F5 Networks Inc. (FFIV) had a “bad” earnings report released yesterday that has them in the crosshairs of investors looking to take profits and shed exposure. The process has been systemic, as anyone associated with networks or cloud computing has taken a beating today. As I write this, Cisco (CSCO), Aruba Networks (ARUN) and Juniper Networks (JNPR) have lost about 1.5%, 6.7% and 3.7% respectively. On the cloud side, Riverbed Networks (RVBD) was down 8% today, with Citrix Systems (CTXS) also losing 7%. I am taking a look at F5 to determine whether there could be some potential value here from investors overreacting to a lukewarm earnings report. I find it hard to believe that a company can lose 25% of their value in one day based on reason alone.
Earnings miss: F5 Networks Inc. has lost over 20% of their market value in one day. Now, to some that would be a red flag and signal to head for the hills. To me, I find it hard to believe that one slight skip on earnings can change the fundamental business model or strategic position of a company. However, it has happened before.
The problem with this situation is that the beating the stock is taking does not match the numbers they released. Now, they missed revenue by $2 million on $269 million versus $271 million. Their profit per share, however, was a solid 88 cents compared with analyst estimates of 83 cents. Their fiscal year Q2 guidance is 84 to 86 cents a share on $275-280 million in revenue, versus analyst estimates of 85 cents and $281 million. There was a strange lack of large orders in the report, which could be interpreted as a negative forward indicator. To me, however, it doesn’t seem as though a company that grew revenue 41% over 2010 Q1 and beat earnings per share guidance should lose a quarter of their value overnight. Keep in mind that the stock had a nice run since October, up 52%, and people might simply be taking profits.
Another angle is that company management has been sandbagging earnings to make sure they beat. In this case, the profit beat hasn’t been as well received by the market as the revenue miss. The price of the stock, which has risen so quickly, might well have priced in a revenue AND profit beat.
Credit Suisse analyst Paul Silverstein seemed to enjoy the earnings report, however. He raised his valuation from $103 to $134 due to best in class revenue growth, margins, EPS and visibility. His guidance for fiscal 2011 included a decrease to $1.15 billion in revenue from $1.16 billion, but an increase in EPS to $3.65 from $3.59. His estimates relied on the assumption that their file virtualization solutions would accelerate in growth. So, what’s file virtualization?
Competitive landscape: File virtualization is basically a layer of intelligence over a network that allows storage devices to move and change their file locations to optimize connectivity and access without disrupting users. F5 has a solution that allows management over a variety of storage environments. Nigel Burmeister, F5’s director of product marketing says the ARX file virtualization:
Natively supports multivendors [and] multiplatforms. Today, most computer data that's file based speaks NFS or CIFS. Cloud storage is typically object based so you now have this translational software that can be used as a gateway. It's a heterogeneous gateway that does cloud storage and works with other forms of NAS.
That sounds pretty good. F5 is also a leading provider of network traffic managing products and systems. Their expertise is in layer 4-7 switching, with little experience outside this niche. As such, their growth is strongly tied to the growth of the 4-7 switching. With little material revenue coming from outside this realm, the earnings report may have validated many investors’ beliefs that F5’s growth has slowed down considerably in recent years. I believe the price that F5 traded at prior to today took into account accelerating growth that was not substantiated by earnings.
Valuation: I’m assuming growth in revenue between 20-25% for the next four to five years. At these levels, I am assigning a price floor of $80 and a ceiling of $110 for FFIV. This is due to a number of factors inherent in both the industry and F5 itself. I believe that their growth, when adjusted for seasonality and the recent downward turn in 2009, has actually slowed considerably over the last five years. Their exclusivity in layer 4-7 switching is a double edged sword, as they are a niche leader but also married to growth in the segment and potential technological obsolescence. I feel they will expand their product library, but that right now the price is too high for much of that value to be realized. There is, however, the potential for a high upside for the right investor; if cloud computing becomes the cash train many believe it will be and F5 turns out to be a market leader, they are in a position to grow at a higher rate.
Ratios: They have solid and consistent profitability mixed with great cash flows. Their FCF margin stands at 34.13%, increased from just 26.9% in 2005. Their liquidity situation is great, which makes sense with all that sustainable cash inflow piling up. From a relative perspective, they are less attractive. Their PE stands roughly at 57 as I write this article, which is much better than it was yesterday when it was stuck in the mid seventies. Taken in the context of their historically mid thirties PE, and I have trouble justifying their current valuation. However, you consider someone like RVBD who has a PE of over 200, and FFIV starts to look a little more attractive.
Conclusions: F5 is an excellent company. I believe if their ARX appliance and file virtualization solutions continue to take off, they are in a position to greatly capitalize on the arrival of cloud computing as a viable business solution. However, even now their valuation is too high for me to jump in. I believe if they were priced at $80, I would be able to give this stock a firm Buy recommendation. At $108, however, it is too near the top of my 12 month price ceiling for me to shell out my hard earned cash. This is no knock against the company in general, I just believe there are other fundamental plays in this industry that can provide a higher margin of safety. For the right investor, however, the potential upside of a cloud computing market leader could be enough to buy this stock, especially after the beating it has taken today.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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