F5 Networks: Emerging AI Narrative

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F5 Networks saw stabilized System demand and robust Software growth in Q4, supported by AI use cases, leading to a return to topline growth.Much of this is the result of improved market conditions, ...

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Just_Super/iStock via Getty Images F5 Networks' (NASDAQ:FFIV) business appears to have gained some momentum over the past few quarters, with System demand stabilizing and Software growth remaining robust, supported by AI use cases. F5's improved margins are also impressive given the company's investments in growth initiatives. I previously suggested that F5 was reasonably valued, although this needed to be weighed against the company's uncertain growth prospects and the potential for margin compression. While F5's hardware business has struggled, this has been offset by software growth. F5's share price is now up over 30%, modestly outperforming the market over the same time frame. F5's valuation still leaves room for further upside, but growth will need to continue improving. This is a tough ask given the decline in System revenue, but the demands placed on infrastructure by AI appear to be providing F5 with the necessary boost. Market Conditions F5 started to see signs of improving demand in the third quarter, including a stronger pipeline and close rates. As a result, bookings growth was solid and new business growth improved. In particular, hardware demand has stabilized and F5 believes that customers have now digested excess inventory. Some customers are still reportedly sweating their assets though due to the tough macro environment. Hardware demand continued to improve in the fourth quarter, which was an important contributor to F5's strong results. There are also signs of COVID supply chain bullwhip headwinds easing beyond just the ADC market. For example, Fortinet (FTNT) has suggested that firewall demand is improving. This supports the notion that the improvement in demand conditions will be sustained going forward. F5 Business Updates F5 provides a range of solutions that help to deliver, secure and optimize applications and APIs across any environment. It has both hardware and software offerings, many of which have come through acquisitions. Customers are facing increased complexity, cost and risk in application security and delivery, a situation that is being compounded by the rise of AI. F5 is trying to address this with its app and API security platform, which allows customers to consolidate point products. It also enables multi-cloud and hybrid infrastructure while maintaining simplicity. In addition, F5 aims to deliver cost-effective and scalable IT operations through standardization and automation. F5's business is benefitting from a number of structural tailwinds, primarily related to the growing use of hybrid infrastructure and increased IT complexity. For example, around 20% of F5’s customers operated in more than six infrastructure environments 12 months ago. A figure that has now risen to 40%. In addition, nearly 90% of F5's customers are operating across multiple environments. App instances are also projected to grow from two billion now to six billion by 2029. API security is a growth area for F5, driven in part by AI. This is also an area that is generally underpenetrated, with a recent F5 survey finding that nearly one-third of customer-facing APIs lack fundamental protection. The number of F5's API security customers more than tripled YoY. API security is also a focus area for Fastly (FSLY) and Akamai (AKAM) recently made an acquisition in this area. This validates the market but also indicates that competition is increasing. F5's security revenue totaled $1.1 billion in FY24, roughly flat YoY. Part of the reason for this was weakness in F5's bot management solution, something that has been an issue over the past two years. F5 attributed this to the fact that it is a high-end managed service and a point solution. F5 is also increasingly focused on helping customers meet the challenges created by AI. In particular, high-performance networking and security are important for both training and inference and LLM inferencing is driving greater usage of APIs. F5's ADC platform and application security and delivery capabilities can provide value in these areas. While this could provide a significant tailwind, F5 believes that it will probably be another 1-2 years before enterprises are deploying AI in production at scale. F5’s solutions can help with:  AI data ingestion AI factory load balancing Secure AI inferencing  F5 is also collaborating to help strengthen its capabilities in this area. This includes a recent partnership with NetApp (NTAP) that aims to streamline the deployment of LLMs. F5 streamlines the use of LLMs across hybrid cloud environments and NetApp offers data management, helping customers implement RAG solutions efficiently and securely. F5 also recently announced a collaboration with Nvidia which aims to transform application delivery for AI workloads. The partnership aims to ensure that BIG-IP Next for Kubernetes works seamlessly with Nvidia BlueField-3 DPUs. A data processing unit integrates a CPU with network interface hardware and helps to relieve the main CPU of complex networking responsibilities. They are targeted at datacenters and high-performance computing, where latency and bandwidth are critical. F5 has stated that it is seeing solid momentum from its Distributed Cloud business, but this isn't apparent in public data. F5's core SaaS and managed services revenue, which includes distributed cloud services, bot defense and NGINX-as-a-Service. Growth here is solid but this is being hidden by churn within F5's bot management solution. Some of this is also the result of planned revenue churn. Managed services include F5's legacy Silverline offering as well as some legacy SaaS solutions. F5 is currently in the process of migrating customers from its Silverline solution to the Distributed Cloud offering, which is creating headwinds. The company is also abandoning some legacy SaaS offerings from the companies it acquired. This process involves $65 million ARR in total, half of which is from offerings that F5 is retiring completely. The majority of the Silverline transition is expected to occur in F25 and FY26. WAF and multi-cloud networking were the first two distributed cloud solutions, with CDN capabilities subsequently added through the acquisition of Lilac. F5 also continues to add capabilities to the platform. F5's Distributed Cloud Services offering now has over 800 customers, an increase of 60% YoY. One third of these customers are new to F5. Figure 1: F5 SaaS & Managed Services Revenue (source: F5 Networks)Financial Analysis F5 generated $747 million revenue in the fourth quarter, an increase of 6% YoY. Services revenue was up 2%, while product revenue increased 10%. Within product revenue, System sales declined 3% YoY and Software revenue increased 19%. F5 expects $705-$725 million revenue in the first quarter of FY25, representing a 3.2% YoY growth rate at the midpoint. For the full year, F5 expects 4-5% revenue growth, with software revenue growth in upper single digit range, systems revenue growth in the mid-single digits and services revenue growth in the low single digits. Figure 2: F5 Networks Revenue (source: Created by author using data from F5 Networks)Figure 3: F5 Networks Product Revenue (source: Created by author using data from F5 Networks)The number of job openings mentioning F5 Networks in the job requirements continues to decline, although this appears to be more reflective of System sales than the overall performance of F5's business.   Figure 4: Job Openings Mentioning F5 Networks in the Job Requirements (source: Revealera.com)The number of F5 job openings remains low, which suggests that F5's growth will remain low going forward. It should also help ensure that the company's operating expenses remain under control though. Figure 5: F5 Networks Job Openings (source: Revealera.com)F5's profitability continues to improve, driven by a combination of rebounding gross margins, cost cutting and operating leverage. Higher product gross margins appear to be the result of revenue mix and easing COVID supply chain headwinds. Improvements in operating profitability have moderated in recent quarters and further gains will likely require consistent growth. The improvement in cash flows recorded in Q4 was largely the result of favorable changes in working capital. Figure 6: F5 Networks Gross Margins (source: Created by author using data from F5 Networks)Figure 7: F5 Networks Margins (source: Created by author using data from F5 Networks)Conclusion F5 Networks is a business undergoing a large transformation, meaning future share price returns are likely to be dominated by the success of this transition. Over the past seven years F5’s software, SaaS and managed services revenue has grown from 13% of product revenue to 58%. Over the same time frame, subscriptions have grown from 20% of software revenue to 85%. While this is promising, F5 must maintain this momentum to ensure the business continues to grow. For example, F5's internal expectations are for long-term software growth in excess of 20%, offset by high to mid-single digit systems revenue decline. If software revenue growth disappoints, overall growth is likely to be weak. F5's roughly 20,000 customers provide a large cross-sell opportunity though.  F5's revenue multiple is now back near the highs of the past decade and its PE ratio is sitting at around 25. There is probably not much room for further multiple expansion without a meaningful growth acceleration though, which appears unlikely. Given F5's modest growth expectations, this probably means that future returns will be low. Figure 8: F5 Networks EV/S Ratio (source: Seeking Alpha)","kind":null,"is_publish_news":true,"is_publish_highlight":false,"is_publish_live":false,"is_publish_wemedia":null,"editions":null,"column":"","sentiment":"0","news_tag":"analysis","news_rank":0,"symbols":[],"gpt_button":1},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.29.1","shortVersion":"4.29.1","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2479521341"}