F5 Networks, Inc. (NASDAQ: FFIV), which specializes in the secure delivery of applications for large enterprises, reported a disappointing June quarter. While non-GAAP earnings per share was in line with expectations, revenue of $517.8 million, representing 4.3% growth, fell short of analyst expectations by $7.85 million.
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That slowdown fed into analyst concerns that competition and cloud adoption could reduce demand for F5's core load-balancing products. However, I think the fears are somewhat overblown for a few reasons.
Macro, not micro
Analysts were quick to ask if F5's slowdown was due to increased competition, but management denied this, citing macroeconomic factors. Management specifically pointed to Europe, where large enterprises continue to feel the fallout from Brexit, especially in the financial sector, as well as the regulatory burdens of the General Data Protection Regulation. That has slowed large enterprises' decisions regarding data centers, where F5 sells its products. Furthermore, uncertainty regarding the U.S. and UK government's budget has slowed public sector spending as well.
Management also stated that CIOs are taking more time to contemplate what combination of data center, private cloud, and public cloud to use for their architectures. Widespread cloud adoption has given companies more options for data and application storage, but more options means more complexity, which has slowed the sales cycle. However, new CEO Francois Locoh-Donou said that these customers are returning to normal or even healthier levels of spending once the decisions are made.
It would be more concerning if F5 was falling prey to competition, however, management stated that "win rates remained strong and in line with historical levels." Competitor A10 Networks (NYSE: ATEN) reported an even sharper revenue slowdown in July, which backs up management's explanation of industrywide softness.
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While Mr. Market tends to project current growth rates going forward, F5 also has potential growth catalysts ahead. On the call, management saw two specific avenues to increase the company's overall market opportunity: easy-to-use virtual editions solutions and application security products.
On simpler virtual editions, management noted the company has typically served the largest enterprises with the most complex workloads. This is a different segment than the simple load-balancing solutions offered by Amazon and Microsoft, which are geared toward smaller companies. Therefore, Donou sees the company coming up with less complex solutions to compete against them in that segment. Rather than a threat, Donou sees competition with these cloud leaders as a potential growth driver.
To that end, the company developed virtual software optimized for Alphabet's Google Cloud last quarter, completing the company's virtual offerings across all cloud vendors. Management pointed to the company's application expertise and customer fears of "cloud lock-in" as preventing big cloud vendors from taking F5's market share.
On security offerings, the company pointed to its expertise in security solutions at the application layer, rather than the "perimeter" of the data center. With the accelerated pace of cyberattacks, including this year's Wannacry attacks, combined with more decentralized corporate infrastructures, having a robust security solution around specific applications is generating strong interest, according to management. Donou also discussed the company's collection of data with regards to application traffic as a potential new source of revenue going forward.
Finally, management also hinted at a number of organic growth initiatives to expand the company's addressable market. To that end, research and development expenses ticked up 6.7% this quarter, outpacing the 4.3% revenue growth. Donou has only about six months on the job, and it is likely he will look to make his mark on the company.
After the post-earnings fall, F5 now trades at roughly 20 times earnings. However, that may overstate its true valuation. The company has excess cash of over $1.2 billion (roughly 18% of its market capitalization), and its free cash flow is higher than reported earnings. For the nine months ended June 30, net income was $285 million, but free cash flow, adjusted for stock compensation, was roughly $360 million. Assuming the fourth quarter is in line, the company should generate roughly $480 million in free cash flow this fiscal year.
Factoring in the company's excess cash, F5's enterprise value-to-free-cash-flow ratio is only around 13.1. At that value, the company isn't pricing in much, if any, growth. But with a new CEO and a large cash hoard to invest in new products or bolt-on acquisitions, it wouldn't take much for F5's stock do well from these levels.
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