F5's Continued Focus on Software and Security Growth Beneficial to Navigating Supply Chain Headwinds

Analyst

Malik Ahmed Khan

Associate Equity Analyst

Jack Keegan

F5 is a leader in application delivery controllers, or ADCs, sells to enterprises, service providers, and government entities. F5 has long been the market share leader for hardware-delivered ADCs, but due to a change in consumption preferences, successfully pivoted to a software-focused business model. We think the company is well positioned to remain the share leader in hardware ADCs while competing in the higher growth software market and grow along with SaaS, application, and edge security over the next decade.

In our view, F5 was initially slow to the software-based ADC environment allowing for new entrants like Amazon AWS to reduce F5’s total ADC market share. Due to successful acquisitions in the software and application security space, F5 is positioned to grow its business through software while it remains the market share leader in legacy hardware products. At this point, software sales are the majority of F5’s product revenue with that figure increasing. We view this as beneficial as F5 is successfully capturing recurring revenue that is inherent to software business strategies.

F5 has over 90% of its engineers focused on developing software, SaaS, and managed services. IT teams may rely on the large public cloud vendors for traffic management within their respective clouds, but F5 helps control the traffic between on-premises, private, and public clouds and has enterprise rich features. In our view, F5 will achieve high rates of customer retention within cloud ecosystems due to product familiarity, customization features, application and network level management, security-focus, and an active developer community. In turn, we believe F5 benefits from intangible assets and high customer switching costs, which leads us to assign the company with a narrow moat rating.

Business Strategy & Outlook

We assign F5 a narrow economic moat rating based on strong customer switching costs and intangible assets. F5’s switching costs stem from the critical nature of its ADC offerings that safeguard application deployment, security, and optimize network traffic flow. We also view intangible assets as a secondary moat source, exemplified by F5’s strong reputation developed from long-term product design expertise and innovation that allow for pricing premiums. With strong recurring revenue metrics coupled with sticky products and software growth, we anticipate F5’s competitive advantages will allow it to produce excess economic returns over the next 10 years.

F5’s building blocks begin in the late 1990s with load-balancing products that were critical for managing server workloads by optimizing response time and avoiding overloading compute nodes within data centers. F5 then developed more advanced application delivery controllers, or ADCs, that performed load-balancing duties coupled with critical network optimization and security for enterprises. Since F5’s initial ADC offering, its products have expanded into a complex family of software and hardware solutions including, but not limited to, web application firewalls, or WAFs, global and local traffic management, analytics, and secure web gateways.

We believe that F5 benefits from high customer switching costs most prominently in enterprises and government entities, as any network downtime or security risk associated with switching from one vendor to another could cause significant disruption risk. The two verticals combined for about 86% of F5’s total bookings in fiscal 2021. 

We believe F5’s products are inherently sticky in both hardware and software. Hardware requires installation, training, is time consuming, costly to remove, and can cause operating interruptions when replaced. Software products have contracts, require training, and updates are provided throughout the lifecycle. We think F5’s product stickiness is exemplified by recurring revenue trending up to the low-70% area and subscriptions accounting for around 80% of its total software revenue. IT teams are increasingly focused on using more applications and software through public clouds and software-as-a-service, or SaaS, vendors. This has resulted in less ADC hardware revenue due to less network traffic and application management occurring on-premises. To adapt and grow with the transition, F5 has over 90% of its engineers focused on developing software products, SaaS offerings, and managed services. Overall, we view this shift from hardware to software as a net neutral for customer switching costs on its own and a positive when considering bundled offerings that further entrench customers into the F5 ecosystem.

F5’s services segment also lends itself to a switching costs moat source due to the complex nature of ADCs that require upfront training and allow for upgrades, customization, and new iterations throughout the lifecycle. This prevents F5’s products from getting stale and having to be frequently replaced. Services have long generated over 50% of F5’s total revenue, although that figure is trending down as software currently results in less services revenue.

Additionally, F5 has developed its intangible assets moat source through its strong reputation among IT professionals. We believe its products are considered best in class, innovative, and reliable, all of which makes F5 a top choice for an essential part of modern businesses. Although intangible assets are a secondary moat source, we think the company’s reliable reputation is critical as risk aversion plays a factor in application delivery controller purchasing decisions. F5’s steady track record allows it to win new business and, thus, benefit in later years by being entrenched with sticky customers. Pricing power is inherent to products that are vital to keeping a business running smoothly, which in turn makes production downtime risk aversion a key purchasing factor.

F5’s sticky products coupled with its strong reputation allow for recurring revenue and pricing power that should lead to higher margins and returns on invested capital. Competition will remain strong and will likely increase with larger players entering the market. Presently, Amazon AWS is the slight overall ADC market share leader helped by its strong AWS brand and capitalizing on recognizing the shift to cloud environments. Competition remains stiff in the software ADC field with the like of Microsoft and Alibaba entering the fold. However, these newer entrants do not offer enterprise-class products like F5 and in the cases of Amazon and Microsoft, only offer products that can be used within a specific cloud infrastructure.

F5 is infrastructure agnostic, enabling deployment across different environments. As F5’s market share has been chipped away, it has focused on increasing its total addressable market. This has resulted in SaaS and edge application security acquisitions. We think that F5 will increase its share in a declining hardware market and remain the second largest overall provider, necessitating its increased focus to more pure security offerings. Recurring revenue from subscriptions should help buoy F5’s margins and increase the stickiness of its products. The networking traffic environment will continue to develop, but we now view F5 as well positioned to adapt and succeed in a changing environment. As such, we believe in F5’s ability to generate excess returns above its cost of capital over the next 10 years.

Narrow

Economic Moat

F5 Networks

F5, Inc. engages development and provision of software defined application services. It offers the development, marketing and sale of application delivery networking products that optimize the security, performance, and availability of network applications, servers, and storage systems. The company was founded on February 26, 1996, and is headquartered in Seattle, WA.

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F5, Inc. is a multi-cloud application service, which engages in the development, marketing, and sale of application security and delivery solutions which enable its customers to develop, deploy, operate, secure, and govern applications in any architecture, from on-premises to the public cloud. Its products include F5 Distributed Cloud Services, F5 NGINX, F5 BIG-IP, and F5 Systems. The company was founded on February 26, 1996, and is headquartered in Seattle, WA.

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