285039c6-615b-4a1f-a707-e3c6c73ea424_F5-Networks-Premium-Analysis.pdf
F5 Networks: Premium Analysis
F5 Networks
Overview:
Like many traditional hardware companies, F5 Networks is shifting from a hardware model to a software-driven business to accommodate an increasingly cloud-driven world. The effects of the shift to cloud services are not fully reflected yet in the company’s revenue growth, which was at 7% YoY in the most recent quarter. The company has been basically range bound with revenue growth around 5% since 2016.
F5’s cloud services are distinguished from running apps on virtual machines in a single cloud from being able to run distributed, container-based microservices across multiple clouds. The services have the added benefit of security, such as advanced web application firewalls. This is important because up to 40% of internet traffic comes from botnets with 20% being bad bots.
The three main products which work to consolidate networking tasks and deploy apps faster., are BIG-IP, the NGINX Controller and a new SaaS offering called Beacon. These three products tie together traffic management, API management, app security and end-to-end app visibility and analytics.
There are a few trends that help to support F5’s future revenue growth. Primarily, the shift away from monolithic architectures and towards microservices architectures (and the popularity of containers orchestrated by Kubernetes). Also, the complexity of multi-cloud and hybrid cloud environments.
However, it is the 5G catalyst that I am most interested in and the reason I am covering the company.
F5 Product Summary:
F5 Networks is well known for its hardware-based Application Delivery Controller (ADC) product offerings. The company recognized a need to move to cloud based workloads due to the decline in ADC hardware and the shift to software-based solutions.
As the number of applications grow, the complexity increases. Companies must deploy, manage and secure applications across private data centers, private clouds, public cloud, microservices environments and multi-cloud environments. This complexity is how F5 hopes to gain and defend its market share.
The customer base for F5 are companies that need to scale and deploy applications very quickly. Essentially, developers write the code for the applications (i.e. the business logic, backend components, and user interfaces). F5 helps to deliver the application to the device, machine and browser.
The company acquired NGINX for $670 million in May 2019. This helped the company to expand to new addressable market opportunities including web servers, application servers, and API gateways. The company is seeing promising early wins for NGINX Controller 3.0. It is also seeing real traction with the F5 and NGINX combination.
Another major recent acquisition was Shape security for $1 billion which helped the company to target the application security market. Shape is a leader in anti-fraud and abuse protection. The company’s existing Canadian banking customer is a BIG-IP customer and experienced an account takeover attack on their web application. With Shape in full mitigation mode, it was able to block a major attack.
Load Balancing
F5’s two products are the F5 BIG-IP Local Traffic Manager and the F5 BIG-IP DNS. The local traffic manager balances loads across servers in a single data center. The DNS uses topology-based load balancing to determine the closest data center.
Load balancing refers to distributing requests across web servers to avoid overloading any one server. Load balancing distributes the requests based on the actual load at each server to ensure availability and helps with denial of service attacks.
Microservices
Microservices is a newer architectural framework designed so that changes won’t break the entire app. The core functions of a microservices framework can be deployed independently, meaning individual services can function without affecting the others. This is opposed to a monolithic approach where the source code is built into a single deployment. With a monolithic/single deployment, there is a lot of downtime as any update requires the entire app to be taken offline.
Microservices closely resembles service-oriented architecture (SOA). In this architecture, individual services communicate through the enterprise service bus (ESB). This allows for iteration and deployment without monolithic development cycles but it also creates a single point of failure (the ESB).
Containerized microservices allow applications to be run independently on the same hardware with much greater control. This is the foundation for cloud-native applications.
NGINX:
The main benefits to NGINX is the software approach to application delivery and API management, as well as the brand name in open source and DevOps. The acquisition creates end-to-end application infrastructure and allows F5 to transform into a more software and multi-cloud approach. The acquisition also helps to combine security technologies with web servers and load balancers.
The goal of F5 and NGINX is to combine the application teams, developer teams and operations under one umbrella to include AppDev, DevOps, NetOps and SecOps.
NGINX’s main competitor is Apache. F5 Networks is popular with the Fortune 500 and NGINX is popular with developers/open source community. More than 400 million sites use NGINX and NGINX Plus, including Netflix, Dropbox and Zynga. In 2019, it was reported that NGINX was closing the gap with Apache and Microsoft in webfacing computer market share to about 30% of the market.
This also provides F5 with inroads into servicing Kubernetes nodes. Kubernetes is a leading container platform that was designed by Google and is now used everywhere. Kubernetes has exploded in popularity with 78% of developers using it for cloud native projects. This is a tailwind for F5 (although not a major catalyst as NGINX is free, open source software).
The most recent product announced from the acquisition is the NGINX Controller 3.0 which helps development teams deploy applications in multi-cloud and hybrid cloud environments. In the recent quarter, F5 secured a leading oil and gas company in the Middle East from the new acquisition. The oil and gas company had both security and API management challenges, it opted to deploy NGINX for API management and F5’s advanced web application firewall for API security.
Shape Security:
Shape Security protects against automated attacks, botnets and targeted fraud. The company mitigates more than 1 billion attacks daily and is deployed on more than 200 million mobile devices worldwide. The company is used by eight of the top twelve U.S. banks. The company separates good traffic from bad traffic. Shape Security will augment F5’s application infrastructures.
According to F5, the acquisition will boost its software revenue growth from 35-to-40 percent to 60-to-70 percent next year. It expects to achieve breakeven non-GAAP EPS within 24 months of closing the acquisition.
5G: Network Slicing, Gi-LAN Consolidation and Edge Computing:
F5 Networks is positioned to help 5G infrastructure scale. The new 5G architecture will have the ability to “slice” the network into different segments from the radio network (RAN) to the core in order to help allocate resources according to various use cases and traffic spikes. The existing 4G core networks do not have networking slicing built into the system. F5 Networks can provide the existing 4G systems with GTP session directors and DNS session directors.
In addition to network slicing on existing 4G systems, F5 Networks can also improve the monolithic architecture of the Gi-LAN Networks, which are independent network functions on dedicated devices from a wide range of vendors. Latency increases with each hop in the chain the data packet has to traverse. The monolithic architectures — with individual service functions on different hardware — can have a major impact on latency. The monitoring of the system is challenging and security is also an issue.
The solution is to consolidate Gi-LAN into one instance/appliance to reduce the latency and simplify the network design. F5 Networks offers a Gi-LAN consolidation solution that includes TCP/IP optimization, firewalls, traffic steering, deep packet inspection, URL filtering and DNS security. Most importantly, F5’s solutions are available in both physical and network function virtualization (NFV) environments. The company’s in-house load balancing is also important to scale and eliminate redundancy.
F5 also facilitates edge computing with virtual edition software for load balancing, web application firewalls, service discovery and monitoring. The company is also well positioned for providing application delivery control and security services for microservices architectures within containerized infrastructures (i.e. Kubernetes).
5G Case Study: Rakuten Mobile
The case study with Rakuten Mobile is especially interesting as a model for how important F5 Networks could become in the near future as telcos can reduce capex and physical infrastructure needs with cloud networks and network functions virtualization capabilities (NFV).
Rakuten is Japan’s biggest mobile virtual network operator (MVNO). In early 2019, the company announced plans to build a network in 12 months without significant capex. The reduced capex is made possible through a cloudnative network. The goal is to shift towards Network Functions Virtualization (NFV) technology, which uses the principles of cloud computing to create service delivery platforms “with greater agility and customization.”
The end result is a Radio Access that is virtualized and running as a virtual network function on a private cloud. You can read more here and the press release regarding Rakuten’s partnership with F5 here.
Financials
F5 Networks reported fiscal Q2 2020 earnings at the end of April. Revenue increased 7% year-over-year to $583 million with EPS of $2.23. This beat analyst estimates by $20 million on revenue and $0.24 on EPS.
In the previous quarter, revenue increased 5% to $543 million.
On a non-GAAP basis, product revenue comprised approximately 45% of total revenue and it grew 10% year-overyear to $262 million. Of this, software represented 35% of product revenue and it grew 96% year-over-year. Excluding the partial contribution from Shape, software grew 65% year-over-year. Services revenue grew 5% to $324 million.
Full year revenue grew 4% to $2.2 billion with non-GAAP income of $626 million, or $10.36 per share, up from $612 million in fiscal year 2018.
The company has cash and cash equivalents and short-term investments of $820 million and $182 million in cash flow from operations. Long-term debt at the end of March 31, 2020 was at $380 million. The company repurchased $50 million worth of shares in the most recent quarter.
For the fiscal Q3, the company expects both GAAP and non-GAAP revenue in the range of $555 million to $585 million and non-GAAP diluted earnings per share in the range of $1.91 to $2.13.
The company withdrew the FY 2020 outlook provided in December 2019 when they announced the Shape acquisition. F5’s gross margins are forecast to be around 85% and operating margins to be 30-32% for full year 2020.
Following the Q2 report, F5 attracted some bullish analysts from Piper Sandler and Nomura who believe there is upside due to strong forward guidance and the current results coming from an acceleration of existing trends rather than a pull forward.
Despite these newly bullish analysts, the overall rating is neutral on F5. Notably, Goldman Sachs has a neutral rating due to the earnings stability being offset by the “less certain spending environment.”
F5 is holding up well with the current shift towards work from home. In the most recent earnings report, the company saw an acceleration in purchases of F5 solutions while some purchases were pushed out to future quarters.
Here are some examples from the earnings call on how F5 Networks has been used during the coronavirus:
• F5 enabled one of the largest banking and investment institutions in the United States to scale its VPN access from 400,000 to 500,000 remote users.
• The company helped a multinational mass media conglomerate to increase network capacity within one day, so that 100,000 additional employees could work from home in the U.S. and London.
• A fortune 10 Retail Healthcare Corporation added 160,000 remote workers to its network in under 24 hours.
Addressable Market & Valuation
F5’s biggest risk is the number of competitors relative to addressable market. Often this level of competition leads to pricing wars.
The total addressable market in the application security market has doubled to $8 billion from $4 billion with the Shape Security acquisition, according to F5’s Investor Presentation. Competitors include A10, Akamai, Cisco, Citrix, Imperva, Juniper, Radware, and Symantec.
The ADC market was valued at $2.9 billion in 2016 and will reach $4.2 billion by 2023, which is modest growth of 5%. According to MarketsandMarkets, the Application Security market size is expected to grow from $2.8 billion in 2017 to $9.0 billion by 2022. Competitors here include Citrix Systems, Radware, A10 Networks, AWS, Array Networks, Barracuda, HAPRoxy, Kemp, VMWare and Microsoft Azure.
Application delivery controller revenue declined 4% to 7% in 2018 with F5 owning 47 percent of ADC market share at that time. This prompted the shift towards software.
According to IDC, there were more than 700 million application instances in 2018 and this will grow to 3.7 billion by 2023 for growth of 500%. There were 314 million enterprise applications in 2018 and this is forecast to reach
1.8 billion by 2023.
The company trades at a forward PE ratio of 15 and forward PS ratio of 3.5. This is at the low range for comparable companies.
Conclusion:
There are reasons that F5 has a low valuation comparatively speaking. The company has been hit hard by the transition away from hardware and on-premise. The NGINX acquisition does little for F5’s top line, which has struggled to break out from 5% year-over-year growth. F5 Networks is also a company that has many competitors with a smaller addressable market than what I typically cover.
However, as companies seek to scale application deployment, there are infrastructure-level issues that cloud software companies will struggle to solve. F5’s experience with hardware and a pivot towards software could be a winning combination. This goes beyond end-to-end application infrastructure, where the company already has a solid reputation (i.e. Datadog and IBM’s RedHat both favor F5 as a partner here). F5 is also doing a good job of staying in front of the trends of microservices and the Kubernetes platform.
The more interesting catalyst for is whether F5 can solve major infrastructure and capex issues for telcos. F5’s network functions virtualization (NFV) capabilities can enable a higher throughput, low-latency network and ensure application availability for wireless networks. I believe F5 could be uniquely positioned to solve these issues which should be in high demand as global competition increases for scalable 5G deployment.