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Morningstar | Cloud Partnerships and Software Facilitate Strong Fiscal 2018 Finish For F5; Raising FVE. See Updated Analyst Note from 24 Oct 2018

F5 Networks saw a solid end to their fiscal 2018, reporting top line results that met expectations and adjusted earnings appreciably above our expectations as well as consensus. Strength in software was the highlight of the quarter, as F5’s incumbency within many on-premise data centers, in conjunction with their cloud provider partnerships, is putting the firm in an advantageous position and offsetting declines in the legacy hardware business. Customers are utilizing the firm’s software modules for centralized traffic management and visibility as they deploy incremental application workloads within hybrid environments. On the back of the results and strong guidance, shares traded as much as 6% higher and continue to be overvalued.

We are raising our fair value estimate to $138 per share from $126, to account for the time value of money after rolling our model forward as well as modestly rosier growth assumptions. We are maintaining our narrow moat rating as well as our negative trend rating, as we continue to believe structural architectural shifts will eventually imperil F5’s competitive advantages.

Revenue grew year over year by 4.6% for the quarter and 3.4% for the full year, to $563 million and $2.2 billion, respectively. Product revenue, which was essentially flat year over year, saw 3% growth in the quarter as software sales, which now represents 17% of product sales, increased by 19%. Leverage from increased software sales helped facilitate margin expansion, with adjusted operating margin widening by 190 basis points sequentially. While we expect sales of BIG-IP cloud and virtual editions will continue to increase as a percentage of sales, we anticipate that competition from cloud players will continue to engender pricing pressure on a multitude of fronts. Core load balancing services will continue to be commoditized, while premium services will be incorporated into broader product suites, placing a lid on margin expansion longer term.

To the extent that hybrid infrastructures continue to be the dominant paradigm, F5 should continue to see demand for their multi-cloud application services, particularly software tools that allow for integration and visibility across multiple environments and topologies. However, as deployment protocols and security governance around cloud migrations continue to improve, we don’t think the secular trend of workloads shifting to the cloud will slow. We envisage a world where most IT workloads are deployed in public or private clouds, limiting the need for complex orchestration across environments.

The firm’s partnerships with hyperscale cloud providers are allowing them to stay relevant amid evolving IT infrastructures. Further, management indicated that in fiscal 2019, the firm will start offering support for "born in the cloud" applications, potentially expanding their addressable market to include digital-native enterprises and other firms with very little legacy on-premise infrastructure. The company expects that their differentiator will be their platform’s depth of functionality and auxiliary features such as advanced security and application acceleration.

While these features help incentivize cloud providers to embark on partnerships at the moment, we see no reason why these players will not incubate their own, cloud-native versions of these services and bundle them into their broader product suites. Given the intense competition within the space, and the gargantuan market opportunity that exists, cloud providers have and will continue to enhance the functionality of their platforms by adding new features and services. Indeed, the reason cloud providers offer load balancing services to their customers is because without it, given the exponential growth in IP traffic and data, it would not make logistical or economic sense for these customers to place workloads in their clouds. We posit that this dynamic will continue to manifest throughout many different instances over the long term. The ancillary features that F5 currently counts on to drive partnerships and differentiation will either be co-opted by cloud providers and bundled into their broader platforms for a significantly lower price, or reoriented to align more seamlessly with continuously evolving cloud infrastructure. As this dynamic manifests, we believe F5 will increasingly be viewed as a noncritical point solution that unnecessarily increases the total cost of ownership. Consequently, we think the firm will be competitively disadvantaged longer term, and this view underpins our negative moat trend rating.