Undeniably, 2019 has been a strong year for technology stocks. The tech-heavy Nasdaq was recently up just over 30%, but it’s important to remember that the stock market and the major indexes are really a market of stocks. Some multi-billion companies have underperformed peers, and others actually have seen their shares take it in the chin. F5 Networks Inc. (NASDAQ: FFIV) has fallen into both categories. After closing out 2018 at close to $160, its shares most recently closed down about 10% on the year at $143.58. Then things went from bad to worse after a key analyst, who was previously positive and above-consensus, decided that it was time to play the Benedict Arnold game with F5 Networks.
Merrill Lynch’s Tal Liani had a Buy rating and a $185 price target that was about $20 higher than the consensus analyst target price, and was only about 3% or 4% shy of having the highest price target on Wall Street. That’s all history now. Liani issued a rare two-notch downgrade, skipping Neutral and taking the stock to the dreaded Underperform rating. That’s a Sell rating equivalent at other firms. The above-consensus price objective was taken all the way down to $140.
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The Merrill Lynch report’s tag-line was “Existential hardware decline too big to ignore,” and that was too big for investors to ignore as well.
While the new valuation is based on about 13 times the expected 2021 price-to-earnings ratio, down from about 16.5 times, Merrill Lynch does not see it as a value stock despite having a sub-market multiple. Liani has cited prolonged pressure on revenue growth coming from a secular shift in demand from appliance-based application delivery controllers (ADCs) to software and cloud-based solutions. According to the report, this has pressured its pricing power at the same time that newer and stronger players are eating into the company.
Competition in business is often deemed to be healthy, but for F5 it’s not healthy when those newer entrants are listed as VMware, Amazon and Google, and also Akamai for its content delivery network. The report said:
We also flag near-term risks to estimates stemming from unsustainably high software growth rates and high concentration of Federal orders in the last quarter which mask greater declines.
As far as the negative trends being secular, the ADCs are shown to be witnessing a fundamental change. While Liani notes that the need for ADC still exists, legacy players are being hit by cloud consumption models while new containers and microservices have changed the way ADCs are consumed. The report said:
Instead of buying hardware appliances with a pre-set level of capacity, enterprises look for a more flexible “on-demand” consumption model. New flexible consumption models not only bring down pricing substantially, but also improve the operations by reducing the provisioning time of resources from months to days, enabling developers to account for network resources and streamline the development process.
The market has been cautious here already, and some of the risks should be priced in. The Merrill Lynch view is that this should not act as a catalyst. In fact, an upside scenario in which a moderation in hardware demand would be less than software growth is now an unlikely scenario.
Wall Street was by and large only looking for 4% revenue growth for this fiscal year and the following one. That hardly leaves room for improvement if the cloud and software keep eating into hardware. Revenue in recent years was not exactly showing robust growth as it was $1.99 billion in 2016, versus a consensus expectation of $2.3 billion this fiscal year.
Shares of F5 were down hard with a 6% drop to $135.00 in midday trading on Thursday. Its market cap is still $8.2 billion, and the 52-week trading range is $121.36 to $173.44.
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