Hotchkis & Wiley’s focus is finding attractive long-term investments for our clients. F5, Inc. (Nasdaq: FFIV) exemplifies an investment that meets both our stringent value and risk criteria. At the current valuation, we believe F5 offers an uncommonly attractive investment opportunity due to its healthy growth potential, robust business quality, strong balance sheet, and responsible corporate governance.
F5 sells software products to corporate IT departments, which use the software to improve efficiency and ensure the security of mission-critical enterprise software applications. As an example, consider a large financial institution operating a mobile banking application. Millions of end users generate heavy, unpredictable traffic volume which can lead to congestion, downtime, and other performance challenges. To mitigate these issues, F5’s software is installed on the bank’s network and directs traffic from end users to available servers. While F5’s software is directing traffic, it also implements security protocols which keep sensitive bank account information safe against a myriad of application attacks.
Exhibit 1: F5 Business Overview
We first discovered F5 as part of a comprehensive research review of the enterprise IT industry. F5 stood out because it had characteristics of a higher-quality software company yet was typically classified as a lower-quality datacenter hardware company. We noticed that F5 has a sticky customer base that has integrated F5’s software deeply into its technical operations. We believe it is costly and time-consuming for these customers to substitute away from F5’s products, leading to low customer churn, high net revenue retention, and a high share of recurring revenue. While F5 does sell hardware appliances, the company’s high gross margins and low capital intensity were more representative of a software company than a commoditized IT hardware provider.
After multiple reviews with our technology sector team, it was determined that F5 deserved a better-than-average score on the three pillars of our risk ratings framework: quality, balance sheet, and governance. F5’s above-GDP growth outlook, high margin profile, and low capital intensity contributed to an above-average quality rating. Similarly, we determined that F5 deserved a better-than-average balance sheet rating due to its strong cash balance, low gross debt, and robust cash flows. Finally, we concluded that F5’s corporate governance risk rating was average due to a positive mix of shareholder return and reinvestment in growth, albeit an uncertain M&A strategy. While it’s not our base case, a large acquisition at an unfavorable valuation would meaningfully worsen our investment outcome.
While F5 has risk characteristics and a long-term, normal profit margin profile similar to other enterprise IT software firms, recent financial performance reflected temporary headwinds that obscured its long-term potential. Pandemic-related supply chain disruptions led to delays in converting order backlog to revenue. Additionally, material investments in both sales & marketing and research & development were obscuring the underlying profitability of F5’s core business—such investments reduce profitability metrics because they run through the income statement rather than being capitalized on the balance sheet. Finally, from an industry perspective, cyclical pressure on IT budgets led to delays in several large, transformational software deals for F5. Our deep industry research indicated that these factors, while material, were temporary rather than secular. While it is difficult to predict the near-term improvement of these factors, our long-term investing time horizon gives us the ability to be more patient than the average investor and look through these short-term issues.
Given the better-than-average scores in our risk-rating framework, we believed that F5’s valuation at 10x normal EPS was attractive relative to the 15x multiple of the MSCI World Index and 16x multiple of the S&P 500 Index. The market appeared to extrapolate current earnings headwinds indefinitely, valuing F5 as if it were a risky business that was in secular decline, rather than a company with a lower-than-average risk profile and the ability to grow EPS at a double-digit rate for many years.
Exhibit 2: F5 Margin and Valuation vs. Software and Hardware Peers
We believe the combination of F5’s attractive valuation and better-than-average risk ratings creates a margin of safety in the event F5’s financial performance underperforms our expectations. The company has numerous paths to success and a remote chance of permanent capital impairment, but we do acknowledge the risk of an unfavorable capital allocation outcome if management pursues an overvalued acquisition. Meanwhile, its low correlation with existing investments results in an effective complement to the rest of the portfolio. Accordingly, we believe an above average portfolio weight is warranted, and today we are one of F5’s largest shareholders.