2023-04-13 02:23:26 ET
Summary
- F5 has seen a 30% decrease in share price, which prompted me to look into it deeper.
- Outlook for the industry isn’t looking very good, especially with supply chain issues still lingering. A not-very-high growth rate is predicted.
- The company's balance sheet, although still in a good position, in the bigger picture reveals weakness.
- DCF analysis suggests the company is overvalued even at these levels, as growth prospects are too low to justify a high P/E ratio.
Investment Thesis
With the Q2 results coming shortly and F5 Inc.'s ( FFIV ) share price going down around 30% in the last year, I wanted to see if the company, given certain realistic growth assumptions and improving margins over time, is worth putting money into. According to the management, the sector will still see some struggles going forward which will dampen revenue growth for quite some time, coupled with the uncertainty in the economy, I believe that the share price has not seen the bottom yet and will have more volatility in the next 6-12 months.
The assumptions of revenue growth for the company do not support such a high P/E ratio and people should be patient in an environment that may send the share price further down.
Technology Industry Outlook
The tech industry flourished during the peak of the pandemic. Organizations had to shuffle quickly to adapt to a very different environment in terms of working, which included updating their many technology offerings so that workers can work from home with minimal disruptions. Many companies accelerated into the future and a hybrid working environment is here to stay. The consequence of the disruptions in everyday life is still felt right now in 2023, in the form of supply chain issues. These issues have persisted and will persist for a little while longer, coupled with even more uncertainty predicted by many economists, the picture is not looking good. I am surprised that the company was still guiding 9% to 11% growth in revenues for '23.
Of course, supply chain issues will go away eventually, the "recessionary" period won't last forever too, and so will revenue growth pick back up. Growth in AI, machine learning, and data analytics will make companies more efficient and profitable in the future. However, it is hard to put a number on what kind of growth we will see once these glaring issues subside, so I need to be conservative in my assumptions. Even if the company is great in the long run, it is very easy to overpay if invested at the wrong time.
Financials
The company is very healthy in terms of liquidity. It has plenty of cash, around $605m as of the latest reported quarter and the last of the debt has been paid off. I like it when companies can finance their day-to-day operations with just their operating cash flow and cash on hand. This sort of position is very healthy in the turbulent environment that we will see very soon supposedly. I was saying the same thing just a month or two ago and we are still waiting for that downturn, which I'm sure will come, it's just hard to tell when.
Speaking of liquidity, the company's current ratio is around 1.0 as of FY2022, which has deteriorated over the last 5 years. This is a little concerning, however, as of Q1 2023, has seen a little improvement, that's a good sign and I hope it comes back to my preferred ratio of around 1.5- 2.0.
The following metrics do not show a very good picture in the long run. ROA and ROE have been declining for the last 5 years. These are clearly in a downtrend. It seems like the company has been losing efficiency in generating profits over time and the management is making some poor decisions on how to reinvest capital, which means the management is investing the capital in unproductive assets. For any company, I would like to see a steady return on ROA and ROE or even an uptrend as management is making smart decisions. I don't want to see a downtrend over the last 5 years, which more than likely will continue going forward, especially in a tougher environment.
The downtrend makes sense because when looking at the company's margins, have been trending downwards for quite a while now and as of the FY22 report they have not improved just yet. If we look at the latest report, we can see that the net margin sits at around 10%, which is slightly worse than at the end of FY22.
The same story can be said about ROIC. The company has been losing its competitive edge and the moat that it once had has been deteriorating quite dramatically since 2018.
The management is not likely allocating its capital very efficiently in the last 5 years, and I don't believe it's because F5 Inc. is operating an unsustainable business. Something needs to change here so the margins can be improved. 9% ROIC isn't the worst, but when looking at where the company was before, it does raise some questions about what the management is doing that is clearly working against them.
Overall, the business has no liquidity issues yet but the downtrend on the main financial metrics above isn't looking too good for the company. Now let's look at what the company should be potentially worth.
Valuation
For the model, I will take some information about the company's future returns from analysts' estimates for the first two years as 18 analysts cover the company and then the coverage significantly drops off to 2 people. From then on, I will grow the revenue growth linearly downwards to around 3% by '32. The company's past performance isn't giving me any indication that it will see a major revenue spurt going forward unless the company announces some mergers which dramatically accelerate it, for now, there is nothing.
'23 and '24, analysts estimate 9% and 6.6% growth in '23 and '24 respectively. 9% is the bottom range that the management gave for the outlook for the whole year, so I'm comfortable with sticking to these assumptions also. I'm also comfortable with 6.6% the year after because we don't know what can happen in a whole year, and just to be safe I will model revenue growth slowing down also. I will use these estimates for my base case scenario. Revenues will go from $2.93B in '23 to $4.2B by '32. It's a reasonable growth in my opinion, maybe a little on the conservative side, but that is why I have two more scenarios. The optimistic scenario will see revenues growing from around $3B in '23 to $5.1B by '32, and for a more conservative outcome, $2.8B in '23 to $3.45B by '32.
I also modeled improvements in margins, because I do believe the company will be able to slightly improve these as time goes on, whether that is through supply chains improving or the company taking other cost-cutting measures to achieve better efficiency. For the base case, I have margins improving by around 400bps-600bps across the board, except for gross margins as these are quite healthy as is. These margin improvements aren't even returning to the margins the company saw in 2018, so it's a bit more on the conservative side in case the company doesn't manage to return to better efficiency. In the optimistic case, margin improvements range from 550bps-750bps, while in the conservative case, the range is 440bps-460bps. As you can see in all three scenarios, I expect some margin expansion.
On top of these assumptions, I will add a 25% margin of safety because the balance sheet, although still in good shape, has shown some weakness in the last 5 years.
The DCF model suggests the company is still overvalued, with an intrinsic price of $96.74, implying a 33% downside from current valuations.
In Conclusion
It is hard to justify a high price when there are such low growth prospects. The company would need to grow at an average of 13.5% per year for the next ten years to justify the current P/E ratio of around 29 (GAAP). So, even with the company going down by around 30% in the last year, it is still too expensive for me, and I don't mind waiting while searching for other opportunities in the market. I will keep this company on my watchlist, especially since the earnings are just around the corner. I am eager to hear what the management is going to provide for guidance and outlook in the sector.
Will the stock ever reach my target? Hard to tell, but weirder things have happened just look at all of 2022. Back at the bottom of the pandemic market, the share price was around $98, but of course, things have changed in the last 3 years. Unless we see better revenue growth in the coming years, I stand by the price above and I'll set a price alert at around $110 a share so I can start to pay attention once again.
For further details see:
F5 Inc.: Still Expensive, As Growth Prospects Appear Low