F5, INC. quarterly report, Q2 FY2014

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F5, Inc. — Q2 FY2014 Form 10-Q

Reporting period: Fiscal second quarter and first six months ended March 31, 2014. Financial statement amounts below are in U.S. dollars; income and cash-flow figures are in millions unless noted.

Business context

F5 sells application delivery networking hardware, software and related services, including maintenance, consulting and training. Its offerings are delivered through direct and indirect channels, with enterprise and government customers across multiple industries. The company reports one operating segment.

Financial performance and position

  • Revenue: Q2 revenue was $420.0 million, up 19.9% year over year; product revenue was $225.1 million (+21.6%) and services revenue was $194.9 million (+18.0%). For the first six months, revenue was $826.5 million, up 15.5%.
  • Profit: Q2 gross profit was $344.4 million; operating income was $110.9 million; and net income was $69.6 million, compared with $63.4 million a year earlier. Diluted EPS was $0.91 versus $0.80. Six-month net income was $137.7 million versus $132.9 million; diluted EPS was $1.79 versus $1.68.
  • Margins: Q2 gross margin was 82.0% versus 82.8% in the prior-year quarter; operating margin was 26.4% in both periods; net margin was 16.6% versus 18.1%. Six-month gross margin was 82.0% versus 83.1%, and operating margin was 26.6% versus 28.2%.
  • Cash flow: First-half operating cash flow was $240.9 million versus $225.5 million a year earlier. Investing activities provided $140.8 million, largely reflecting investment maturities and sales; financing activities used $331.3 million, primarily for share repurchases. Cash and cash equivalents increased to $239.8 million from $189.7 million at September 30, 2013.
  • Liquidity and debt: Cash, short-term investments and long-term investments totaled $1.165 billion at March 31, down from $1.271 billion at September 30, 2013. Management reported no long-term debt. Current assets were $950.4 million and current liabilities were $597.8 million.
  • Other indicators: Deferred revenue, current and long-term, totaled $587.7 million, up from $531.4 million at September 30, 2013. Q2 days sales outstanding was 48. Stock-based compensation was $70.2 million for the first half, versus $54.3 million.

Changes versus prior comparable periods

  • Revenue growth reflected higher demand for core application delivery networking products and a larger installed base driving maintenance purchases and renewals. ADN products accounted for 98.4% of product revenue in Q2; ARX product sales declined.
  • Operating expenses rose 18.3% in Q2 to $233.5 million. Research and development increased 28.0%, primarily from higher personnel costs and headcount; sales and marketing increased 17.8%, primarily from commissions and personnel costs. General and administrative expense was broadly unchanged.
  • Q2 net income grew more slowly than revenue, while net margin declined. The effective tax rate rose to 37.2% from 33.0%, primarily because the federal research credit expired at December 31, 2013 and the prior-year period included a retroactive tax benefit.
  • Other income, net fell to $0.02 million in Q2 from $2.1 million, primarily due to foreign-currency losses. For the six-month period, other income was also lower, reflecting foreign-currency losses and a $1.0 million legal-settlement charge in Q1.
  • First-half cash and investments declined by $106.2 million, mainly due to $350.0 million of share repurchases, partially offset by operating cash generation.

Outlook, commentary and risks

  • Management said existing cash and investments, together with operating cash generation, should meet operating requirements for at least the next 12 months. It identified operating income as the expected primary driver of future cash flow and said it may pursue strategic acquisitions or investments.
  • No specific revenue or earnings guidance is provided in the filing text. Management expects international sales to remain a significant part of revenue and R&D expense to remain consistent as a percentage of revenue in the foreseeable future.
  • The board authorized an additional $500 million for the repurchase program in January 2014. By May 5, 2014, the company had repurchased and retired 15.5 million shares at an average $77.00 per share, with approximately $604.5 million remaining under the programs.
  • Key risks include reliance on a small number of distributors (three accounted for 44.7% of first-half revenue), use of a single contract manufacturer for ADN products, component-supply constraints, unpredictable and quarter-end-concentrated sales, competition and product-transition risks, international exposure, and software or hardware defects and security vulnerabilities.
  • The company reported no pending legal proceeding that it believed was reasonably possible to have a material adverse effect, while noting ordinary-course claims and inherent uncertainty. It completed its March 2014 goodwill qualitative assessment and concluded impairment was not more likely than not; no impairment indicators were noted. A $6.1 million goodwill correction related to deferred tax assets from a 2007 acquisition was described as immaterial, with no other financial statement amounts affected.
  • Unrecognized tax benefits were $6.6 million; management did not expect changes over the next 12 months to be material. The investment portfolio was investment grade or better; management identified interest-rate and credit risks but said there had been no material change in market-risk disclosures.

Important facts for investors to verify

  • Whether the revenue growth and maintenance-renewal trends continue, particularly given the company’s dependence on ADN products and concentrated distributor channel.
  • Whether operating costs, stock-based compensation and the higher effective tax rate constrain earnings growth and margins.
  • The pace and pricing of further repurchases, and the effect of buybacks on liquidity and diluted share count.
  • Exposure to its single primary hardware contract manufacturer, component suppliers and quarter-end shipment timing.
  • Investment portfolio valuation and interest-rate sensitivity, as well as developments in tax audits, legal claims and other contingencies.