F5 Networks (FFIV)

This tech company is beefing up its cloud and other software services and remains a buy.

F5 Networks (FFIV)

from Dow Theory Forecasts

F5 Networks (FFIV) is the country’s largest seller of a product you’ve probably never heard of—application delivery controllers, or ADCs.

These devices manage traffic on computer servers, allowing websites and communications networks to operate quickly and efficiently—a fitting product for a company soon to be run by Manny Rivelo, a 19-year veteran of networking giant Cisco Systems (CSCO).

While the hardware-upgrade cycle continues for now, F5 plans for a softer future. The company sells software-based ADCs that run on the servers it manages. In November, it launched Silverline, a cloud-based service that sells security software and will in the future make ADC software available via the Internet. F5’s subscription-software business is tiny, but Rivelo expects it to “become material in a couple of years” and provide a long, steady revenue stream.

Over the last 12 months, F5’s mix of products and services generated growth of 16% in sales, 29% in per-share profits, and 24% in operating cash flow.

No stock is perfect, and the chief criticism of F5 Networks involves the deceleration of product revenue as more corporations opt for cloud-based rentals rather than the purchase of their own equipment. Of course, deceleration is not the same as a stall. In the six months ended March, product revenue rose 9% and accounted for 52% of total revenue while services revenue jumped 18%.

That trend helps explain F5’s focus on software and services. Analysts project sales growth of 11% and per-share-profit growth of 19% this year, followed by respective gains of 11% and 13% in 2016. F5 has topped profit estimates in four straight quarters.

While product-revenue deceleration may continue in coming quarters, help is on the way. In addition to growth from services and software, F5 stands to benefit from:

Accelerating demand for enterprise applications, and the network infrastructure they require.

Increasing use of mobile apps, a fast-growing market where F5 already has a solution available.

Market-share gains in cybersecurity, as new product offerings Versafe and Defense.net help transform the unit into a key growth driver for F5.

Continued share gains in the wake of Cisco’s exit from the ADC market.

At 21 times trailing earnings, F5 trades 13% above the median for communications-equipment stocks in the S&P 1500 Index but 25% below the median for internet software & services. Such a valuation makes sense for a company that straddles the line between industries.

F5 pays no dividend, but last year the company spent a net $569 million on stock buybacks, reducing its share count by 5%. Given its strong cash flow, F5 seems likely to continue the buybacks—without sacrificing research & development, which has accounted for 12% to 16% of sales in each of the last nine fiscal years.

F5 remains a Focus List Buy and a Long-Term Buy.

Richard J. Moroney, CFA, Dow Theory Forecasts, www.dowtheory.com, 800-233-5922, July 2, 2015