F5 Is Set to Thrive

F5 Networks FFIV announced its intent to acquire privately held Nginx, a provider of open-source software for application delivery controllers and microservices, for $670 million of cash by acquiring all issued and outstanding shares. Nginx and F5 were competitors in the ADC marketplace, with Nginx focused on software-based solutions to disrupt F5's traditional hardware dominance. We view this acquisition as in line with F5's strategic efforts to focus on software with cloud-based and virtualized products. Management expects fiscal 2019 and fiscal 2020 to now see increased revenue growth with lower non-GAAP operating margins and non-GAAP earnings per share growth. After updating our model, we are maintaining our fair value estimate of $181 per share.

Nginx is a leader in the web application server, microservices, and API management side of development operations, whereas F5 excels at routing and managing the applications for the end users. F5 will now be able to offer a more complete solution for application and traffic management, from the developer side to the networking side. Per Nginx and Internet services company Netcraft, over 374 million websites (around 25% of total) used Nginx software in February and 67% of the top 10,000 sites ran on Nginx (per W3Techs data). This massive installation base should provide potential incremental opportunities for F5 to manage the flow of applications after application development for multicloud deployments, in our view. Additionally, we think F5 benefits from purchasing a company that's garnered success with a cloud and virtualized model, since F5 aims to make inroads into those markets.

F5 increased its revenue growth target for fiscal 2019 and fiscal 2020 to midsingle digits from low to mid-single digits but expects non-GAAP operating margins to decline to around 33%-35% from 35%-37%. Nginx had $26 million in revenue in 2018, which was a 65% annual growth rate per F5 management.

Per PitchBook data, Nginx raised $84 million in capital cumulatively, with its latest round of funding in June 2018. F5 has committed to maintaining the Nginx brand; Nginx's CEO and founders will join the F5 team and lead the Nginx operations. The deal is expected to close in the second calendar quarter.

Data Proliferation Should Be a Boon to F5 F5 Networks is the leader in application delivery controllers, selling to enterprises, service providers, and government entities. More than half of its revenue comes from selling support and maintenance services for its products. Mission-critical ADCs manage the uptime and delivery of applications and network traffic flow. ADCs were traditionally purchased as hardware that sits between firewalls and servers to mitigate traffic flow issues related to server failures. Growth in public cloud-based workloads caused a decline in the on-premises ADC hardware required and shifted ADC demand to software-based solutions. In our view, F5 was slow to embrace cloud-based workloads as it perilously defended its incumbent offerings, but a revamped management team properly pivoted F5's focus toward software- and cloud-based products as growth catalysts to supplement its legacy hardware dominance, and we think the company is set to thrive.

With 90% of its development team dedicated to software, F5's roadmap is focused on virtual instances of ADCs, stand-alone application security products, and products and services for multicloud application control. IT teams may rely on the large public cloud vendors for traffic management within their respective clouds, but F5 helps control the traffic among on-premises, private, and public clouds. With about 40% share of the ADC market, F5 is likely to remain the go-to provider of solutions for its customers' cloud ecosystems due to product familiarity, customization features, application- and network-level management, security focus, and an active developer community.

We believe the expected data proliferation generated by Internet of Things and 5G devices will be a boon to F5. The complexity of managing application traffic will increase as disparate devices spread beyond the data center while requiring lower latency, larger data workloads, and protection from a growing quantity of security threats, in our view. We think F5's consolidated approach to application and networking traffic flow across the entire network will remain in strong demand as businesses expand their creation and consumption of applications and data.

Narrow Moat Based on Switching Costs In our view, F5's switching costs are associated with the mission-critical aspects of ensuring applications are properly deployed, secure, and optimized for network traffic flow. We believe intangible assets are a secondary moat source, seen in F5's strong reputation, pricing premium, and design expertise. We expect a continuation of F5's stellar record of producing economic returns on invested capital in excess of its cost of capital for at least the next decade.

At the end of 2018, revenue was split about 65% from enterprises, 20% from service providers, and 15% from the government sector. Services are more than 55% of sales; the remaining revenue comes from product sales. For the last five years, gross margins have remained in the low 80s and operating margins in the high 20s.

In the late 1990s, F5's initial load-balancing appliances became a critical aspect of managing server workloads in data centers. Its products ensured that network traffic was balanced among servers and would redirect traffic from servers with issues. In the 2000s, the usage of applications to run and develop software programs and manage data workloads exploded in enterprises, and F5 segued its portfolio to become the leader in application delivery controllers. ADCs ensure that applications function at an optimal level and accelerate application delivery, in addition to processing load-balancing functions for network traffic. Over time, ADCs added more complex features like web application firewalls, global traffic management, and analytics. We estimate, through Gartner and F5 data, that F5 controlled around 40%-50% of the ADC market in 2018. Enterprises IT networks rely on these products for optimal application and network traffic flow, and we believe switching vendors would be tremendously disruptive.

IT teams are using more applications and software through public clouds and software-as-a-service vendors, which potentially means lower ADC hardware sales due to less networking traffic and application management needing to occur on premises. Staying alongside this shift in networking and having over 90% of its product development team focused on software, F5's strategic focus pivoted toward software-based ADCs, multicloud application solutions delivered as cloud-based software, offering F5 as a service, and virtual editions of its products. F5's Silverline is a managed security platform that gives customers the ability to route their traffic through F5's hardware all the time or as needed; we believe this is attractive to IT teams desiring professional security services in a flexible consumption model. In our view, as customers migrate more applications and workloads from on premises, there is value in staying with F5's software solutions over swapping vendors or implementing a multivendor approach. F5's operating system is considered best in class, and changing software solutions would be a painstaking task, in our view. From a partnership side, we believe the hyperscale cloud vendors find value in collaborating with F5 due to its strong brand presence and engineering aptitude, which drives increased traffic flow to their respective clouds. We opine that IT teams have morphed their networks alongside F5's product releases to stay ahead of the latest traffic technology for applications, data centers, and multicloud environments.

F5's customizable approach to software provides enterprises flexibility to create the best solution for their networks. The iRules feature set allows customers to tailor traffic flow per their unique situations, and we believe this customer-centric approach helps keep F5 products engrained in networks. F5's DevCentral, an online community of developers and network architects, had over 350,000 registered members at the end of 2018. This collaborative environment allows individuals to share best ideas and request product enhancements. In our view, this online community is not a network moat source; however, we do believe this is an attractive feature to encourage staying with the F5 ecosystem. F5 has rolled out new features to its products through user developments in DevCentral, and we believe this community is ancillary to F5's switching costs and intangible assets moat sources.

Pivoting to Meet Expanding Competition We give F5 a medium fair value uncertainty rating. Although we think F5 was caught off guard with the growth in cloud-based workloads, which created a lower demand for F5 hardware, our view is that the company's strategic pivot will keep it ensnarled in customer networks.

F5's competition now includes hyperscale cloud providers like Amazon AWS AMZN and open-source ADC software-based solutions, in addition to the traditional ADC players like Citrix CTXS, Radware RDWR, and A10 Networks ATEN. The hyperscale cloud providers have the advantage of customers offloading workloads and data into their public cloud environments at a torrid pace as well as being the source of where many applications reside. As customers expand their networking presence, they could forgo on-premises solutions from F5, except for mission-critical on-premises traffic. In turn, F5 could be forced to rely on software and cloud-based sales, which could become price-sensitive if the company does not provides unique technological advantages versus lower-priced open-source or hyperscale cloud solutions. An additional threat is the large cloud providers creating solutions for intracloud and on-premises traffic.

In our view, a key aspect of F5's strategy is its technology alliances with leading cloud providers, networking companies, and security providers. Partners pushing their own solutions, in the case of cloud providers, or competing vendors instead of F5 would be detrimental and affect long-term growth opportunities. F5's reliance on value-added resellers and managed service partners creates a revenue concentration risk. At the end of 2018, Ingram Micro was 16.8%, Arrow ECS was 10.9%, and Westcon Group was 11.3% of revenue. While F5 has traditionally showcased revenue concentration, we think that being dropped from a line card or not properly encouraging the resellers and partners to sell F5 solutions versus competitors could be drastic for the company.

F5 is financially sound, in our opinion. It has solidly generated strong free cash flow, possesses a war chest of cash, and has no debt on its books. At the end of 2018, F5 possessed $1.04 billion in cash and cash equivalents. We believe F5 will continue to mainly use its cash for operating expenditures, with development costs remaining at 16%-17% of revenue while sales and marketing stays around 29%-30% of revenue. F5 performed share buybacks of around $550 million in both fiscal 2018 and fiscal 2017 (and repurchased about $2.9 billion between fiscal 2014 and fiscal 2018). We believe F5 will continue repurchasing shares as its main vehicle of shareholder returns, as it announced an additional $1 billion authorized for share buybacks in January 2019. The company has never paid a dividend, and we do not foresee it paying one in our explicit forecast.