Buy VMware and F5 Networks
You'd never believe it from the headlines you read every day -- Europe is imploding, China is losing steam, the U.S.'s growth is slowing to a crawl -- but markets are nearly back to their 52-week highs. If the S&P 500 were to rally just a few percent, we'd be at levels not seen since late 2007, before the financial panic took full effect.
However, one of the interesting aspects of the past few months is that while markets fell throughout May and have rebounded since, investors seem to be latching onto a specific kind of stock: Big, safe, dividend-paying stocks like AT&T and Verizon have been on a rally all year. However, growth stocks were sold off in heavy fashion.
To me, this shows the continuing cautious nature of markets. People can only get about 1.5% from a 10-year treasury, so a dividend-paying stock yielding 4%-plus looks like quite the bargain. Investors are willing to buy "safety" and yield and have shifted away from the highfliers of yesterday in the process.
I'm going to take advantage of the situation today to buy a small stake in both VMware (NYS: VMW) and F5 Networks (NAS: FFIV) . I think they're both leaders who have what it takes to see impressive growth rates in the years ahead despite some economic headwinds, and while they've both seen pops recently, they're still far from their 52-week highs.
What are F5 and VMware?
If you're only vaguely familiar with VMware and F5 Networks, they're both leaders in the data center field. VMware has an iron grip on virtualization, the essential technology which can allow hardware to be split up into separate virtual environments. A simple example of the technology is creating several virtual environments running different operating systems and applications on the same server. The end effect is that data centers are significantly more utilized, and administrative tasks across a data center can be simply managed from a piece of software.
In F5's case, server efficiency once again plays a big part in the company's success. The company's core product is called an "application delivery controller," or ADC, which performs a function known as "load balancing." The gist of load balancing is that it offloads functions from servers and distributes traffic evenly among them. That quick description of load balancing belies the complexity at play in F5's products, and the field continues pushing into advanced areas like security. The fact that the company has managed to create a huge market share lead over rival Cisco (NAS: CSCO) shows how difficult it is to create a suite of products that rivals F5's flagship BIG-IP line.
Why they'll continue to succeed
Let's save delving into the inner workings of VMware and F5 for future articles. For now, let's consider the opportunity ahead and how past performance has proven the company's advantages.
F5 as a leader
According to researcher Gartner, in the fourth quarter of 2011, F5 controlled 45.7% of the ADC market and continues to take share from competitors. Cisco led market share as recently as 2005 but has now slid back to third place with just 10.9%. F5's largest competitor is now actually Citrix, which not only has the second-largest market share of 17%, but can better go toe-to-toe with F5 in the "advanced" segments of ADC.
The end result of all this progress has been F5's spectacular 22% compounded revenue growth rate over the past five years. Earnings grew by an even better pace of 27% compounded. This growth rate will be hard to repeat in the next five years, but if the company continues growing above ADC market rates, dominating the high end, expanding into adjacent networking areas, and building its services business, F5 has the ingredients to see heady growth over the next five years.
Right now F5 is trading at a P/E of 30, which is pretty pricey. However, thanks to the company's continued growth in services backlog that's yet to be recognized, it trades at about 18 times trailing cash flow. Taking these two numbers together and considering F5's potential, investors are getting a fair price for a great company right now.
VMware as a leader
VMware's greatness in the data center is more widely known that F5's. The company's installed base is estimated to be well more than double that of its fiercest competitor, Microsoft (NAS: MSFT) , despite Microsoft's recent gains. That lead is likely greater in the valuable enterprise space, as Microsoft has found traction in small and medium-sized businesses. On the lower end, the company faces competition not only Citrix, but also from an Open Virtualization Alliance that includes some pretty powerful members.
I've largely eschewed VMware in favor of buying EMC (NYS: EMC) , which owns about 80% of the company. I did so largely because I found I could maintain exposure to VMware while enjoying the much more favorable valuation of EMC. However, as VMware continues to grow its earnings while its share price remains flat, it gets quite a bit "cheaper."
Consider that the company collects not only licensing revenue for its software, but also maintenance and support sales. The "problem" is how long it takes to recognize these support contracts. VMware will collect payments today but recognize them over the life of a contract. As far as accounting goes, that's the right way to recognize the sales. However, it also puts GAAP earnings significantly below the cash flow the company continues taking in.
Also, as the IT environment stalls, this gives VMware a buffer against belt-tightening customers. Last quarter its licensing grew only 11%, but thanks to the recognition of continuing support sales signed when the IT environment was healthier, its support segment grew 34%.
In the end, VMware's revenue recognition leads the company to trade at about 56 times earnings but only 20 times free cash flow. Again, this isn't a cheap price by any means, but looking at the two numbers in combination shows that VMware isn't nearly as expensive as its P/E ratio might indicate.
Putting it all together
As with all stocks, there are plenty of risks to both VMware and F5. While they're both commonly cited as "cloud stocks," I actually think the cloud poses threats to both. They're both dominating the current IT environment, but further moves by companies to "public clouds" like Amazon's EC2 would endanger their profitability. In F5's case, the growth of "virtual appliances" threatens its current model and margin structure.
However, given their potential, I like the price I'm getting for each stock right now enough to take a small position in each. Both have seen recent gains off their lows, which you never like to see. However, at some point you either have to strike or risk missing a long-term winning opportunity through the constant inaction that is "waiting for a better price." Personally, I'll take a nibble of about $500 of each company, and if they see any retreats in coming weeks, I'll take the opportunity to buy a larger position.
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The article Buy VMware and F5 Networks originally appeared on Fool.com.Eric Bleeker owns shares of Cisco and EMC. The Motley Fool owns shares of Cisco Systems, Microsoft, and EMC. Motley Fool newsletter serviceshave recommended buying shares of F5 Networks, Microsoft, and VMware.Motley Fool newsletter servicesformerly recommended Microsoft.Motley Fool newsletter serviceshave recommended creating a bull call spread position in Microsoft. The Motley Fool has adisclosure policy.We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. Try any of our Foolish newsletter servicesfree for 30 days