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Why It’s Time to Sound the Alarms at F5 Networks, Inc. (FFIV)

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The stock market — and particularly the tech sector — is filled with companies that are trading on high expectations. While the likes of, Inc. (NASDAQ:AMZN), 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, Inc. (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 Systems Inc. (NASDAQ:CSCO) and Juniper Networks, Inc. (NYSE:JNPR), but the company has not produced the growth to justify its valuation. And after a solid earnings report from rival Fortinet, Inc. (NASDAQ:FTNT) , the Street is getting impatient waiting on its potential.

F5 NetworksTerrible 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 Technologies Ltd. (NASDAQ:CHKP) 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.

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