In January 2021, I called F5, Inc. (NASDAQ:FFIV) a continued transformation story. The company has seen some acceleration in growth on the back of strategic acquisitions. As the company announced its next strategic deal early in 2021, the company hiked its long-term ambitions as well.
All of this looked quite compelling, and while there were some earnings questions, the strategy was arguably the right one, although that appeal was not imminently seen with shares trading around the $200 mark at the time.
F5 has been a hardware play on application delivery controllers for quite a long time. The company realized that it had to make a transition into software as both hardware and software were moving to the cloud, creating challenges to its traditional business model.
The transition made F5 a tricky investment proposition as the company had quite a strong track record, yet continued innovation might render large parts of its business to be no longer relevant in the future. Shares peaked around the $200 mark in 2018, as the peak coincided with the company posting revenues at $2.2 billion on which operating earnings of $590 million were reported.
This translates into very profitable operations, with earnings surpassing the $7 per share mark. Adjusted earnings came in at nearly $10 per share, yet the vast majority of the difference between both metrics stemmed from stock-based compensation shares, something which should not be adjusted for.
The 62 million shares were valued at $11.8 billion at $190 per share, albeit that the valuation fell to $10.4 billion if we factor in a substantial net cash position of around one and a half billion at the time, with operating assets trading at a realistic earnings multiple in the low-twenties.
With management and the market recognizing that the company needed to improve its offerings, F5 went on a shopping spree. This included a $670 million deal for NGINX in 2019, to add application delivery skills to the line-up of offerings, only to acquire Shape Security in a billion deal later that year as well. Shares fell to $130 late in 2019, as revenues rose modestly, as was the case for adjusted earnings.
Following the knee-jerk reaction in 2020 following the pandemic, shares rallied to $190 by year-end, as the company posted a 5% increase in full-year sales to $2.35 billion in October 2021, driven by software sales growth. Despite the modest sales growth, the same cannot be said for margins.
Adjusted earnings per share fell a dollar to $9.37 per share, but more worrisome was that deal-making only increased stock-based compensation expenses, with GAAP earnings down to $5.01 per share, down two dollars from the year before. Pegging realistic earnings around $6.50 per share (after backing out stock-based compensation expenses) while net cash fell to $900 million following deal-making, the risk-reward no longer looked compelling at 27 times realistic earnings.
To further transform the business, F5 announced the acquisition of Volterra in a $440 million deal, as the company guided for high single-digit sales growth going forwards. Given the fact that the transition was still in the early innings, pressuring earnings somewhat, and with earnings multiples increasing to 27 times again, I found it very easy to avoid shares of F5 at the time.
Boom – Reset
Since my cautious stance around the $200 mark at the start of 2021, shares actually rallied to a high of $250 late in 2021 as shares of the company rose alongside the boom in technology names at large. In response, shares have sold off to a low of $150 in recent weeks, before having rebounded to $170 at the time of writing.
In September of last year, F5 announced a bolt-on deal, paying $68 million to acquire Threat Stack, a cloud security and workload protection provider, a deal set to add some $15 million in sales to the fiscal year 2022. A month later, F5 announced 11% revenue growth for the fiscal year 2021 to $2.60 billion as earnings improved as well.
Adjusted earnings rose by nearly one and a half dollar to $10.81 per share as GAAP earnings improved modestly to $5.34 per share, with the discrepancy still being large, and largely tied to stock-based compensation expense, with realistic earnings seen around $7.50 per share as growth was still withheld by chip shortages.
Net cash still stood at more than $660 million, equal to about $11 per share, as the company guided for 8-9% sales growth in the fiscal year 2022. In January, F5 posted 10% sales growth as earnings grew alongside topline sales growth . Second quarter sales actually fell 2% despite 40% software growth as the company was hurt in the hardware business because of chip shortages, causing earnings to fall quite a bit as well. Amidst this, the company further revised the full year sales guidance downwards.
Late in July, the third quarter results looked quite upbeat if you ask me. Third quarter sales rose 4% on the back of 38% software sales growth. Based on the fourth quarter guidance, which calls for sales at a midpoint of $670 million, full year sales are likely to be flat just over $2.6 billion, actually set to increase modestly from the year before. GAAP earnings likely come in around $10 per share, with realistic earnings likely seen around $6-$7 per share. Net cash of $400 million boils down to nearly $7 per share, as this is not too inspiring, with net cash balances having fallen quite a bit following the M&A run in recent years.
With shares trading at $170 now, the operating assets are valued at 23-27 times earnings, based on fair earnings of $6-$7 per share as falling hardware sales are causing additional pressure on the business, with the smaller software business not yet making enough of a dent to inspire growth.
A Concluding Thought
Truth is that the transformation of F5 does not look enticing enough to me yet here. While the transformation continues, so far it only pressures earnings, all while the legacy hardware operations are hurt even more by supply chain issues and component shortages.
Given all of this, I still find myself performing a balancing act. Shares are down 15% over the time span of about eighteen months, as the company is only seeing stagnation in terms of earnings and sales. Declining earnings and depleting net cash balances do not create a great risk-reward set up here, with a continuation of sales and earnings growth required to drive any kind of appeal.