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F5 Networks: A Puzzle for Value Investors

On the surface, this appears to be a great company at a great price

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Mar 13, 2018
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F5 Networks Inc. (

FFIV, Financial) makes the electrons in our computers run more rapidly, although most of its focus is on the world’s biggest companies, not those of us with our single computers or single smartphones. These big companies deal in big data and big computing networks, so when their computers (and assorted add-ons) run more quickly, the savings are correspondingly big.

For an investor’s perspective on the stock, I found it using what I call the Macpherson model, which was developed by Thomas Macpherson; it is a way of implementing

Warren Buffett (Trades, Portfolio)’s famous dictum to buy great companies at great prices. As described in the article “Defining Valuation: DCF and Other Tools Part 2," the model has four criteria that are plugged into the All-in-One Screener (all from the Fundamentals tab):

  • Debt-to-equity: set to 0 (i.e. no debt).
  • Return on assets (10 year): at least 15%.
  • Return on equity (10 year): at least 15%.
  • Return on capital (10 year): at least 15%.

After the screen has run, users see below the screener a list of stocks that meet these criteria. The companies that appear on this list are what Macpherson would consider (subject to further research) great companies. Notethe criteria above correspond with the first two columns on a stock’s home page; these are what they look like for F5:

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Each of the criteria reflects Macpherson’s emphasis on the three essential conditions for a great company:

  • A competitive moat (sustainable pricing power).
  • Financial strength.
  • Profitability.

But, finding a great company is only half the challenge. The other half is being able to buy the company at a great price. This does not mean cigar-butts or really cheap stocks. Instead, it means a company selling below its intrinsic value as defined by one or more discounted cash flow values.

Fortunately, the All-In-One Screener also provides DCF data, and the entire list can be sorted by three types of DCF: free cash flow, earnings or projected free cash flow. This is what the list looks like when sorted by DCF-free cash flow:

The first company with great characteristics and a DFC estimate, mixi Inc. (

TSE:2121, Financial), describes itself as “a Japanese company which provides social networking services.”

The second is the focus of interest in this article: F5 Networks. For those looking for bargains, F5 has the best DCF-free cash flow to price ratio:

  • DCF-free cash flow: F5 has a present or intrinsic value of $316.45, compared with the closing price of $147.48 on March 9. In other words, the current price is just 47% of the present value; or you could buy a dollar’s worth of F5 equity for 47 cents and have a 53% margin of safety.
  • DCF-earnings: F5's present intrinsic value is $184.47; the current price is just 80% of that. In this case, you can buy a dollar’s worth of equity for 80 cents and have a 20% margin of safety.
  • Projected free cash flow: Irrelevant in this case because F5 has had consistent revenue and earnings.

To confirm the company has consistent revenue and earnings, view this 10-year chart:

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Whether 47 cents on the dollar is a great price is in the eye of the beholder. How much margin of safety does each investor demand before clicking the order button?

Note, too, that while GuruFocus provides default values for each variable in the DCF calculator, each user should input different numbers to test the strength of a buy or sell case. Small differences in the variables can make a big difference in output values when the time range is 10 years. Create more bearish and more bullish scenarios to test assumptions and projections.

Let’s look at some specifics, starting with the 20% default rate in the DCF-earnings calculator: Is F5 likely to grow at the rate over the next 20 years?

  • First, 20% per year is a big challenge for any company. It is especially challenging to keep up for 10 years. Note from the dashboard, though, the company has bought back significant numbers of shares. Morningstar puts the buyback yield at 6.58% on average over the past five years, which if continued would take care of about one-third of that 20%.
  • Looking to past performance, GuruFocus reports F5 has grown its earnings per share without non-recurring items at an average of 23.60% over the past 10 years.

F5 Networks is owned by eight of the GuruFocus gurus:

Jim Simons (Trades, Portfolio), Joel Greenblatt (Trades, Portfolio), Ray Dalio (Trades, Portfolio), Pioneer Investments (Trades, Portfolio), Paul Tudor Jones (Trades, Portfolio), Ken Fisher (Trades, Portfolio) and David Dreman (Trades, Portfolio). During the last quarter of calendar 2017,  John Rogers (Trades, Portfolio) sold out, one guru reduced his holding and four others increased their stake.

But behind that positive scene there is troubling news. The percentage of iInstitutional ownership plunged from the mid- to high-90s to just under 61%, as shown in this chart:

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What's behind this sudden exit? Bert Hochfeld at SeekingAlpha says there are two issues:

  • F5 was one of the few information technology vendors that did not bring in higher prices in 2017.
  • This comes on top of failure to grow for several years, while a boost expected from a "product refresh" has not yet materialized.

Hochfeld adds efforts are underway to move into higher growth areas, but that may take some time. The following GuruFocus chart projects slowing earnings per share for 2019 and 2020:

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Conclusion

First, there is a lesson here, which is that we should not trust in 10-year averages alone; F5’s troubles are relatively recent, but still enough to question whether it is a great company and if the margin of safety is adequate, given the recent difficulties.

Given the flat forecast, it will be important to review management strength. Does this slow down reflect the leadership turmoil that began in 2015? Has the turmoil affected innovation?

Have the company’s capital allocation policies changed? Did it spend too much on share buybacks and not enough on research and development? The news suggests the company began its product refresh later than it should have.

On the other side, this is still a debt-free company with a broad array of patents and intellectual property and, of course, a robust stream of cash flow.

All of this asks us to decide whether recent missteps have created an opportunity for investors. Many value investors would argue the company is now available at a great price, but will it recover its ability to increasingly reward shareholders? Only due diligence will tell.

Disclosure: I do not own shares in any of the companies listed, and do not expect to buy any in the next 72 hours.

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