(By
Grady Burkett, CFA) F5 Networks (
FFIV)
has effectively leveraged its first-mover advantage in server load
balancing to build a business that possesses structural competitive
advantages, primarily customer switching costs. Its financial
performance rivals that of dominant software vendors. F5 generates very
high returns on capital thanks to the significant amount of software
content embedded in its appliances, its large base of high-margin
maintenance service revenue streams, which are recurring in nature, and
the relatively small amount of capital needed to run the business. F5's
stable and strong market share, increasing customer penetration, and
strong services revenue growth also point toward a narrow economic moat.
Although we recently upgraded our moat rating to narrow from none and
increased our fair value estimate to reflect our more optimistic
long-run view of the business, we believe the shares are currently
overvalued.
F5 Is Essentially a Software Company
F5's products, services, and business model support industry-leading
returns on invested capital. F5's core products are its application
delivery controllers. ADCs can perform a variety of tasks related to
delivering and securing software applications, but their core function
is server load balancing. This process distributes traffic load more
evenly across Web servers to ensure that the end user receives the best
experience possible when visiting a website or using a software
application.
F5's ADCs can also perform extremely complex tasks such as
application health monitoring, data traffic management, Web application
security, protocol optimization, and data center load balancing. They
are widely recognized as being the most flexible, reliable, and capable
in the industry, and F5 is currently the runaway leader in ADCs.
The firm installs its proprietary operating system, iRules extensible
scripting language, and additional software modules onto hardware
appliances composed of off-the-shelf components assembled by third-party
contract manufacturers. F5 relies heavily on value-added resellers to
distribute its appliances, while nearly 40% of revenue is derived from
services that provide for software upgrades, hardware maintenance, and
technical support.
A large portion of F5's expenses, such as software development,
marketing, and channel support, can be leveraged, and the firm requires
very little physical capital to support revenue growth. As a result, its
returns on invested capital have expanded as revenue has grown over the
past three years, and they are now among the highest in the data
networking industry.
While F5 sells a broad array of hardware appliances and chassis/blade
systems to accommodate different customers' IT environments and
resources, all of its hardware runs its common operating system and
supports its scripting language, iRules. Additionally, the firm sells
software modules that run on its hardware platform to perform a variety
of security and traffic optimization functions such as application
security, secure sockets layer offload, and Web acceleration. As a
result of the significant amount of software content embedded in its
systems, the firm typically generates product gross margins around 80%.
Although we expect competitive forces to put modest pressure on gross
margins over time, we think F5 can continue to add software features to
its platform to partially offset competition-based product gross margin
pressure.
Additionally, F5's customers typically purchase high-margin services
contracts that allow for software upgrades, patches, hardware
maintenance, and technical support. Services have become an increasingly
large portion of revenue over the past several quarters, which suggests
to us that F5 is deepening its relationships with its current
customers. F5 just recently reached scale, and its operating margins
recently surpassed 30%. Given the firm's strong competitive position and
growing revenue base, we expect operating margins to average roughly
30% over the course of the current business cycle.
As F5 has introduced more software features and deepened its
penetration within its customer base, it has been able to build a strong
services business. The firm's services include recurring items such as
software upgrades, SSL VPN licensing, hardware maintenance, and ongoing
technical support, as well as professional services such as network
management, performance analysis, and capacity planning.