Focus on secular growth: Despite the Europe crisis, this tech stock has legs

Have you ever had those recurring dreams where you go to sleep and you can just feel that your mind is going to show you the same images again? The world is stuck in the euroTwilightZone, constantly replaying the cycle of relief/elation/anxiety/reality check in regards to every European country. When you have a major economy like Portugal asking an oil-rich but still developing Angola for money, you know something is out of whack.

Last week France lost its vaunted AAA credit rating from S&P, the same geniuses who awarded the same rating to cdos-cubed backed by houses with negative equity. Here’s one line from their rationale for the downgrade:

“This reflects our view that the effectiveness, stability, and predictability of European policymaking and political institutions have not been as strong as we believe are called for by the severity of a broadening and deepening financial crisis in the eurozone.”

Oh really? Something has changed now? These developed western economies along with the peripheral nations like Slovenia haven’t been carrying debt loads greater than 100% of central government revenue for years? Shocked to realize there’s gambling going on here?

But of course we don’t expect anything different. The NSRO laws that allow the ratings agencies to maintain an oligopoly were put in place in 1975 in response to banks wanting lower capital requirements; the answer of the SEC was to let them make increasingly risky loans as long as they got someone (i.e. Fitch, S&P, Moody’s) to stamp that these loans were Triple A-OK. The same attitude, where the carrying of debt is more important than the size of the debt, is evident in the Eurozone’s attitude towards Greece. Instead of forcing almost total write-downs they are attempting to browbeat private investors to accept 50 cents on the dollar. Greece, a country that is totally shut out of international borrowing markets, and has $14B of debt coming due in March, is looking to fix the problem by getting its creditors to extend it more credit at a lower rate, around 4%. That’s what a good corporate credit can expect to fetch in the unsecured market, not a totally bankrupt sovereign. Dream on.

And this is why the French downgrade business matters so much. They, along with Germany, are the dream enablers, propping up a now-downgraded EFSF rescue fund that is supposed to act as a backstop to all this new paper. And because they are talking about terminal realties, where the larger economies step in to bail-out the smaller ones, I’d say they have enough firepower in the interim to keep funding Greece’s credit card bill (and by extension Italy, Spain and Portugal).

The timeline is so utterly compressed that any agreements have to be finished by the 1st week in February, so that they may be debated by at upcoming eurocrat conventions. No wonder plenty of smart hedge fund managers are betting that Germany pays Greece’s bills in March rather than face down doomsday. The markets have been relatively patient, with funding costs dropping for PIS (Portugal, Italy, Spain, like the acronym?) but there are serious signs the party will be over sooner than they think.

As I noted last Friday on, investors are becoming more concerned withreturn-of capital than return-on capital. With currencies and bond yield whipping around so violently, it is not clear that the stock market has discounted actual resolution/serious of this mess. Which is what we really care about.

So we’re here to talk about our newly added long to the Revolution Portfolio, F5 Networks. While you absolutely cannot ignore macro happenings it’s the long-term secular trends where you make the most money. And the emergence of the cloud as an underpinning technology for the next couple decades of growth is one of the biggest investing opportunities.

There’s always something going on in the broader markets that guide equity prices, your job as an investor is to find stocks whose story is being ignored because of market gyrations. I’ve been studying and watching F5 for the last 7 years — that’s a handful of bear and bull markets, about dozen financial crises and a potential apocalypse. Through all of that F5’s story has remained strong, only getting better as the company matured. In 2004 I wrote in my newsletter for :

“One company that Juniper’s not taking share from is F5 Networks (FFIV), which I suspect is having yet another gangbuster quarter. In fact, I want to put more of the model portfolio’s cash into this stock. I expect the company to beat estimates and raise guidance for its next quarter. I also am hearing chatter that there are larger fish looking to swallow this one up. They better hurry or F5 will move up the food chain quickly enough to become an acquirer itself.”

At that time F5 was a fourth the size it is today. In 2006 for the Financial Times , I said:

“F5 has managed its business, its strategies and even its finances very smartly since I first bought this stock in 2003. The company has more than $250m in cash on the balance sheet with no debt, and has been growing at more than 50 per cent a year on the top line for the last three years.

“Analysts’ earnings estimates have been ridiculously out of touch with reality. In 2004 the consensus sell-side estimate was $1.16 a share for 2006. Eighteen months later the consensus for this fiscal year (which is still much too low) is $2.04. With $7 a share in net cash and the ability to earn close to $3 next fiscal year (that’s my estimate, the sell-siders have it at about $2.40 right now), I’m buying F5 at about 20 times enterprise value to forward earnings.”

None of this is to tout my past recommendation prowess (which, as all Wall Street brokers are required to tell you, do not predict future results) but to make two points. The first is that this stuff, namely digging into financial realities, talking to management, analyzing balance sheets, is more than a short-term insider game of expectations; there are really underlying businesses here and we are looking to buy a stake in their very long-term prospects. Secondly, and more saliently to this case, F5 has been riding the cloud wave for a seriously long time and is positioned to keep doing so.

On a shareholder call in November, F5’s SVP of business development Dan Matte talked about a part of the business that is really starting to get traction, the virtualization and software side. F5’s hardware has been the driver of the growth for the last decade, and now that these systems are in place, they can start selling add-on higher-margin services. IT departments are loathe to just replace a system, even a bad one, because they have to justify expenditures to executives who tend to see red when confronted with huge costs and any delays in business continuity. F5 is so tightly interwoven into some of the biggest video delivery platforms in the world, making the switching cost enormous. Instead I’m looking for them to keep selling into a recurring revenue pipeline, increasing their offerings, and margin expansion. I’m particularly excited about their push into security, where they can profit from companies that want to keep embarrassing headline risk to a minimum.

It’s always good to be skeptical of a managements claiming that they can shoot for the moon and do everything new while losing nothing old. But looking at F5’s balance sheet I feel pretty comfortable with pulling the trigger. The stock trades at a little better than 7x sales, which is not outrageous for a company growing revenues 27% a quarter. F5 has no net debt, half-a-billion of cash on hand, and will throw off nearly that much in free-cash-flow this year. And while the stock may be up huge since I first recommended it, it’s down about 25% in the last year, providing us with a nice entry point.

Editor’s note: Keep up with all of Cody’s picks online. Bookmark this link to the Revolution Investing portfolio: