Because the rise of cloud computing has pushed F5 Networks' (FFIV 0.73%) legacy hardware-based business into decline, the company's own transition to a cloud-based software model has become vital to its efforts to remain relevant.
Its fiscal first-quarter results confirmed it's making encouraging progress in that direction. And last month, F5 accelerated the pace of those changes with its largest acquisition ever -- it bought Shape Security for around $1 billion. The size of the transaction relative to F5's scale represents a risky bet -- but given the company's modest valuation, it also provides investors with an interesting investment opportunity.
A mandatory transition from hardware to cloud-based software
F5's legacy business consists of selling hardware-based application delivery controllers (ADCs) that optimize the performance and security of computing architectures. These devices filter and distribute network traffic across server groups that host the applications users want to access.
However, with the growth of cloud computing, these on-premises devices have become less relevant. For instance, during the last quarter, revenue from F5's systems segment (which includes the company's hardware ADC) dropped 11% year over year to $170 million. This business remains important, though. It still represented 72% of the company's product revenue during that quarter. (Outside of products, the company generated 58.8% of its revenue from services such as consulting, training, and maintenance).
But F5 initiated its transition to a software-based model a few years ago. It virtualized its ADC -- making the software independent from hardware -- and developed a cloud-native version.
This new software-based ADC sits between remote users and applications hosted in the cloud, which is an ideal position to add cybersecurity features. For instance, F5 offers a web application firewall, which filters network traffic between clients and servers based on in-depth web traffic analysis.
And in May, the company accelerated its transition to its software ADC business. It acquired the open-source ADC company NGINX for $670 million to expand its footprint with developers and profit from that company's products' synergies with its existing solutions.
During the last quarter, F5's growing software business offset its declining hardware portfolio -- product revenue stayed flat year over year. Revenue from software increased to $65.7 million, up 50%. The software revenue base remains small compared to the legacy hardware business, but management is confident that revenue growth from software will exceed 50% next quarter.
The acquisition of Share Security represents a risky bet
In fact, taking into account the acquisition of the cybersecurity player Shape Security in December, management indicated revenue growth from software would land in the range of 60% to 70% during fiscal 2020.
This deal makes sense since Shape Security offers a cybersecurity product that can be integrated with F5's ADC cloud offering. In a nutshell, it uses artificial intelligence to prevent sophisticated bots from abusing the applications it protects.
In addition, Shape Security's application cybersecurity market seems attractive. A study from Mordor Intelligence estimates this market should grow annually by 25% and reach $15.25 billion by 2025.
This transaction represents a significant bet for F5, though.
The company didn't provide any financial details about Security Shape. But given the lofty valuations of other cloud-based cybersecurity stocks, it's reasonable to assume F5 paid a high multiple of revenue. For instance, the market currently values CrowdStrike and Zscaler -- two high-growth cloud-based cybersecurity vendors -- at price-to-sales ratios of 29.6 and 21.7, respectively. Also, the purchase price of $1 billion in cash amounts to 2.5 times F5's research and development expenses during fiscal 2019.
Attractive risk/reward ratio
F5 must continue to achieve strong growth from its software solutions to offset the secular decline of its still-important hardware-based business. Given the synergies, the acquisitions of NGINX and Shape Security make sense and should contribute significantly to the company's software revenue growth. The successful integration of NGINX and Shape Security with F5's portfolio involves important execution risks, though.
But given the company's modest enterprise value-to-sales ratio of 3.2 and its forward P/E of 12.2, the market seems to be pricing F5 for weak growth -- at best -- over the long term. Thus, its stock offers an interesting risk/reward ratio for investors looking for exposure to the cloud computing space at a reasonable price.