F5's Growth Is Far From Over

Server virtualization, mobile computing, and data center consolidation have led to rapid data traffic growth and increased network complexity, and  F5 Networks (FFIV) has been a primary beneficiary of these secular trends. The firm's core products--application delivery controllers, or ADCs, which direct data traffic to and from web and application servers--have become key components in data center environments. F5 has steadily gained market share, largely at  Cisco's (CSCO) expense, and the firm now enjoys roughly 50% market share.

We believe the application delivery controller market will continue to grow, and we expect F5's revenue to grow faster than the overall market as it continues to gain share and drive incremental services revenue. F5 is also well positioned to gain share in the $6.5 billion network security market, and we expect product revenue growth to accelerate throughout 2013.

F5 Reiterates Long-Run Strategy and Near-Term Opportunities at NYC Technology Center
On Sept. 4, we attended an open house investor meeting hosted by F5 Networks at the firm's New York International Technology Center. F5 opened this center, its third, earlier this year to provide current and prospective customers an opportunity to test its products in live environments and receive briefings on current offerings and product roadmaps. While management provided no financial or business updates at the event, we came away with a greater appreciation of the firm's strategy, market opportunities, and challenges. We are maintaining our $100 per share fair value estimate and narrow economic moat rating.

CEO John McAdam began the event by reiterating his view of the near- to intermediate-term growth drivers for F5, emphasizing that management's top priority is to reinvigorate product revenue growth. McAdam pointed to an overdue product refresh cycle, market share gains in network security, and Cisco ACE replacements as three key catalysts. While the security opportunity is unlikely to provide significant upside for several more quarters in our view, we do think F5's product growth could be boosted by a refresh cycle at some point in fiscal 2014. McAdam pointed to an active installed base of 33,000 older-generation application delivery controllers with an average age of approximately 6.5 years and more than 70,000 additional appliances nearing three years in production environments. We think F5 can push a significant portion of these customers to upgrade to newer appliances by bundling new features, reducing support for older generations, or some combination of both. Management acknowledged that the company needs to do a better job of moving customers to newer generations. We agree. In our view, customer switching costs are probably high enough that the firm could force an upgrade cycle without risking material customer attrition at this point.

Beyond potential near-term growth drivers, management reiterated its long-term strategy of extending ADC functionality, capturing share of the network security market, increasing its footprint in service provider networks, and supporting emerging data center networking architectures and application delivery models.

Finally, management stressed indifference as to whether customers purchase hardware-based ADCs or software-based ADCs in order to alleviate ongoing investor concerns that software-based traffic steering techniques could reduce demand for the firm's hardware in virtualized environments. We agree that F5 is in a relatively strong position to be an important supplier of virtual firewalls, ADCs, policy enforcement, and other virtual network services in emerging overlay environments. Still, it is not completely clear to us how network overlay architectures such as VMware's NSX will provide incremental opportunity for F5 without cannibalizing existing hardware sales.

Market Share and Customer Reliance Position F5 for Future Growth and Sustained Margins
As enterprises and telecommunications carriers continue moving voice, data, and video toward a converged IP network, effectively and securely managing network traffic has become an increasingly complex task. ADCs have allowed users to simplify this task while improving overall network efficiency and reducing expenditures on other equipment. ADCs sit in front of a firm's servers and manage traffic from the outside world. They ensure efficient and secure movement of data by discerning the nature of the traffic--where traffic is coming from, what type of information it contains, and where it is going--and then either block, redirect, or expedite delivery of each data stream to the proper server. ADCs monitor the network topography and the current state of the network, and that information along with rules set by the network administrator allows the ADC to adapt to constantly changing network states in real time. Some of these tasks could be handled by the servers themselves, but centralizing these tasks at a single point in front of the servers allows the servers to run more efficiently.

F5 is now looking to leverage its strong position in the ADC market to expand into new markets. The company recently acquired Traffix, which makes diameter signaling controllers used by service providers to help manage the flow of subscriber information across their LTE networks. F5 already generates a significant portion of its ADC revenue from service providers, and this existing installed base should ensure that the company is invited to bid on new diameter signaling controller business. F5 is also looking to make a bigger push into the $6.5 billion network security market by making additional security features available on its existing platform. F5 is currently very strong in niche areas of network security, like web application firewalls and SSL VPNs, and we think that the firm has a reasonably strong chance at extending its reach into the broader security market. If F5 can succeed in either of these newer efforts, our current forecasts--and valuation--for the firm are likely too low.

Despite our enthusiasm for F5's prospects, the company is not without its risks. Cisco's recently announced partnership with  Citrix Systems  could boost Citrix's already strong competitive position within the ADC market. Additionally, external factors like technological shifts or a change in price/performance preferences could force F5 to accept lower margins or invest more heavily in marketing or research and development to maintain its current growth trajectory. There are numerous vendors of WAN load balancing devices and security appliances that don't have the performance or prestige of F5's products, but could create a more competitive environment for F5--especially in smaller enterprises, if not large consolidated data centers.

Broadened Product Line and Customer Base Lead to Narrow Moat
We have long believed that F5's operating system and growing database of traffic control scripts create customer switching costs and a modest network effect, and the firm's efforts to broaden its product line and customer base have compelled us to assign a narrow economic moat. F5's customer base has evolved from an initial focus on Internet service providers, managed hosting providers, and e-commerce sites to a current emphasis on the corporate IT market. Customers include  Deutsche Telekom (DTEGY),  Citigroup (C),  eBay (EBAY),  General Electric (GE), and  General Motors (GM).

​F5 expends significant time and resources to provide configuration templates and best-practice guides that are specific to particular software application deployments. For example, F5 and  Microsoft (MSFT) recently co-developed a 50-page configuration guide for deploying F5's Big-IP version 11 software with Microsoft Exchange 2010 client access servers. F5 maintains dozens of configuration guides for widely deployed software applications such as  VMware's vMotion,  Sap's (SAP) NetWeaver,  Oracle's (ORCL) Fusion middleware SOA suite, and BEA's WebLogic. In our view, customers that utilize these guides and other deployment services offered by the firm in order to configure, deploy, and manage its ADCs in support of particular applications will be reluctant to change vendors for future deployments or capacity expansions.

Most large-scale deployments require additional customization to optimize application performance, and F5's extensible scripting language, iRules, allows customers to develop traffic management scripts that best support their specific environments. Once a customer has created a library of scripts that is optimized for its particular organization, we think the customer will be unlikely to change vendors and lose that built-up knowledge. F5's market dominance creates a virtuous cycle, as the firm can economically invest more dollars in product development, channel support, and professional technical services than its competitors, which in turn allows the firm to provide its customers and resellers with a more compelling product and service than smaller or less-focused competitors.

We do sense growing interest in software-based approaches to advanced traffic management among Internet firms and traditional service providers. Our current view, following the Sept. 4 investor meeting, is that network service chaining and other software-based approaches will create a longer-term headwind to F5's revenue growth, but not be disruptive, though we maintain our stable moat trend.

We continue to expect the majority of F5's customers to stay with F5's hardware platforms for the foreseeable future. Traditional enterprises will find it less costly to periodically upgrade their installed ADC platforms than they would migrating to a software-based architecture or switching to a competitor's offerings. As enterprise customers integrate F5's ADCs into their networks, and as those customers use the firm's development tools to build custom features into their ADCs, we think customers will be increasingly reluctant to re-learn a new vendor's software and rebuild lost functionality.

Management Is Equipped for Future Industry Shifts
F5's long track record of strong financial performance and solid execution gives us confidence in management's ability to navigate future shifts within the data networking industry. We believe F5's capital allocation practices are appropriate given the strong secular growth drivers underlying its products. F5 continues to invest heavily in sales and marketing as it looks to leverage its strong position in ADCs to grow its installed base and deepen its customer engagements. Although this strategy caps near-term operating margin expansion, it helps ensure that F5's competitive position will remain strong for many years to come.

F5 has historically used acquisitions as a method of attaining technologies and expertise in areas that are adjacent to the ADC market. Although not all of these acquisitions are bearing fruit, we think it is important that management continue to take strategic bets in order to expand its footprint, and ensure long-term relevance as the data networking industry evolves.

Fair Value Estimate Is $100 per Share
Our explicit forecast assumes F5's revenue will grow 8% this year and compound during the next five years at approximately 12% per year, growing to $2.4 billion by 2017. We expect the overwhelming majority of F5's growth to come from its suite of ADC appliances and core software modules; any inroads the firm makes into the network security market and diameter signaling controller market would add upside to our growth estimates.

F5's gross margins have steadily improved during the last three years, as the firm has introduced a growing suite of software modules for its appliances, and gross margins now hover around 83%. We currently model 2 percentage points of gross margin deterioration through 2017, as eventual pricing pressure applied by service providers and other large customers is partially offset by increasing adoption of new software features.

Still, we model operating margins to increase modestly, to around 32% by the end of our explicit forecast, reflecting our belief that operating leverage will more than offset the gross margin decline. F5's operating expenses accounted for 52% of revenue in 2012, and we expect this number to steadily trend downward as the firm's growth opportunities narrow. For comparison with a mature data networking company, Cisco's operating expenses typically account for roughly 40% of the firm's revenue. F5's $1.3 billion cash balance accounts for $16 of our $100 per share fair value estimate.