Key Drivers Behind F5 Networks Higher Valuation

Ashit is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

F5 Networks (NASDAQ: FFIV) reported a 20% increase in total revenues during 2012. The company reported revenues of $1.38 billion despite a weak macroeconomic environment. The company possesses a robust balance sheet in addition to high liquidity and zero debt. It primarily designs application delivery controllers, and currently holds a staggering 25% market share in the total ADN market. It also offers file storage virtualization and a few other services that contribute roughly 42% to the overall revenues.

The company's stock price experienced a drastic fall since April 2012 when it peaked at $138/share. The current price trades close to $93/share; nonetheless, with a strong potential to grow future revenues, I continue to keep a bullish view on the company. The decline in the stock price is correlated to the macro economic situation instead of a weak outlook on the company. The following data underpins my bullish view on the stock.

Key Drivers of F5’s Business

F5 products and services are purchased by a variety of tech based companies. The core product of the company performs load balancing functions. It breaks up the internet traffic and distributes it uniformly across several servers. The company’s products are appealing to enterprises dealing in financial services, healthcare, and transportation to name a few. It operates an approximately 83% gross and 30% operating margin. The business structure is not highly capital intensive as software is its principal product. It is noteworthy, F5 has approximately 40% SG&A cost and only 15% R&D cost to gross profit. This offers F5 a massive financial leverage to invest intensively in product marketing and innovation.

The business can be distributed into five distinct segments

Application Delivery Network

ADN is the highest contributor (56%) to the overall revenues of F5. By the end of 2012, the size of ADN market was close to $ 3 billion; however, it is estimated the market will expand to $7 billion during the next seven years. The exponential growth in the market size will be underpinned by a rapid rise in cloud computing and internet traffic. Furthermore, the company is aggressively forming strategic alliances with large players such as SAP and Oracle. It also works with Microsoft in order to offer the best to its customer in virtualization. Currently it holds a dominant position in the market with a massive 25% share. I expect the market share to grow even more by the end of this year on the grounds of strong partnerships, stand-out products and a dynamic distribution channel.

Consulting and Other Services

F5 offers a variety of services that turns the core product into an augmented product. Currently other services contribute roughly 42% to the overall revenues. Services such as hardware repair, consulting and support are integrated with the products as maintenance. As the sales grow for core products, I expect such maintenance or add-on services to draw higher volumes of cash.

File Virtualization Solutions

Data storage on local servers can be hazardous in large organizations. In addition, it is costly and usually remains underutilized. File virtualization solutions facilitates network attached storage systems in large organizations to increase its utilization and enhances the overall performance. The revenue contribution from this segment of the business is approximately 2%; however the margins earned are above 80%.

File virtualization will become mandatory for all large global organizations as, data is distributed across several data centers in different countries. Therefore, tiering data becomes crucial in order to access it with minimal interruption. Going forward, this division is expected to grow further and contribute more to the overall revenues.

Competitive Landscape

 It is imperative for investors to comprehend the competitive landscape of F5 Networks and where it stands against key competition before making an investment decision. It primarily, competes with EMC (NYSE: EMC) within the file virtualization domain and Cisco Systems (NASDAQ: CSCO) in Application Delivery Networks. EMC generates 65% of its revenues through information storage followed by VMware at 21% approximately. It has a market cap of $53.4 billion and reported revenues and gross profit of $22 billion and $14 billion during 2012, respectively. In contrast, Cisco is much larger by market cap. It currently has a market cap of $117 billion and reported revenues and gross profit of $47 billion and $29 billion during 2012, respectively. It generates nearly 31% of its revenues through network switches followed by network services (23%) and routers (17%). Both companies provide F5 Networks a stiff challenge in their respective domains.

 Favorable Trends

Ever Increasing Internet Traffic – Internet penetration has grown on an exponential scale in the past decade. Going forward, the global IP is expected to increase even more rapidly. The enterprise internet traffic is also expected to speed up as video communication is getting more and more popular. Large global organizations feel a growing need to communicate through the internet medium as it’s highly cost effective. The increasing internet adoption gives the company a highly positive outlook.

Growing popularity of Cloud Services and Data Virtualization – As organizations grow into global phenomenon, they will then turn to third party cloud services for data storage. Large amounts of data can be stored at a much lower cost with an easier global accessibility. According to Research firm Forrester, by 2020 size of the cloud computing market will reach a jaw dropping $241 billion from $41 billion during 2011.

All trends point at an upward rally in the stock price towards its previous levels of $130/share; however, investors must have a long-term horizon. The fundamentals of the company are robust and the industry trends look favorable.

Ashit Gulati has no position in any stocks mentioned. The Motley Fool recommends Cisco Systems and F5 Networks. The Motley Fool owns shares of EMC and F5 Networks. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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