Why F5 Networks’ Stock Is Worth $135

F5 Networks (NYSE:FFIV) has reported steady growth in revenues over the last few years, driven by robust demand for its offerings. The company has been one of the largest players in the application delivery networking (ADN) market, commanding a 20-25% market share in recent years. However, growth in the company’s core product sales has slowed down compared to industry-wide growth, mainly due to competition from new entrants in the market as well as from native cloud-based service providers. To offset the slowdown in product sales, F5’s services segment has grown in double digits, as shown below. F5’s foray in the cloud-based, “as-a-service” and virtual offerings of flagship products have helped drive services segment revenues.

This transition should help drive future growth for the company, while core product sales are expected to remain sluggish. Below we take a look at F5’s business segments, the market in which it operates and the justification of our $135 price estimate for F5 Networks. F5’s stock price has fallen from around $145 at the beginning of the year to less than $120 currently.

See our complete analysis for F5 Networks

Application Delivery Networking Market And F5’s Presence

The ADN market has grown significantly this decade. The ADN market was estimated at around $2.1 billion in 2009, and grew to a $4.1 billion market by 2016, a compound annual growth rate of over 10%. F5 primarily provides ADN products that are used in load-balancing (distributing traffic across multiple servers), health-checking (monitoring the performance of servers and applications), rate shaping, TCP optimization and Secure Socket Layer (SSL) encryption and acceleration solutions. The company uses its networking hardware with its legacy software products, such as Local Traffic Manager, BIG-IP DNS and Link Controller and Advanced Firewall Manager, to ensure that applications can be reliably accessed over IP networks.

Until a few years ago, before cloud-based services became popular, the ADN market size was directly proportional to the number of web applications being deployed in on-premise data centers. However, in recent years applications are increasingly being deployed on the public cloud, which has reduced the demand for a traditional load-balancer and other networking equipment. As a result, F5’s share in this market has fallen by around 2 percentage points in the last three years.

This trend could continue in the coming years, with F5 competing with native cloud providers, in a market that it traditionally doesn’t dominate. For example Amazon (NASDAQ:AMZN) uses elastic load balancing (ELB), which is used to distribute incoming application traffic across multiple Amazon EC2 instances in the cloud for applications using Amazon Web Services. Going forward, cloud based load-balancers are expected to disrupt the traditional application delivery controller market. Consequently, we forecast F5’s product revenue to grow in mid-single digits in the coming years as well.

Services Can Offset Slowdown In Product Sales

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. Over the years, F5’s services revenues have become more meaningful due to the significant aggregate customer base acquired by the company. Service revenue as a percentage of product sales has increased from around 87% in 2013 to over 110% in 2016.

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. Not only is it more advantageous for customers to deploy SaaS solutions, it helps software companies generate recurring revenues. In addition, F5 Networks has recently launched application services to be deployed in multi-cloud environments that offer customers higher flexibility and more security. 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 140% by the end of the decade.

Both services and product segments operate at similar gross profit margins of around 82-84%, leading to a health operating profit margin of around 38%. Using our forecast figures for 2017, we estimate F5 Networks’ fundamental value to be around $8.6 billion, which is nearly a 15% premium to the company’s current market capitalization.

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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