The stock market -- and particularly the tech sector -- is filled with companies that are trading on high expectations. While the likes of Amazon, which sports of P/E of more than 3,000, has done well delivering for investors, there are also many cases where such lofty expectations remain unmet. This is despite the strong underlying potential of several of these companies.
This has been my main point of contention with F5 Networks (NASDAQ:FFIV), a stock I've always wanted to like but just can't. Although F5 is the dominant force in the application delivery security business, it's hard to not consider this company a disappointment. F5 has arguably superior technology to Cisco (NASDAQ:CSCO) and Juniper Networks, but the company has not produced the growth to justify its valuation. And after a solid earnings report from rival Fortinet (NASDAQ:FTNT), the Street is getting impatient waiting on its potential.
Terrible was followed with merely so-so
F5 didn't have a great end-of-year quarter, as it missed on both top and bottom lines. In fact, the fourth quarter, which produced revenue and earnings-per-share growth of 15% and 6%, respectively, was the company's worst in terms of performance in more than three years. Then again, this was not a huge surprise considering the fiscal concerns of Europe, an area to which the company has some reasonable exposure.
So, with issues abroad and the fact that IT spending was still not up to prior levels, investors were not expecting a strong first-quarter report. It's a good thing, because they didn't get it. Revenue arrived 13% higher year over year and advanced 1% sequentially. That was the good news. But unfortunately, both figures missed consensus estimates. Then again, relative to expectations, these numbers weren't that bad. Besides, F5's revenue arrived 10% higher than what Check Point Software just reported.
However, given that shares of F5 are trading at a P/E ratio that is five points above the industry average and more than two times the ratio of Cisco, it's still a disappointment. Meanwhile, Cisco just completed its seventh consecutive earnings beat with no meaningful signs of slowing down. Although carrier spending and the adversities of Europe have weighed heavily on this sector, companies that are managed well figure out ways to mitigate the damage.
Fortinet, which beat both top and bottom line estimates, serves as a perfect example. The company just posted a 25% increase in revenue with a 26% surge in net income. Plus, both Fortinet and Cisco have similar European exposure to F5 and are competing for the same domestic customers. So what's the problem?
F5 does deserve credit for growing service revenue 28%. This means that the company is doing well and is outperforming Juniper and Cisco in the service category. It's also outperforming Check Point, which is considered the best in the business. But F5 managed to offset its strong service performance with a dismal 4% growth in product revenue. Plus, it was down 2% sequentially. And this was supposed to be F5's strength.
Can profitability silence the alarms?
On the bright side, the company made significant improvements in profitability. Gross margin advanced year over year by almost one percentage point and improved sequentially by forty basis points. And, despite the uninspiring performance in product revenue, F5 made them count. As evident by the improved margins, the company got the most from the product it was able to move. But operating income shed 2% sequentially, which was caused by an uptick in sales and marketing expenses.
This is not so much of a concern, however. As an investor, I would have been angered if the company opted instead to sit on its hands and did nothing while bleeding market share. This is precisely what Juniper has done. Plus Cisco has exited the application delivery control market altogether. Essentially F5 does not have to compete with two of its biggest rivals and is still unable to fully dominate this market. Something's wrong.
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.
But all in all, compared to Juniper and Check Point, this wasn't a terrible performance for F5. Unfortunately, this first quarter followed a horrendous fourth quarter which made things look worse. That the stock didn't tank following the report means the company is getting a pass for now. But for how long? Eventually, investors will realize that the potential they are paying for in these shares today is not being met in execution.
Plus, with Cisco and Fortinet performing so well, explanations such as macro and sector problems no longer carry weight. In the meantime, valuation matters for F5. And for this stock to make sense again, the P/E needs to come down commensurate to the company's reduced guidance. Astute investors should be hearing alarm bells.
Fool contributor Richard Saintvilus has no position in any stocks mentioned. The Motley Fool recommends Amazon.com, Check Point Software Technologies, Cisco Systems, and F5 Networks. The Motley Fool owns shares of Amazon.com, Check Point Software Technologies, and F5 Networks. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.