Why F5 Networks’ Services and Maintenance Segment Is More Valuable Than Its Core Application Delivery Business

Application delivery networking (ADN) provider F5 Networks (NYSE:FFIV) has reported a steady growth in revenues over the last few years, driven by robust demand for its offerings. F5’s services segment has outpaced growth in its core ADN product sales. According to our estimates, the company’s services segment makes up around 54% of its value, while its ADN segment makes up only about a third of its total valuation. Below we take a look at the factors justifying the higher valuation of its ancillary services business.

See our complete analysis for F5 Networks

F5 Networks: Overview of ADN Business

The company provides software-defined application services designed to ensure that applications delivered over networks remain secure to users across locations on any device. F5’s core technology uses its flagship scalable software platform called Traffic Management Operating System (TMOS). Over the years, enterprise IT customers organizations have made investments in an attempt to optimize the secure delivery of their applications to users using server virtualization and, more recently, software-defined networking to reduce costs, increase flexibility of operations and to deploy and manage IT infrastructure through virtualization. As IT infrastructure becomes increasingly dynamic and scalable, it also tends to become more complex. This is where F5’s core competency fits in. The company’s legacy software products, such as Local Traffic Manager, BIG-IP DNS and Link Controller, Advanced Firewall Manager and end-user protection services such as WebSafe and MobileSafe, provide a secure and effective way to ensure that applications can be reliably accessed over IP networks.

The application delivery network (ADN) market has grown significantly this decade. The ADN market was a $2.1 billion market in 2009, which has now grown to a $4.5 billion market, a compound annual growth rate of almost 12%. Within this market, F5’s market share increased from around 20% in 2009 to over 26% by 2014 before falling to under 21% in 2016. F5’s loss in share in recent years is attributable to growing competition. F5 is facing competition not only from new entrants in the ADC market, but also from native cloud-based service providers. Traditionally, ADC vendors have focused on helping customers manage applications in their own data centers. However, as more and more applications are now being deployed in cloud data centers, ADC vendors are increasingly focused on evolving their support for applications on the cloud. Consequently, traditional load balancing companies have to compete with the offerings of cloud vendors as well.

According to research firm Global Info Research, the Application Delivery Network market is expected to grow at double digits through 2021 to become $8.3 billion market, up from $4.5 billion in 2016. ((Global Application Delivery Networks ADN Market, Markets Report Center, January 2017)) We forecast F5 Networks to continue to lose share to competing firms in this domain. Its market share could further decline by around 3 percentage points to under 15% by the end of the decade. Despite losing share in the market, we expect F5’s ADN business to continue to grow at around historic rates of 5%, as shown below.

Services and Maintenance Business

Like most tech product companies, F5 offers customer service and technical support to attract and retain large enterprise customers. F5’s range of support services include installation, phone support, hardware repair and replacement, software updates, online tools, consulting and training services. F5’s customers typically purchase one-year maintenance contracts after purchasing products. Over the years, F5’s services revenues have become more meaningful due to the significant aggregate customer base acquired by the company. As shown below, service revenue as a percentage of product sales has increased from around 60% in 2011 to over 110% in 2016.

Services revenues have grown at a CAGR of nearly 20% over the last five years. As the delivery of IT solutions increasingly transitions from an “on-premise” deployment to a cloud-based or Software-as-a-Service (SaaS) model, software companies derive more of their revenues from their services segment. ^[1] Not only is it more advantageous for customers to deploy SaaS solutions, it helps software companies generate recurring revenues. This trend should help fuel growth in F5’s services segment. We forecast services to continue to drive growth, albeit at a slower pace than historic levels. We forecast service revenues as a percentage of product sales to increase to around 145% by 2021.

As discussed earlier, services are likely to drive much of the top line growth for F5 networks in the coming years. Both these segments operate at similar gross profit margins of around 82-84%. Consequently, F5’s services segment is more valuable for the company, according to our estimates. While the services business would, of course, have limited demand without the presence of core ADN product sales, the transition of customer preferences from license agreements to SaaS solutions serves as an opportunity for F5 monetize its services offerings.

You can modify the interactive charts in this article to gauge how changes in individual drivers for F5 Networks can have on our price estimates for the company.

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1. Moving to a Software Subscription Model, Gartner, November 2015 [↩]