F5 Networks (NASDAQ:FFIV) posted solid fiscal second-quarter revenue growth and better-than-expected non-GAAP (adjusted) earnings per share as the tech specialist transitions from its legacy hardware business to cloud and cybersecurity software.

As a result, shares jumped by more than 10% on earnings, but investors should look beyond these apparently strong results. 

Strong revenue growth fueled by acquisitions

Fiscal second-quarter revenue of $585.6 million, up 7.5% year over year, reached the midpoint of management's guidance range of $580 million to $590 million, which seems encouraging given the coronavirus-induced uncertainties.

Some customers rushed to close some projects before potential disruptions arise, and the sudden increase in remote workers boosted the company's access and control solutions. But as some other companies shifted their priorities and postponed some deals, the net effect of the coronavirus was neutral. 

In fact, the acquisitions of NGINX and Shape in May and January, respectively, for a total of $1.8 billion, fueled that strong revenue growth. Without the contribution of $14 million from the cybersecurity specialist Shape, revenue growth would have come closer to 4.9%. And excluding revenue from the application-delivery player NGINX, F5 would have posted a less exciting low-single-digit top-line growth.

Revenue from legacy hardware -- appliances that speed up and secure the access to applications by optimizing the performance of on-premises computing infrastructures -- decreased by 11% to $171 million as more and more enterprises have been moving some of their applications and infrastructures to the cloud. In contrast, the company's software revenue increased by 96% year over year, boosted by NGINX and Shape.

Man looking at cloud with shield and lock symbol with a magnifying glass.

Image source: Getty Images.

Operating margin below forecasts

The contrast between F5's declining legacy hardware business and the growth of its cloud and cybersecurity software portfolio shows the company's shift to software-based solutions is materializing.

In 2018, management had forecasted that shift would drive non-GAAP operating margin in the range of 35% to 37% during 2019 and 2020. It then lowered that range to 33% to 35% following the acquisition of NGINX.

However, given the company's second-quarter non-GAAP operating margin of 29.1%, that goal seems still far away. And management forecasted the operating margin to drop below 28% during the next quarter, based on the midpoint of guidance.

Most likely, the acquisition of Shape explains these lower-than-forecasted margins. Thus, investors should keep in mind that F5 must still deliver flawless execution to integrate its acquisitions and improve its operating margins in the high 30s in the medium term, as management initially planned.

Non-GAAP vs. GAAP

Many companies would dream of F5's current non-GAAP operating margin in the high 20s, though. But investors should keep in mind that these non-GAAP results exclude some important items.

For instance, F5's second-quarter non-GAAP operating income excluded $23.5 million of acquisition-related costs. Management discussed during the earnings call that it would prioritize the integration of NGINX and Shape before pursuing other acquisitions. Yet since the company is likely to still rely on acquisitions over the long term to fuel its growth, investors should consider a portion of these acquisition-related costs as a recurring item.

Management also excludes share-based compensation (SBC) from non-GAAP results, but this non-cash expense represents a real cost to shareholders as it increases the number of shares, which diminishes their value. During the last quarter, SBC amounted to $51.2 million, or 8.7% of revenue, and SBC should reach $52 million to $53 million next quarter.

As a result, taking into account some other minor items that were also excluded from non-GAAP calculations, F5's second-quarter non-GAAP operating margin of 29.1% translated into a much lower GAAP operating margin of 14.3%. And given the recurring nature of SBC and other costs excluded from non-GAAP results, you should expect the difference between F5's GAAP and non-GAAP earnings to remain significant over the next several years. 

Effect on valuation

F5's transition to software-based solutions is materializing, and the company remains solid with $1.0 billion of cash, cash equivalents, and investments that far exceed its $400 million term loan. However, investors should value the company with prudence. 

Based on the last 12 months, F5 looks like a cheap tech stock, given its enterprise value-to-sales ratio of 3.6 in the context of its 7% revenue growth at a non-GAAP operating margin close to 30%. But that ratio becomes much less attractive if you measure it against the company's low-single-digit organic revenue growth (growth without acquisitions) and GAAP operating margin below 15%.