F5, Inc.: Cautious On Growth Trajectory

Investment action

Based on my current outlook and analysis of F5 (NASDAQ:FFIV), I recommend a hold rating. I remain cautious about the near-term growth trajectory despite seeing signs of stabilization. I would wait for a few more quarters of confirmation before validating that growth is on the right track. That said, management deserves credit for optimizing its cost structure, which I expect to drive margin expansion.

Basic Information

F5, Inc. offers comprehensive options for managing network traffic over the internet. The business' software helps with optimization of both website traffic and content. F5 provides services to help ISPs and e-commerce sites automatically distribute web content.

Review

FFIV has been a strong performer over the years it has been operating. Looking at the past 15 years, revenue has grown every year (except in 2009), reaching a height of $2.7 billion in FY22. The stock price also reflected this strong performance, rising from $30+ to a height of $249. However, coming into FY22 and recent quarters, where the macro environment has killed a lot of business deals as the cost of capital has risen for many enterprises, FFIV saw its revenue growth dip to low single digits.

With systems driving growth at 5% y/y and software declining at 3% y/y, total revenue in 3Q23 showed a modest recovery back to 4% y/y, growing revenue to $703 million. Gross margin came in at 82.5%, and total operating expenses came to $346 million, which was below the $348-$360 million target range. As a result, EPS came in better than expected at $3.21, beating the consensus estimate of $2.85 and management's own guidance of $2.78 to $2.90.

I remain cautious about the FFIV growth trajectory, but it was certainly encouraging to see the business seeing signs of demand stabilization. Although customers are still cautious with their spending, which has resulted in postponed deals, demand trends have improved in comparison to 1H23 and have not worsened further. Notably, the business showed positive growth of 4%, and EPS came in better than expected. On the most recent call, executives discussed how service providers are currently operating at the "red line" of their asset utilization and how it is only a matter of time before they need to increase capacity. This is consistent with previous capacity expansion cycles. However, I think it's best to hold off until there's more proof of stabilization and demand recovery.

“I would say, on that front, we -- where -- the sample size of customers where we have, really the ability to see that and understand that is limited. But for those where we can see it, we have a number of customers that are getting close to or exceeding kind of a -- I want to call it a red line. But the maximum they would have normally gone through in normal times. And so that just points to us that, at some point, they will expand capacity. And this is consistent actually with what we have seen in prior macro slowdowns, where customers have tended to sweat their assets in this way. And in the past, when we have seen customers sweat their assets this way, we have seen it happen for four quarters to six quarters. Now every -- every macro slowdown is different in shape and in different in how it plays out, but that's what we have seen in the past.” 2Q23 call

Apart from stabilizing demand, another encouraging aspect is FFIV's significant progress in broadening its business beyond the traditional ADC (application delivery controller) market to provide additional features related to application security and observability. I view this strategic shift positively because it aligns naturally with ADCs, and FFIV's strong market presence in application delivery for both traditional legacy applications and modern containerized applications positions it well to capture market share in these new areas. Additionally, FFIV is expanding its business reach through innovative distribution methods, such as its managed services platform, F5 Distributed Cloud Services. This represents another favorable move as it enables customers to access FFIV's application delivery and security services through an as-a-service model, thus reducing barriers to adoption.

In addition to external factors, the 3Q23 EPS beat can be attributed in large part to management's successful efforts to streamline the business from a cost perspective. Recall that FFIV implemented a cost reduction exercise back in late April that yielded very positive results, as seen in 3Q23. Coupled with improving gross margins due to easing supply chain issues and related ancillary costs, I expect FFIV to continue to see margin improvement in the near term (hitting management’s FY24 target of =>300 bps EBIT margin expansion).

The revenue from the Systems division is another factor keeping me on the fence. Management anticipates a sequential decline in 4Q23 system revenue despite the fact that lead times for product shipments are almost back to normal at two weeks and that it has reduced its backlog significantly. This suggests to me that demand is weak below the surface. One would expect revenue to grow if underlying demand is strong because of the elevated boost from backlog normalization; however, this does not seem to be the case. It was also reaffirmed by FFIV that the positive impact of the backlog reduction in FY23 would act as a headwind of 600 to 800 basis points to revenue growth in that same year.

Valuation

Given my cautionary outlook, I expect FFIV to grow by mid-single digits in FY23, which is ~500 basis points below management FY23 guidance (management expects $2.97 billion in revenue at the start of the year). As I remain worried about the macro situation, I expect the same revenue growth of 5% in FY24 as well. However, I give credit to management's ability to continue streamlining the business; hence, margins should continue to improve from here, at 100 basis points per year. In the near term, I do not expect any significant catalyst to re-rate the stock upwards; hence, I believe FFIV should continue to trade at the current 12.5x forward PE, a slight discount to peers given its modestly lower expected growth rate and weaker profit margin at the EBIT and net level.

Final thoughts

My recommendation for FFIV is a hold rating. While there are signs of demand stabilization and the company has made commendable efforts in optimizing its cost structure, I remain cautious about its immediate growth trajectory. It's essential to observe a few more quarters to confirm that the growth is on a solid track. The recent 3Q23 results, with a modest revenue recovery and better-than-expected EPS, are encouraging, but the macroeconomic environment still presents challenges.