2023-08-08 14:24:14 ET
Summary
- F5, Inc. reported solid Q3 results, with continued growth and significantly improved margins, but still faces soft demand and the exhaustion of its hardware backlog.
- F5 is still facing soft demand though and the exhaustion of its hardware backlog is likely to weigh on growth going forward.
- F5's valuation is relatively low, but weaker hardware sales represent a substantial risk.
- F5 will likely need to demonstrate further progress in its cloud business before investors are willing to pay a higher multiple for the stock.
F5, Inc. ( FFIV ) reported solid results in Q3 FY2023 and is quite upbeat about forward prospects. In particular, margins are now improving rapidly on the back of pricing, easing supply chain pressures and improved cost control. F5 still needs to reckon with the exhaustion of its hardware backlog though, and the demand environment remains soft. F5's stock isn't expensive, but the company is likely facing the prospect of several soft quarters.
Market
F5's customers reportedly remain cautious on the back of macro uncertainty, delaying purchases until absolutely necessary. Demand is stabilizing though, and F5 is pleased with how its application and API focused approach is resonating with customers. The importance of this should not be overinterpreted as conditions have merely stopped deteriorating rather than started to improve.
Hardware demand has been weak this year, but this has been masked by the backlog of orders that built during the pandemic. F5’s backlog has come down significantly and it appears likely that this will begin to impact product sales in the next 1-2 quarters. Management stated on the third quarter earnings call that hardware demand will probably be down from Q3 levels in the fourth quarter. It is also likely that the bottom isn’t in yet. F5 has suggested that past cycles of this nature have lasted 4-6 quarters, and that they are only three quarters into this cycle. Hardware demand is expected to be higher in 2024 than it is this year, but the elimination of F5’s backlog is expected to create a 6-8% headwind to total revenue growth. Longer-term, F5 expects hardware demand to decline by mid-single digits annually in terms of units.
These trends appear to broadly reflect the observations of other companies offering similar services or exposed to similar demand drivers. Fastly ( FSLY ) is seeing strong demand for its application security portfolio, which grew 32% YoY in the second quarter. Cloudflare ( NET ) also believes that the demand environment stabilized in the second quarter. Fortinet ( FTNT ) appears to be the exception, in that its second quarter commentary was quite negative. Fortinet’s billings were soft, and an unusually large volume of deals fell out of the quarter, which was attributed to macro uncertainty. Fortinet expects product lead times and backlogs to approach normal levels in the third quarter, and it will take time for the market to digest several years of elevated hardware demand.
F5 Networks
F5 offers a range of solutions across application security and delivery. While the company's core market has historically been Application Delivery Controller hardware, F5 has positioned itself to benefit from the growth of modern applications and APIs through internal development and a series of acquisitions.
Figure 1: F5 Solutions (source: F5 Networks)
F5’s BIG-IP portfolio serves traditional applications across on-prem and the cloud, and F5 believes these solutions are taking share from competitors. F5’s next-gen hardware products (rSeries and VELOS) are reportedly rapidly gaining traction with customers, representing 70% of Q3 systems bookings. F5 rSeries is designed on a new microservices-based platform layer and an API-first architecture. It supports BIG-IP app delivery and security services and aims to lower costs through consolidation. VELOS is a next-generation chassis system that aims to provide performance and scalability in a single ADC. Customers can scale capacity by adding modular blades in a chassis, without disrupting users or applications.
NGINX serves modern, container-native and micro-services based applications and APIs. F5 saw strong demand for F5 NGINX in the third quarter, with large enterprises adopting NGINX for their cloud and Kubernetes workloads.
F5 has built a portfolio of SaaS and managed services through a combination of internal development and acquisitions over the past few years. F5 Distributed Cloud Services was launched in February 2022. F5 can combine networking, security, and distribution of applications and APIs, which it believes is a unique set of capabilities. Modern applications are causing the usage of APIs to grow rapidly supporting growth of the API security market. F5's Distributed Cloud API Security service is seeing strong growth, albeit off a small base. F5 launched its Distributed Cloud Multi-Cloud Networking offering in March and is reportedly seeing strong early traction.
F5 believes that its portfolio of solutions is beginning to resonate with customers. Particularly its ability to secure multi-cloud networks and provide visibility, control and security across all applications. While F5 is optimistic about the prospects of its business, particularly within application security, its long-term competitive positioning is unclear. For example, Cloudflare has suggested that it is displacing traditional application security hardware vendors (web application firewalls, load balancers, etc.). It is difficult to build a unified platform out of a collection of bolt on acquisitions, and it is still early days for many of F5's newer products.
Financial Analysis
Revenue increased by around 4% YoY in the third quarter, with services growing 8% and product revenue fairly flat. Services growth was driven by maintenance renewals, pricing and higher maintenance attach rates. Within products, systems revenue increased 5% YoY as supply chain constraints eased. It should be noted that systems revenue was extremely weak in Q3 2022, artificially inflating the YoY growth rate. This was offset by software revenue, which was down by 3% YoY. Software revenue increased 32% sequentially though and subscription software revenue increased 4% YoY. Subscription revenue contributed 87% of F5’s total software revenue in the third quarter.
Fourth quarter revenue is expected to be fairly flat YoY, which would presumably be driven by a large decline in product sales. F5 has suggested that investors should expect a 6-8% revenue growth headwind in 2024 due to the impact of the company’s hardware backlog on shipments in 2023. Given this, revenue growth is likely to be negligible or possibly negative in FY2024.
Figure 2: F5 Revenue (source: Created by author using data from F5 Networks)
Figure 3: F5 Product Revenue TTM (source: Created by author using data from F5 Networks)
Geographically, EMEA was an area of strength in the third quarter, offset by weakness in the Americas and APAC.
Table 1: F5 Revenue Growth by Region (source: Created by author using data from F5 Networks)
In terms of product bookings, Government customers were an area of particular strength in the third quarter, offsetting weakness amongst enterprise customers and service providers.
Figure 4: F5 Product Bookings (source: F5 Networks)
Gross profit margins improved in the third quarter due to service revenue growth, pricing and easing supply chain constraints. Product margins still have some way to go before recovering to pre-COVID levels though, which is likely partly due to lower costs still working their way through inventory.
Figure 5: F5 Gross Profit Margins (source: Created by author using data from F5 Networks)
Operating profit margins improved significantly in the third quarter as a result of improved sales and marketing efficiency and higher gross profits. With revenue growth likely to soften going forward, further margin improvements may be more difficult to come by.
Figure 6: F5 Operating Profit Margins (source: Created by author using data from F5 Networks)
Valuation
F5's valuation is quite low, which reflects investor skepticism regarding the company's ability to stay relevant as its core market undergoes an architecture change. The company's low valuation, strong balance sheet and ability to generate free cash flows positions it to repurchase a substantial quantity of stock though, which should support the share price. For example, F5 repurchased approximately 250 million USD worth of shares in the third quarter, representing something like 2.5% of the shares outstanding.
Figure 7: F5 Networks Relative Valuation (source: Created by author using data from Seeking Alpha)
For further details see:
F5, Inc.: Hardware Headwinds