F5 Ready to Dive

Posted On May 12, 2016 11:27 am

Like many industries, network management providers are under intense competition as businesses shift to the cloud and companies like Amazon can provide a full suite of outsourced hosting. Firms like F5 Networks (FFIV) are struggling to maintain their prior growth trajectory.

F5 Networks develops, markets, and sells networking products to optimize the security, performance, and availability of network applications, servers, and storage systems. Its services include security firewalls, data flow management and context-aware access to networks. I’ll admit to barely knowing what that means, except it and companies like Cisco (CSCO) and Juniper Networks (JNPR) previously enjoyed incredible growth during the late 90’s and early 2000’s, by providing the plumbing to build out business’s internal and external internet infrastructure. With a shift to the cloud their services are no longer as crucial and network providers are being forced to pivot their business models. I think it will be a challenge and shares of F5 are likely to dive in coming months.

Many Things Amiss

Shares of F5 had already tumbled some 20% heading into its April 20 earnings report and expectations were so low the stock actually popped following a miss and lowered guidance. The company reported revenue of $483 million, a 2% decline from the year ago and quarterly profit of $75.4 million, or $1.52 a share, was well below the $1.63 expectations. The company also narrowed its full year forecast to the lower end.

But investors seemed willing dismiss the miss simply due to a $6.4 million in payout to rival cybersecurity firm Radware for patent infringing lawsuit. The news that company CEO, Manny Rivelo, was unexpectedly resigning with no explanation showed things definitely amiss.

With shares back near resistance at the $106 level I think it offers a good entry point to establish a bearish position.

FFIV Chart 5.12.16

Now to be sure, F5 could still get back to both top and bottom line growth over the next few quarter, as it still enjoys strong margins in its service business, but none of that is really going to matter until F5 can perk up its product growth rate and its overall reported growth rate. The shares look only slightly undervalued on the basis of 7% to 8% long-term growth, but the company likely needs to generate double-digit product revenue growth again to get a real tailwind behind the shares.

And while F5 is currently the leader in Application Delivery Controllers (ADCs) with over a 52% share, which it came to dominate when Cisco (CSCO) exited that market some 4 years ago, ADC is increasingly moving to the web and with Amazon entering the market expect both market share and margins to come under pressure, which have already been in steady decline.

FFIV revenue image 5.12.16

The above is well known and helps explain why over the past 6 months, F5 Networks’ shares have had 9 downgrades and 1 upgrade. In the course of the last 7+ months, the shares have lost 27% of their value. The real question to be answered? Does the decline adequately compensate potential buyers and current holders from achieving some reasonable returns as the growth of cloud continues and as the primitive AWS ADC software achieves some degree of market acceptance?

With shares still trading at 23x next year earnings, I think the valuation is vulnerable to multiple compression and the stock could move to a new leg down. I’m establishing a bearish position through a vertical put spread. Specifically:

-Buy July 105 Put and Sell July 90 Put for a $4.00 Net Debit

My expectation is for shares to head back down to 52-week low near the $90 level. Here is what the risk graph for the spread looks like.

FFIV Order 5.12.16

About author

Steve Smith

Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.