F5 Networks (FFIV +1.00%) posted better-than-expected fiscal 2021 first-quarter results last Tuesday, partly thanks to the accelerating trend toward the digitization of enterprises. More surprisingly, the application delivery specialist's legacy hardware business benefited from an unexpected boost that should continue beyond the short term.
From hardware to software
Over the last many years, F5 Networks has been selling application delivery controllers (load balancers). Those devices filter and distribute incoming data traffic across the servers that host an organization's applications to optimize performance. But those hardware appliances have become less relevant as enterprises have moved some of their applications and computing infrastructures to the cloud.
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So F5 Networks has been updating its portfolio to offset the decline of its hardware business. It developed cloud-based load balancing capabilities, and it bolstered its offerings via acquisitions.
Early in 2019, F5 Networks bought NGINX to modernize its application load-balancing capabilities with cloud-native solutions. Late that year, it tacked on the cloud cybersecurity specialist Shape Security, which allowed it to integrate features such as fraud detection. And this month, it announced it was spending $500 million to acquire Volterra with the goal of building a simple solution for customers to develop, deploy, and secure applications across multiple clouds, including edge locations (closer to users).
Through this strategy, F5's transformation into a software-based business is occurring. During its fiscal first quarter, which ended on Dec. 31, total revenue increased 10% year over year to $626 million, as revenue from software jumped by 70% to $111 million. Excluding the extra contribution from Shape Security, year-over-year organic revenue growth (without acquisitions) from software remained strong at 35%.
As a result, revenues from software increased to 18% of total revenues, up from 11% in the prior-year quarter. Services still represented the company's largest segment with $333 million of revenue. But its piece of the total pie shrank from 59% a year ago to 53%.
Hybrid clouds to boost hardware
That software revenue growth was in line with management's forecasts. During F5's analyst and investor meeting last year, management highlighted its goal of growing software revenue at a compound annual rate of 35% to 40% over the next couple of years.
By contrast, the company's systems segment, which includes legacy hardware load balancers, exceeded expectations. Sales grew 5% year over year to $179 million during a period when management had anticipated a secular revenue decline in the mid- to high-single-digit percentage range.
Interestingly, that outperformance wasn't the result of short-term extra spending by enterprises looking to modernize their outdated on-premises infrastructure. Instead, during the earnings call, CEO Francois Locoh-Donou highlighted that enterprises had prioritized hybrid clouds to remain flexible and support a mix of on-premises and cloud applications.
Hybrid clouds should remain a relevant choice for enterprises, which bodes well for F5's legacy hardware on-premises business beyond the short term. As an illustration, Microsoft posted outstanding quarterly results this week, partly thanks to "healthy demand for our hybrid and cloud offerings." And International Business Machines has been pivoting to hybrid clouds over the last several years in an attempt to capture growth opportunities.
A reasonable valuation
Despite the unexpected boost from the company's systems segment, management didn't update its fiscal 2022 outlook (Horizon 2), which seems disappointing. But during the earnings call, Locoh-Donou admitted that "there is the possibility that our hardware business will do better in Horizon 2."
So management kept a conservative outlook, which is certainly reasonable given the global uncertainties engendered by the coronavirus pandemic.
In any case, this tech stock is trading at a forward price-to-earnings ratio of 17, which seems fair considering its anticipated revenue CAGR of 6% to 7% over the next couple of years.
Given the company's conservative guidance, investors looking for exposure to the hybrid cloud market should keep F5 Networks on their watch lists and consider buying the stock on the dips.
