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Morningstar | Software Growth Shielding F5 From Hardware Headwinds; Maintaining FVE of $181. See Updated Analyst Note from 25 Apr 2019

Narrow-moat F5 Networks reported 2% year-over-year revenue growth to $545 million in the quarter, which was below our expectations, but we welcome the 30% annual increase in software sales as ADC consumption habits shift from on-premises appliances to software-based solutions. Operating margin of 26.2% came in below our forecast and was 40 basis points below the previous year's results as F5 ramped up hiring for sales and research and development (an approximately 5% increase in head count sequentially). Compared with the prior year, products revenue was flat at $238 million as the increase in software sales, with strength in public-cloud delivered offerings, offset the 5% year-over-year decline in system sales. Services revenue increased 4% year over year to $307 million. Although systems revenue decline and dips in operating margin could seem alarming, we believe F5 is deploying its resources appropriately to match the cloud-centric expectations of its customers and we are maintaining our fair value estimate of $181 per share and we believe this security provides an investment opportunity.

In our view, the increased operational costs are setting F5 up for growth in a cloud-centric selling environment. We believe F5 can capitalize on enterprises requiring software to deploy and manage workloads securely across multiple clouds and on-premises, while 5G and NFV can catalyze the service provider segment, and the Nginx acquisition opens the developer market side of applications. For next quarter, management guided a revenue range of $550 million-$560 million and a non-GAAP EPS range of $2.54-$2.57. Guidance does not include any impact from the Nginx acquisition that is expected to close in the second calendar quarter of 2019. We expect the top line to be achieved through continued software strength, tempered system sales declines, and service growth; also, we posit F5 can achieve the bottom-line target while ramping up development costs.

The major software growth drivers behind F5's push into software-based solutions are security requirements, automation and orchestration, and being a centralized method of managing multicloud environments. Additionally, F5 has adjusted it sales model to provide subscriptions and ELAs to mimic the spending environments of public cloud providers. We welcome this flexibility over F5 refusing to adopt to the prevalent software consumption trends brought on by cloud-based ecosystems.