F5, Inc.

Moat: 3/5

Understandability: 3/5

Balance Sheet Health: 4/5

F5, Inc. is a multi-cloud application security and delivery provider, helping organizations ensure their applications are secure, fast, and reliable in complex IT environments.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

F5 operates within the realm of application delivery and security. They don’t directly sell hardware or software, but are instead a software-based provider of networking solutions. They’re in the business of Application Delivery Networking (ADN) solutions, application security, and application services to both large and medium-sized enterprises, and service providers. As such, its customers may be any companies with applications delivered over networks.

Business Overview:

  • Revenue Distribution: F5 generates revenue through several avenues. This includes product revenue (sales of hardware and software appliances), as well as recurring revenue from software subscriptions, maintenance, and other professional services. Their growth is primarily driven by software as hardware becomes a smaller percentage of overall sales. The growth will depend on their ability to transition their existing customers into subscription based models.

Recurring revenue is the primary driver for growth in the future for F5, and their success in achieving this will be crucial to their success.

  • Industry Trends: The cybersecurity and application delivery market is rapidly evolving with new threats and increased network complexity. Organizations are moving towards cloud and multi-cloud environments and this change is accelerating. As a result, they need strong security and application delivery. Companies are looking for robust technologies that allow them to secure all their applications, while also enabling them to function flawlessly for their end users. This dynamic creates both opportunities and challenges for F5.
The market has also become more competitive with large tech players becoming more involved. However, the increase in complexity allows for a greater requirement for specialized offerings that favor F5. *   **Margins**: A look at the Q1 2024 shows an operating margin of 27.4%, which is relatively stable. The company is also focusing on a transition to a subscription based model. It is likely, that margins will get better as they reduce hardware costs and sales and move into recurring revenue streams, that are higher-margin.
*   Cost of Revenue: Primarily made up of product costs and service expenses, costs for labor, equipment, and others. As the company transition into software based products, we will likely see the cost of revenues drop, leading to higher gross margins.
*   Operating Expenses: Composed of sales & marketing, R&D, and general & administrative expenses. Management is focused on controlling these costs through restructuring and other efficiencies, which should enable profitability. *   **Competitive Landscape:** F5 operates in a competitive landscape alongside major players in networking and cybersecurity, such as Cisco, Palo Alto Networks, Fortinet, and Akamai. They differentiate themselves by focusing on application delivery and security and their multicloud and hybrid solutions, as well as by the level of customer support they offer.

A good illustration of the importance of strategic decision making for F5 is shown in the most recent earnings call where the CEO stated that they are focusing on multi-cloud networking and security to provide solutions for specific client needs. *   **What Makes F5 Different?** The company differentiates itself through its emphasis on application-centric security and delivery solutions, which are tailored to address specific customer pain points across complex multi-cloud and hybrid environments. Their software based approach, combined with expertise in application delivery networking allows them to provide a higher value service. This has allowed F5 to move away from being a hardware vendor and position itself as a software solutions provider that can be tailored to complex client needs. The recent move to expand its managed security and software subscription services supports this effort.
 *   They also have high expertise in the area of network security solutions, and particularly application delivery network capabilities. This makes it more than just a cybersecurity vendor; they provide specialized solutions that allow for more effective functioning of a network, as well as maintaining the security of that network.
*   Their main area of advantage is having multi-cloud / hybrid networking solutions. These allow for companies that have many different cloud providers to manage all the data and traffic in one place, and secure all the applications running. *   **Other Relevant Aspects:** F5 is going through a transformation to recurring subscription services, which is essential to its long-term growth. The company is seeing strength in their recurring software sales and also in their new products. However, they have to balance their long-term goals with the needs to reduce expenditures on hardware, given the current market uncertainty.
 *   There are some uncertainties with changes in demand as consumers become more hesitant to spend more money during the current economic conditions. However, IT security has not seen declines that have been present in other industries.

It’s also notable that F5 announced a major restructuring plan in Q2 2023 to control costs and increase growth. This plan included a reduction in force (layoffs), and streamlining of some areas of operation. The effects of that action are still felt today with further operational improvements being made.

Financial Analysis:

  • Revenue: F5’s revenue is showing positive trend of growth. The Q1 2024 results show revenue of $700 million, up 3% YoY (4% YoY in the previous quarter). Software revenue makes up the biggest portion with about 59% of revenue and growing. Product revenue decreased by 13% YoY. F5 is focused on recurring revenues, which is reflected in these numbers. This shift to software based revenue will lead to higher growth in the long-term.
Their software revenue was up 22% year-over-year. As this trend is relatively recent, it's important to continue to monitor, and evaluate, the company's ability to continue to grow these sales. *   **Profitability:** The company has maintained positive profitability, however they are doing significant investment into their transformation. Gross margins were quite high at 84%, while their operating margin was at 27.4%, which is still good given ongoing restructuring.
*   Profitability is expected to rise over time as they transition to a subscription based revenue.
*   It is important to keep an eye on operational expenses, as these are currently high and the company is trying to reduce those. *   **Cash Flow:** Operating cash flow was down significantly from the previous year. Free cash flow has also declined because the company has focused on spending more money, and its focus on subscriptions rather than hardware sales will have an effect. This is something to watch as free cash flow is important for value creation.
 *   The good side however is, the company is still able to do share buybacks. For the three months ended December 31, 2023, they repurchased 1,294 shares for $190.2 million.

As a result of their transformation efforts, the company is sacrificing some of their profitability, with increased costs and reduced free cash flow, but this should be short-term. It is important to see if the benefits are realized in the coming years.
  • Balance Sheet Health: With a debt-to-equity ratio of around 120%, and an increase in debt during the last year, their balance sheet is not the best in the industry. They have a good amount of cash and cash equivalents, which will help to weather short-term issues.
    • The cash is mostly composed of marketable securities, and cash in different currencies, which can be readily converted to cash, which makes them a very good asset for the company to hold in such uncertain markets.

Moat Rating: 3 / 5

  • Intangible Assets: F5 has some brand recognition, especially in the security industry. This does provide some level of moat, but it’s not very significant as some competitors have equally strong brands, as such this moat is limited to a “narrow” moat. They also benefit from patent protection in some areas, but nothing substantial, as such this moat is not a driver of value and only a minor consideration.
  • Switching Costs: Companies that use F5’s services often have high switching costs. It’s not as high as something like Oracle databases, however, companies that have implemented the F5 service typically use those services for a long time. As such, these companies have a harder time to go to competitors. This is an important factor in making F5 have a competitive advantage.
  • Network Effects: The company does not benefit from pure network effects, as it’s not directly a social network of a marketplace. However, they do benefit from clients being interconnected to them, for their software platform, which will make the network effect play a part, but not a dominant one. As such, the network effect is not as impactful on F5 as it can be for other types of companies.
For F5, the value of their products and services, is not increased through the number of users they have but the reliance that the user base has on the security and network management solutions they provide. *   **Cost Advantages:** They do not have a significant cost advantage. While the company tries to optimize operations to reduce expenses, they are not particularly differentiated in their cost structure. This moat can be disregarded from the equation.

Justification for the Moat Rating: F5 does not have a strong economic moat. Though, it has some competitive advantage due to switching costs, and the intangible benefits from their brand, the company is not able to benefit from network effects or a low cost production advantage. As such, the company only has a narrow moat, which should protect them for a while, but not indefinitely.

Risks to the Moat and Business Resilience:

  • Technological Disruption: The cybersecurity and application delivery industry is subject to rapid technological change. New technologies or changes in technology can quickly eliminate any competitive advantage that the company has. This is a big threat for their mote, which is not very wide.
  • Competitive Pressure: The company competes with major players in the networking space, so competition from them could lead to reduced market share and profit margins. As competition can be brutal in the industry, this is a continuous danger to F5.
  • Integration of Acquired Businesses: The company has been active with mergers and acquisitions to grow its presence and product offerings. The integration process of such entities could have challenges and not be able to realize value of acquisitions.
  • Economic Sensitivity: As the company provides services to enterprise clients, it is very likely they will feel the effects of market uncertainty, particularly if a large recession occurs. This may lead to delays in purchases or clients switching to less-expensive alternatives.
  • Execution Risk: With the recent transformation and organizational changes, F5 needs to prove it can efficiently manage its business and still maintain its leading place. Any misstep in that could harm their business.
  • Cloud-Native Competitors: As more applications are developed for the cloud, cloud-native security and delivery solutions may displace F5’s offerings.
  • Data Security: While they are in the security business, any major data security breach at F5 could destroy the brand value and reputation they have built up over many years.
    • An example of this is the recent data breach of one of their customers, which highlights some potential issues.

Understandability Rating: 3 / 5

  • The company has a complex business model with specialized solutions. While the basics are not complicated, truly understanding the company does require a significant amount of research.
  • It is also difficult to predict some areas of the business, because the IT and security market evolves at a fast pace, with a lot of emerging competitors as well as established behemoths present.

Balance Sheet Health Rating: 4 / 5

  • The company does have significant debt obligations, however, they also hold a large portion of marketable securities and cash, to weather short-term issues. The major issue that makes this balance sheet not receive 5/5 is the leverage, which will have to be managed going forward.
  • The financial numbers themselves are very good, and indicate a financially sound and responsible management.

This analysis was made on 2/3/2024 using data from their latest 10-K reports, 10-Q reports, earnings calls, investor presentations, financial statements, and articles that are public.