F5 Networks To Buy Edge-As-A-Service Specialist Volterra

F5 Networks is buying startup Volterra for about $500 million for its distributed cloud services expertise. The deal will strengthen F5’s leadership position in enterprise application security and delivery, according to the company.

Application delivery specialist F5 Networks revealed its plans to acquire Volterra, a four-year old startup with an edge-as-a-service platform, for about $500 million.

The definitive agreement, announced Thursday afternoon, will involve F5 acquiring all issued and outstanding shares of privately held Volterra for approximately $440 million in cash and approximately $60 million in deferred consideration and assumed unvested incentive compensation to founders and employees, according to the two companies.

The deal will strengthen F5’s leadership position in enterprise application security and delivery. Together with the Volterra platform, F5 will be building a secure, app-driven edge platform -- Edge 2.0 -- with “unlimited scale” for enterprises and service providers, F5 said in a statement.

[Related: F5 Networks’ NGINX Portfolio Won’t Slow Down ‘Modern’ App Developers]

“Current edge solutions are simply inadequate for today’s enterprise customers. It’s time to break out of closed edge systems that only perpetuate the pain of building, running, and securing apps,” said François Locoh-Donou, president and CEO of F5 in a statement. “With Volterra, we advance our Adaptive Applications vision with an Edge 2.0 platform that solves the complex multi-cloud reality enterprise customers confront.”

Founded in Santa Clara, Calif., Volterra owns a platform that lets enterprises build, deploy, secure and operate applications and data in a uniform fashion across all public and private clouds and edge compute environments.

“The need to deliver rich digital experiences has meant that more and more of our customers are asking for expanded security and reliability features that are seamlessly integrated across their clouds and edge deployments,” Ankur Singla, Volterra‘s founder and CEO said in a blog post on the announcement. “As part of F5, we will have access to industry-leading app security capabilities to augment our unique SaaS-based networking, security and app management platform. We also get immediate access to a top-tier go-to-market team that has the deep industry experience in the app delivery and security market.”

Prior to starting Volterra, Singla founded and let software-defined networking company Contrail, which was purchased by Juniper in 2012 for $176 million.

As a result of the deal, F5 is expanding its total revenue growth expectations for its fiscal years 2021 and 2022. F5 is also repeating its commitment to $1 billion in share repurchases in the next two years, including a $500 million accelerated share repurchase in fiscal year 2021.

F5 (FFIV) Up 10.2% Since Last Earnings Report: Can It Continue?

F5: Hardware Headwinds Hitting

piranka

Despite the stock performing well over the past five months, F5, Inc.'s (NASDAQ:FFIV) returns in 2023 are still only in line with broader indices. This is counter to my expectation of poor performance due to:

While system sales are expected to drop sharply going forward and F5's new businesses have so far demonstrated limited traction, margins have rebounded sharply due to F5's focus on expenses. This, along with a modest valuation, has helped F5's stock perform strongly in the second half of 2023.

F5 stated on its fourth quarter earnings call that the demand environment has shown signs of stabilization, particularly amongst enterprise customers. F5's hardware orders reportedly rebounded in the fourth quarter, supporting this view. In terms of verticals, technology and financial services customers were areas of strength, offset by service provider weakness. Service providers are delaying asset purchases and prioritizing spending.

F5 expects continued growth in FY2024, driven by automation and generative AI. F5 also believes that customers will be forced to begin investing in application infrastructure again. Given the boom in hardware spending over the past three years it is not obvious that this will be the case though. Some customers have obviously delayed purchases due to financial pressure, but I would be surprised if this represents a majority, or even a significant minority of customers.

Figure 1: Job Openings Mentioning F5 in the Job Requirements (source: Revealera.com)

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. F5 is still in the process of integrating these solutions into a converged solution though.

This is change that has been necessitated by the growing importance of the cloud and edge computing, which has changed how applications are developed and deployed. While F5 has positioned itself to remain relevant, there is a large amount of uncertainty regarding what extent acquisitions will offset structural headwinds to F5's legacy business.

F5's Distributed Cloud Services offering now has over 500 customers, more than a 200% increase YoY. Penetration has predominantly been within F5's existing customer base so far though, with only 29% of Distributed Cloud customers new to F5. WAF and multi-cloud networking are F5's first two distributed cloud solutions. CDN capabilities were also recently added through the acquisitions of Lilac, and F5 has a backlog of other services it wants to add to the platform.

F5 is seeing continued adoption of NGINX amongst larger enterprises for their cloud and Kubernetes workloads. Customers are also leveraging NGINX for app layer security for containers. NGINX serves modern, container-native and microservices-based applications and APIs.

Figure 2: Job Openings Mentioning NGINX in the Job Requirements (source: Revealera.com)

While F5's ADC business will continue to face headwinds, the company continues to invest in it, and as a result, expects to take a share in both hardware and software form factors. F5 aims to provide on-prem deployments with the benefits of the cloud (multi-tenancy, rapid upgrades, etc.) while lowering total cost of ownership. F5's rSeries and VELOS platforms represented more than 80% of Q4 systems bookings. rSeries is designed on a new microservices-based platform layer and an API-first architecture. It supports BIG-IP app delivery and security services and aims to lower costs through consolidation. VELOS is a next-generation chassis system that aims to provide performance and scalability in a single ADC. Customers can scale capacity by adding modular blades in a chassis, without disrupting users or applications.

Security is an important part of F5's business, contributing approximately 1.1 billion USD revenue in FY2023. F5 was disappointed with the performance of its most advanced anti-bot and anti-fraud managed service solutions this year, which it attributed to customer spending caution and budget scrutiny. F5 has reportedly seen good traction with its lower-end Distributed Cloud anti-bot offering though, as well as from security on NGINX.

Like most edge computing companies, F5 is counting on AI inference workloads to provide a tailwind. Organizations will need to support inference across datacenters, public clouds and the network edge, which F5 believes it is positioned to support. While inference could begin to create incremental demand in 2024, I think it is still too early for this to be material for companies like F5.

F5 also expects the use of AI to accelerate growth in the number of applications and APIs, which would naturally be a tailwind for F5's business. The number of applications is likely to be limited by demand rather than supply though. Applications require users and organizations must acquire these users, the real bottleneck to growth in most cases.

F5's fourth quarter revenue was 707 million USD, a 1% increase YoY, with 54% of revenue coming from services and 46% from product. Services revenue grew 9% on the back of high maintenance renewals and price increases. Service revenue is likely to moderate going forward as F5 laps price increases and spending on upgrades versus maintenance normalizes. Product revenue increased 7% YoY, with systems revenue down 25% due to lower backlog related shipments.

Figure 3: F5 Revenue (source: Created by author using data from F5 Networks)

Backlog has now returned to normal levels, which will present roughly a 180 million USD revenue headwind in FY2024.

Figure 4: F5 Product Backlog (source: F5 Networks)

BIG-IP and NGINX term subscriptions were up 9% in FY23. SaaS (includes Distributed Cloud) and managed services only increased 2% though. F5 has stated that it is seeing solid momentum from its Distributed Cloud business, but this isn't apparent in public data. Some of this is 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 USD ARR in total, half of which is from offerings that F5 is retiring completely. The process is expected to be completed over the next year. F5's perpetual license software revenue was also down in FY2023, although the company attributed this to an unusually strong prior year.

Figure 5: F5 Product Revenue (source: Created by author using data from F5 Networks)

F5 expects customer caution to continue in FY2024 but also believes that customers will need to begin replacing assets again in the next year. Software is expected to provide flat to modest revenue growth due to headwinds from the transition of SaaS and managed service offerings. Global services revenue is expected to return to low-single-digit growth as F5 laps price increases. As a result, FY2024 revenue is expected to be flat to down low-single-digits YoY. F5 expects to return to mid-single-digit revenue growth in FY2025 though.

Table 1: F5 Revenue Guidance (source: Created by author using data from F5 Networks)

While F5 has suggested that supply chain issues have largely resolved and delivery times normalized, F5's product margins remain depressed. How much if this is due to revenue mix, versus declining system or software margins is unclear though. This is an important trend to watch as F5 needs to maintain high gross profit margins to support investment in its security and distributed cloud businesses.

Figure 6: F5 Gross Profit Margins (source: Created by author using data from F5 Networks)

While gross profit margins remain under pressure, F5's operating profit margins have rebounded sharply in recent quarters, with much of the change driven by improved sales and marketing efficiency.

F5 has been focused on reducing its operating expenses, but given the company's ambitions, it still needs to invest in product development and customer acquisition. How these dynamics play out in coming quarters will have a large impact on F5's share price going forward.

Figure 7: F5 Operating Profit Margin (source: Createed by author using data from F5 Networks)

Figure 8: F5 Operating Expenses (source: Created by author using data from F5 Networks)

Despite the stock moving around 20% higher over the past two months, F5 still appears reasonably valued, with the company's EV/S multiple towards the lower end of its historical range. Investors need to weigh its valuation against uncertain growth prospects and the potential for margin compression as the company invests in growth initiatives. The fact that software revenue has been fairly flat over the past 15 months and is expected to remain fairly flat over the next 12 months is hardly comforting. The recent drop in sales and marketing expenses also isn't suggestive of a company capitalizing on a large growth opportunity. 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 F5's distributed cloud business struggles, the stock could still prove expensive at current levels.

Figure 9: F5 EV/S Multiple (source: Seeking Alpha)