Is F5 Getting Too Good for Its Own Good?

In my recent article on F5 Networks (NASDAQ: FFIV  ) , I raised the issue of the company's valuation. Amid competition concerns, the stock was expensive, trading on enormous expectations, with twice the P/E of rival Cisco (NASDAQ: CSCO  ) . What's more, this was on the heels of a subpar first quarter, during which F5 missed on both revenue and earnings per share estimates. The richness in the stock price notwithstanding, I was not ready to dismiss the company's potential. In the article, I made the following point:

F5 has to get back to its strengths, which lie in its products. And investors should feel encouraged that there are some catalysts on the horizon, including a new product cycle. From that standpoint, the company deserves a little more time to fix its underlying operational issues. Product revenue can't stay in the single-digits. Either the market has become saturated or F5 is not executing up to par and neither scenario is good for the stock.

Remarkably, F5 seemingly listened. During that span, the company has made a key acquisition in LineRate and announced the F5 Mobile App Manager, a new hybrid cloud solution for mobile application management, which now puts the company in a position to steal market share from Citrix (NASDAQ: CTXS  ) and Aruba Networks (NASDAQ: ARUN  ) . Add the fact that last week, the stock lost as much as 8%, while falling below $100 (intraday) and returning to its 50-day average? It's time to reevaluate our position.

The hunter has become the hunted
Although F5 owns roughly 50% of the application delivery control, or ADC, market, there were always concerns about the big, bad Cisco. This is even though F5 has been eating Cisco's lunch in this area for years. As dominant as Cisco has been in the enterprise, its application control engine, or ACE, has been a loser. Consequently, Cisco, which saw its market share drop to 11%, opted to exit the ADC market last year. This has now become a two-team race between F5 and second-place leader Citrix, which holds a 20% share. But then Citrix and Cisco decided to pair-up to unleash a unified attack on F5 and the rest of the market.

F5 protested the partnership. The company doesn't think this type of arrangement is good for the industry nor customers. Dean Darwin, F5's senior vice president, offered the following while speaking to CRN: "It is very hard to preserve channel margins and ensure opportunity protection in a two-vendor strategy model. There's just not enough margin to go around and it causes a lot of confusion for partners. It also introduces a lot of channel conflict that, frankly, neither company has had a great track record of solving."

It sounds like bad blood. But it's just the beginning. Citrix has brushed off the criticism and has since forged a similar partnership with Palo Alto Networks (NYSE: PANW  ) as both companies try to stunt F5's momentum. It's worth noting that a former F5 global sales executive, Mark Anderson left the company to become Palo Alto's senior vice president of worldwide field operations. In other words, while these are strategic business moves, it's also personal. Meanwhile, F5's ADC dominance has generated a lot of attention and the company, which once hunted for respect, has become hunted.

The fight is nasty, but can be won
However, as an investor, I wouldn't want to have it any other way. Markets that are worthwhile tend to generate increased competition -- it's called capitalism. F5's challenge is to seek new addressable markets, which it's done with LineRate acquisitions. But it may require more deals. And I think the company should look to leverage its new Mobile App Manager/BYOD initiative with a partnership with Aruba Networks, whose specialty is in bring-your-own-device. This is a market that Aruba created and currently owns. Plus, it would be F5's response to Citrix, Cisco, and Palo Alto.

But how long can F5 fight off these rivals and still focus on growth? The only guarantee on Wall Street is that market leaders don't hold that title infinitely. That said, I don't think F5's growth will stall for a couple of years. And while these shares are far from cheap -- trading at five times trailing sale -- F5 should continue to gain incremental market share in the ADC market. Plus, assuming momentum holds at modest levels, these shares can support a fair value in the $120s.

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