the near term. Moreover, the company is funding 40% ($400 million) of the transaction through debt which is likely to further impact the company’s earnings.
• As a result, we expect the division’s net income margin to contract by 4 percentage points and 2 percentage points in 2020 and 2021, respectively.
• Notably, this translates into an increase in expenses for F5 by $115 million by the end of FY21.

#3. Additional expenses are likely to weigh on the company’s earnings resulting in erosion of $0.49 per share in FY’21

• Additional revenue of $140 million is likely to be offset by additional expenditures of $145 million over 2020-2021.
• We expect the company’s net income to decline to $534 million as opposed to our existing forecast of $561 million. Our analysis also takes into account the fact the company will be funding a part of the transaction through debt which will result in additional costs.
• Assuming shares outstanding of around 55 million, this translates to a reduction in EPS by around $0.49 per share.

#4. This reduces our price estimate for F5’s shares by 5%

• In our base case (pre-acquisition) scenario, we estimate a price estimate of $182 for F5’s Stock.
• This figure reduces to $173 after factoring in the impact of the acquisition.
• However, we remain optimistic about F5’s growth prospects over coming years, and maintain a price estimate that is almost 25% ahead of its current market price

Details about our forecast for F5’s EPS for FY21 are available in our interactive dashboard.

To sum things up, the acquisition of Shape will help F5 to become an end-to-end application protection company that would protect the applications from the development stage all the way to when end users interact with them. However, the price tag of $1 billion looks a bit steep for the company that has just around $70 million of revenues. Moreover, the means of financing the deal will likely be a drag on the earnings in the near future. In fact, the reduction in the company’s projected valuation as detailed above indicates that F5 paid roughly $500 million more than it should have for Shape Securities.

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