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Morningstar | F5 Delivers Solid Fiscal 3Q; Products Back in the Green, but Shares Overvalued. See Updated Analyst Note from 26 Jul 2018

F5 Networks reported strong fiscal third-quarter results, with the top line coming in at the upper-end of management guidance and margins widening slightly. The products segment delivered year-over-year growth for the first time in four quarters, driven by continued strength in their software solutions for public and private cloud infrastructure, as well as their standalone cybersecurity products. This growth was offset by continued softness in the systems business. Services, which we view as the main growth driver in a normalized environment, continued its momentum in the quarter. We are maintaining our narrow moat rating and $126 per share fair value estimate for this name. As the architecture of IT infrastructure continues to shift, we believe well-capitalized cloud providers likely will take share from F5 in their traditional areas of dominance. Additionally, we do not view F5 as competitively advantaged in the cybersecurity business, and given the intense competitiveness of this space, we don't see their progress here as accretive to margins. Consequently, we are also maintaining our negative moat trend rating. The shares dipped 3% in after-hours trading but remain significantly overvalued at current levels.

Revenue of $542 million represented a 4.7% increase year over year. Software remained stable as a proportion of product sales at 15%, and its 24% year-over-year increase, offset by a 1.5% decline in the much larger systems business, drove a 1.6% top-line increase in the products segment. Services revenue continued to impress, increasing by 7% in the quarter over the prior year. GAAP operating margin expanded by 110 basis points to 28%. We attribute this expansion to operating leverage generated from growth in software sales, driven by continuing strength in public cloud revenue.

F5 continued to demonstrate a commitment to remain relevant in an increasingly cloud-centric IT ecosystem. Management announced plans for a restructuring effort, with the aim of orienting the business more toward the growth frontiers of cloud application services and security. Stemming from this realignment, management expects to incur restructuring charges of $23-$25 million during the fiscal fourth quarter of 2018. In this same vein, the firm pointed to positive feedback from the release of its BIG-IP cloud product, as well as deepening partnerships with Microsoft's Azure and Amazon's AWS, as evidence of their position as a multicloud application services leader.

While we view the company's execution and progress on this front as impressive, our long-term view of the competitive landscape continues to be bearish for F5. In our view, cloud providers such as Microsoft and Amazon may be partners at the moment, but we envisage a future where these titans begin to compete more aggressively, bundling application delivery controller services into their cloud platform and infrastructure packages. It will be increasingly difficult for F5 to offer competitive offerings in this environment, given the firm's current cost structure.