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Morningstar | Cloudy With a High Chance of Using F5 for Application and Traffic Management; Raising FVE to $181. See Updated Analyst Note from 08 Mar 2019

Narrow-moat F5 Networks, the leader in application delivery controllers (ADCs), now sees cloud-based networking as a growth avenue instead of a threat to its on-premises product expertise. We increased our moat trend rating to stable as we posit a revamped management team wisely pivoted toward software and cloud-based products as growth catalysts to supplement its legacy hardware dominance. We believe multi-cloud application and traffic management solutions should drive durable growth, while increased software sales and services can expand operating margins, and we are increasing our fair value estimate to $181 per share from $138.

The growing amount of public cloud-based workloads shifted ADC demand to software-based solutions. With 90% of its development team dedicated to software, F5's roadmap is focused on virtual instances of ADCs, standalone application security products, and multi-cloud application control solutions. IT teams may rely on the large public cloud vendors for traffic management within their respective clouds, but F5 helps control traffic between on-premises, private, and public cloud environments. With about 40% share of the ADC market, F5 will likely remain the go-to provider of solutions for their 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 threat vectors, in our view. We posit that F5's consolidated approach for 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.

Our expectation is for a five-year revenue CAGR of 5% as sales ramp up from 3.4% growth rate in fiscal 2018. We expect software and cloud-based product sales to more than offset potential declines in ADC hardware sales. In our view, customers migrating to multi-cloud environments can become a tailwind for F5 as the proliferation of dispersed applications and data will require sophisticated traffic management and security solutions across the entire network ecosystem.

We believe revenue from F5's shift toward selling more software, virtual systems, and cloud-based solutions will result in products outpacing services over our explicit forecast period. In our view, services may decrease toward 54% of sales in fiscal 2023 versus 55.6% in fiscal 2018, as customers require less on-premises maintenance and support. In our view, the products mix shift from hardware to software can raise gross margins to 85% in fiscal 2023 versus 83.3% in fiscal 2018. We model F5's revenue growth rate to outpace operating expenditures growth, and we foresee operating margin expanding toward 33% in fiscal 2023 compared with 28.2% in fiscal 2018. In our model, R&D remains around 16%-17% of revenue, sales and marketing slightly declines toward 29% of revenue by fiscal 2023, and G&A remains around 7% of sales.