F5 Inc

Fundamentals

Written by Thomas White and Ophir Gottlieb
Follow @OphirGottlieb

PREFACE
F5 Networks (FFIV) is one of the top tech success stories of the past decade but is attempting one of the greatest pivots in our time. The stock has utterly collapsed from $134 in August to now $97.



The critical question has become, is this a value play in an otherwise toppy tech market or the beginning of an ugly decline in a company making a massive pivot?

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BREAKING
FFIV made headlines last week when CEO Manny Rivelo resigned over a personal conduct issue and was replaced by his predecessor John McAdam, who stepped down as chairman to reassume the CEO role. The stock popped 3% on the announcement.

Rivelo just took over as CEO on July 1st and while his tenure was brief, it was eventful. Shares popped 15% in early August after an earnings beat in FQ3, but after a FQ4 earnings miss and soft FQ1 guidance at the end of October, the stock hit the skids closing at $94.31 (a nearly 30% decline).

So, has the leadership tumult created a buying opportunity in a premier tech stock, or have the prospects for FFIV really faded?

BULLISH CASE
FFIV is one of the top tech success stories of the past decade as the leader in the Application Delivery Controller market. An application delivery controller is a network device which helps improve and optimize the performance of web applications.

It does this in a variety of ways such as load balancing across different servers and by providing services such as compression, caching and some security functions that used to be performed by web servers. Riding the internet boom, FFIV has seen revenue explode over the past 10 years surging over 750% to nearly $2 billion in revenue.



That deluge of revenue has been converted into profits. Net Income is up nearly 700% over the past 10 years.



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FFIV has maintained a fairly consistent level of investment in R&D over the years. In the past 10 years R&D spending has increased over 950%, and R&D spending as a percentage of revenue is near its 10 year high.



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THE MASSIVE PIVOT
The big challenge facing FFIV is the increasing adoption of cloud platforms like Amazon Web Services and Microsoft Azure. Erik Suppiger of JMP Securities expressed these concerns:



FFIV insists that the cloud is an opportunity and not a threat and that its controllers are critical to hybrid and multiple cloud deployments. They have succeeded in partnering with other leading firms like VMWare and Cisco to further entrench themselves, and in October FireEye and FFIV announced a partnership to provide integrated solutions.

No matter how you look at it, the company is in the midst of a massive pivot from on-premise solutions to hybrid/ cloud environments.

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RISK
The bear case can largely be summed up in one chart -- revenue growth:



Aside from the Great Recession, FFIV revenue growth is near all-time lows. This compounds the previously mentioned fears about Cloud adoption.

Ex-CEO Rivelo pointed to a hardware refresh as a driver of growth, but analysts are skeptical. Jason Adler of William Blair sees the company stuck in a difficult position



Another perhaps ominous sign is the rapid build up in inventories over the past two years, and the corresponding decline in inventory turnover. Inventories have increased over 50% in the last two years (blue bars) and inventory turns have decreased substantially (orange line).



Sometimes inventory buildup can be a good thing if a company is preparing for expected rapid growth. This seems hardly the case here, analysts are struggling to identify drivers of growth going forward and computer hardware is a fairly perishable product.

To be fair, the overall inventory levels are not the concern, they are actually pretty good compared to peers, but the real concern is the trend. It lends credence to the narrative that the rise of the Cloud is proving to be a headwind to FFIV.

Of course this week's news just underscores the risks present in FFIV, Jason Ader of William Blair wrote "the number of recent executive departures is alarming and could be disruptive to the business."

On the other side, Jess Lubert with Wells Fargo wrote that the stock adequately discount most risks to the company.

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CONCLUSION
There is no denying the substantial risk present in FFIV shares. Where will the growth come from? Will the executive churn impact the ability to generate growth? Is the Cloud going to negatively impact FFIV's business? These are all critical questions.

However, the most important piece of the puzzle may be the valuation. Depending on your appetite for risk, the recent ~30% drop in price of FFIV shares may be sufficient compensation for the risks being assumed. In addition to the possibility that FFIV can navigate the myriad challenges in front of it and accelerate growth, there is also speculation that FFIV could be a takeover target.

Brent Braclin of Pacific Crest notes this possibility. He said, "management disruption increases the potential for F5 to seek a strategic buyer in 2016". With $1.2B in cash and no debt on its balance sheet, FFIV could be a very attractive target indeed. If you subscribe to this takeover target theory, the bull thesis becomes compelling, as the takeover target theory provides a floor for the share price, reducing downside exposure.

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Thanks for reading, friends.