Report
Ali Mogharabi
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Morningstar | F5 Continues Solid Execution Within Hybrid Environments; Long-Term Outlook and FVE Unchanged

F5 Networks’ fiscal 2019 first-quarter results were lukewarm, with the top line result in line with our estimate but below consensus expectations, and the bottom line superseding both our expectations as well as consensus. The confluence of incumbency within the application services space and cloud partnerships continue to allow the firm to remain relevant. As enterprises continue to evolve their IT infrastructures, customers find value in F5 software and services facilitating security and interoperability as they deploy workloads across different clouds and topologies. Management issued relatively conservative guidance, and though shares moved modestly lower after-hours, they remain at a premium relative to our unchanged $138 fair value estimate. We are also maintaining our narrow moat and negative trend ratings for this application services leader. While we think the firm can adapt its solutions and go-to-market strategies to defend its competitive position in the near to medium term, we continue to see secular headwinds longer term.

Total revenue of $543.8 million represented a 4% year-over-year increase. Revenue from products rose 3% with software, which accounted for 19% of product sales in the quarter, growing 21% and systems declining by less than 1% year over year. Management is targeting 30%-35% growth for software, implying an acceleration in the growth rate as we progress through the year. We view this as a lofty target even in the midst of a healthy IT spending environment and the firm’s advantageous short-term positioning, and anticipate that the company may fall marginally below the low end of this range for the full year.

The firm performed commendably on the margin front, with adjusted gross and operating margins widening by 50 and 100 basis points to 85.2% and 36.5% respectively. Efficiency automation within the service segment along with higher-margin software sales in the Product segment engendered the healthy margin expansion.

We were quite intrigued by management’s commentary when asked about Avi Networks, an upstart competitor in the space. Management indicated that it doesn't come up against the firm very often, as Avi primarily wins business for “long-tail applications,” which essentially refers to born-in-the-cloud applications and the workloads of many digital-native businesses. These are workloads that the firm had hitherto not supported, but will begin supporting this year as it launches its Cloud-Native Application Services Platform. While management is confident in its ability to compete along this new frontier, we foresee a grueling battle ahead. From our vantage point, these applications are structurally different in their configuration and development, and represent a paradigm-shift regarding the dynamics of network traffic pathways. As workloads continue to shift to the cloud, more and more enterprise applications will reflect this paradigm, in our view. We anticipate that this will challenge F5’s ability to differentiate itself from players like Avi as well as the bundled solutions of infrastructure-as-a-service, or IaaS, providers, as the competitive dimensions in this space shift further away from hardware performance and architectural positioning within data centers.

Management also touted its best-of-breed hardware margins of 80%-plus, and insisted that the 90%-plus software margins augured well for the company’s long-term profitability. Indeed, the firm has historically been able to price its appliances and services at a premium, stemming from intangible assets predicated on its brand and relationships, as well as the switching costs involved once a customer has endured a full deployment cycle. However, we believe these pricing premiums, and the concomitant ability to earn economic rents, will be significantly weakened over the longer term. We foresee the firm’s noncommoditized offerings eventually being co-opted by IaaS providers and bundled into comprehensive platform solutions for a fraction of the cost, or ultimately becoming moot as the dynamics of traffic management are reconfigured within cloud-native environments. These convictions underpin our negative moat trend rating for F5.
Underlying
F5 Networks Inc.

F5 Networks is a provider of multi-cloud application services, which enable its customers to develop, deploy, operate, secure, and govern applications in any architecture, from on-premises to the public cloud. The company's application services are available as cloud-based, software-as-a-service, and software-only solutions supported for multi-cloud environments. In connection with its solutions, the company provides a range of services, including consulting, training, installation, maintenance, and other technical support services. The company's products and solutions include hardware platforms, software and software-as-a-service platforms, cloud-based managed services, and service provider solutions.

Provider
Morningstar
Morningstar

Morningstar, Inc. is a leading provider of independent investment research in North America, Europe, Australia, and Asia. The company offer an extensive line of products and services for individual investors, financial advisors, asset managers, and retirement plan providers and sponsors.

Morningstar provides data on approximately 530,000 investment offerings, including stocks, mutual funds, and similar vehicles, along with real-time global market data on more than 18 million equities, indexes, futures, options, commodities, and precious metals, in addition to foreign exchange and Treasury markets. Morningstar also offers investment management services through its investment advisory subsidiaries and had approximately $185 billion in assets under advisement and management as of June 30, 2016.

We have operations in 27 countries.

Analysts
Ali Mogharabi

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