F5, Inc. (FFIV) Earnings Call Transcript & Summary

Good afternoon, everyone. I'm Samik Chatterjee. I cover some of the IT hardware and networking equipment names at JPMorgan. For the post-lunch session, we're starting off with F5 networks. We have the privilege of hosting François Locoh-Donou, the CEO of F5 Networks, for the next 35 minutes or so. What I'll do at this stage is before I get started with the questions, I'll just remind everyone on the line that they do have the option of sending in questions through the Q&A feature. And I will ask it on your behalf in this format.

So let's get started. François, thanks for coming to the conference. Thanks for participating rather at this virtual conference. Maybe just kind of the big topic of the day. We did expect going into the latest earnings release that you would have some modest benefit from the COVID-19-led disruption and the work-from-home trends that you're seeing. But clearly, you have more insights into that. So if you can share what are you seeing relative to customer activity and engagement for your products as a consequence of the work-from-home trends or the disruption from COVID-19?

Samik, thank you for having me. So as far as the -- our second fiscal quarter that ended in March, I think what we saw was net neutral. The impact of COVID-19 to F5 was net neutral because we had -- on the one hand, we had a bit of acceleration for -- from our -- the part of our portfolio that's work from home, specifically around VPN access. But at the same time, we did see some orders pushed out because some customers reprioritized things like laptops and other things like that. So in that period of time, it was essentially net neutral. What we see going forward in terms of our customer spending priorities, I would say there are -- I can see 4 priorities, but they have a different horizon. So the first priority in the March to May time frame has been enable everybody to work from home. That was the most immediate, most urgent thing to do. Second after that is the realization that, "Hey, we're using our applications more and more. We have many more users coming on our digital applications, whether our employees or customers, so we need to increase the capacity of these applications." And so we're seeing spending in what I would call critical application infrastructure to support existing applications with a bigger usage essentially. The third -- and by the way, that one is happening right now, and I think will continue for several months. The third after that is a lot of customers realizing that, again, more digital channels, whether it's employees or customers or partners, that's creating new exposure and vulnerabilities for security. And so application security and securing these applications and securing these new digital experiences, we're seeing customers start prioritizing this because there is a lot at stake. And then we're also seeing, and that's the fourth and last priority, is customers wanting to automate more their creation of digital experiences because they realize they can't have a lot of people doing it necessarily on their premises. And so they're trying to -- getting out of the stitching manually all of these digital experiences together. I'd give you an example of a customer in APAC that had outsourced a lot of their application support and development, and they're in-sourcing that and automating that because their outsourced model did not work very well in the crisis. So I think we will see more and more of that, of customers moving to automation as part of the digital transformation initiatives. And in these areas, these 4 areas that I've just mentioned, we are not seeing a slowdown. We're seeing companies actually execute on that.

Thanks for that. Maybe if you can on -- I mean those are the strategic priorities as you kind of outlined. But even on top of that, there's this overarching concern that enterprise customers as they're looking at the macro environment and trying to navigate a very weak macro in the first half and particularly exiting the first half, they would start to pare back on their spending. And hence, kind of some of these strategic projects maybe get pushed out to some extent. So if you can layer on in terms of how you will outline the strategic projects and which direction they want to go? How that shapes up when you particularly kind of add to it the factor that some of them might be looking to pare back on kind of spending plans for the year? How do you see that kind of trajectory going forward?

I think, Samik, a lot of the -- I don't know if we are the best, I guess, forecasters on that or commentators because a lot of what large enterprises are focused on some of these critical projects, their application infrastructure project. We are part of that. And so when you see -- when you -- we all believe that there is a tightening or there will be a tightening of enterprise IT spending. Of course, if you're dealing with small businesses, you're seeing it right now, is the vast majority of your business is going to be the businesses that are directly impacted by the pandemic, specifically transportation, hospitality, of course, you're going to see it immediately. That is less than 10%. Those verticals are less than 10% of our verticals. So as I said on the April call, when we looked at what had happened for us between the beginning of March and the time of our earnings call, we haven't seen any impact of this tightening enterprise IT spending. I think as it tightens in the future, assuming that it will happen, I think what our -- I think what you will see is those companies that are at the heart of some of the priorities I've just articulated will probably see less of an impact than those companies that are perhaps more nice to have in the short-term in terms of technology spend.

Got it. Help me kind of -- this is 1 question that I see often from investors in terms of there is a rate of kind of 3% to 4% in terms of enterprise IT spending growth that we've seen over the long run and most investors are looking of it being kind of GDP plus/minus 1%. F5 as a company that's levered to application services growth, how should they think about kind of F5 as a way to outgrow that underlying enterprise IT spending growth? How should kind of -- where is application services growth longer term going to be? And how is F5 going to either be in line with that market or outperform that market? How should we think about that?

I think, Samik, today, I think there is still a number of investors that when they look at categories of enterprise IT spending, they categorize F5 as an ADC player and -- because of our history. I think it is time for investors to reconsider that because F5 has changed a lot over the last 3 years. And so if you look at today where we're at, there's so much change in the way that applications are built and deployed that we have invested through the acquisition of NGINX, through our own organic investment in things like API Gateway being embedded, API management, Ingress controllers being embedded in this microservices, these modern architectures. And so if you look at the traditional ADC market, outside of SaaS, it's very modest growth that is projected. But if you look at the growth of modern applications to which we now have an exposure -- a strong and growing exposure, then you're likely to see higher growth there. And our place in these environments is growing every single week. The other aspect of that is we have now also created very strong exposure for F5 in the space of application security, both with the organic investments and the acquisition of Shape, things like API security, anti-bot, anti-fraud, which is exploding. And so in this area, you're going to see also growth that will far outpace the growth of general enterprise IT spending.

So let me kind of then take it more in terms of what your recent performance has been and try to break down that software revenue growth that you've seen. Last few quarters, we've seen strong software revenue growth with decent tax ratio from 1 quarter to another. Just break down kind of what aspects of the -- what are the aspects driving that software revenue growth at this point? And as we look forward, what are the product launches, what is going to be a bigger driver as you look forward over the next 12 months?

If you look at the software growth today, Samik, it's been driven, I would say there are 3 factors. The first factor is that we have done a lot of work to make the F5 software, the BIG-IP software, that supports a lot of applications. We've made a lot of work to make that software easier to consume in private cloud and new kind of automated environment. So we've done that with making the software lighter weight, making it easier to deploy, making the software API first so it can be orchestrated and be part of these automated environment, doing all the integrations with public cloud providers so that, that software is really easy to consume in public clouds. And so that's kind of factor #1. Factor #2 is we have also made the software commercially easy to consume by doing all the work to enable not just perpetual licenses, but 3-year subscriptions, 1-year subscription for people to rent the software in public clouds by the hour on a utility basis. And so the number of commercial models that are now available just have unlocked a lot of latent demand that was there for the software. And then the third factor is we started to see the impact of NGINX now in the growth of our software in these modern application environments and starting to see F5 security being attached to NGINX environments. So I would say those 3 factors. The first 2 have started playing out several quarters ago and the third one more recently, but all 3 have contributed to the growth of our software. If you project to the future, they are growth catalysts that are ahead of us and have not yet played out. And so you're going to see continued growth in software related to security, both organic and now with Shape, where I think we're going to see a strong growth. You're going to see continued strong growth of our software in public clouds, both because of F5 Cloud Services and the partnership with AWS where we're getting even more exposure to public cloud deployments. And then you will see also with the new products we're building with NGINX, that's going to be another catalyst of growth in software. So we feel very good about software growth for F5 because we've seen all this growth today, but not all the catalysts have yet played out, and there's some things that are ahead of us that I think will start playing out in 2021 and beyond.

Got it. Let me touch on 2 and try to take a deep closer look at 2 of those things; one, NGINX, and secondly, the public cloud growth. Firstly, on NGINX, I think if we remember correctly, one, it was kind of a 6- to 9-month project on which we had embarked in terms of transforming NGINX with enterprise-grade controller so that you can start selling NGINX into your large enterprise customers as well. What are the early kind of -- what is the early feedback that you're getting from the large enterprises? What's the traction? And does this potentially then accelerate the NGINX growth from what you've been seeing over the past few quarters?

Yes, it does because that is one of the future catalysts I was talking about earlier. So we released the new NGINX controller at the end of January, and we've seen very good traction with it. That controller, essentially, if you think of the population of NGINX users, historically, they have been primarily very sophisticated DevOps users that can take the NGINX data planes and put all the LEGO blocks together to create a solution. That group of people is a minority, I would say, even within the DevOps community. And so with the controller, we're now able to give a much easier use of the technology for a much larger group of people. And so it does increase the addressable market for NGINX. It also increases the deal size for NGINX. And that controller is also a vehicle that allows us to bring more of F5 and Shape security capabilities into an NGINX solution. So that -- and for large enterprises, that allow them to have a single pit of glass for things like load balancing, but also API management, some security capabilities. And so it appeals to a broader set of buyers.

Got it. Moving to the second topic, kind of public cloud growth that you're seeing. I think even if I go back just a couple of years ago, kind of the basic ADC solution that the public clouds were offering was a big part of the bear case on F5 and F5's growth. Can you discuss what really has kind of -- I mean we've seen a big moderation in that bear case on the stock, and you kind of clearly executed very well to kind of address those concerns. So how has the public cloud growth strategy for F5 change? Where are you in terms of cloud-native products that you had launched? And what kind of traction you're seeing there?

I think, Samik, you're right about that bear case that I think was on F5 about public cloud. I think what we've been able to demonstrate over the last couple of years is that F5's value proposition is really tied to the applications that we support. And so if these applications move, F5 moves with it. And part of all the growth you've seen in software is people deploying more of applications in public cloud, but deploying F5 software with these applications. And so all of that's being executed with integration with public cloud providers, all the changes we've made to the software and increasingly the go-to-market relationships like what we're doing with AWS and combining our solutions together. We are now not -- however, having now NGINX as part of our portfolio, we now have also a cloud-native solution that is very light weight. That is -- and that fits extremely well in containerized microservices environment. And so the new applications that are being built in either on-prem or in public cloud, in these new modern microservices architecture, we now have a growing exposure to these modern applications and increasingly they're being built in public clouds, but we have a strong play there. And so I think that's what the NGINX acquisition has brought to us. And if you go beyond that, now because of our presence in the F5 traditional presence and the combination of NGINX, we are truly able to give a vision of the performance of applications across both on-prem and public cloud environments that essentially no other players are able to provide to our customers.

François, let me ask one of the questions that came in on the chat and kind of is a related topic. The question is, is Kubernetes containers, microservices more of an opportunity or a threat? And if an opportunity, how is F5 positioned and how to think about the benefit?

It's definitely an opportunity for us because the applications that F5 has supported today, I'm going to say, if you want to call them the more traditional applications, are not -- for the most part, are not being refactored into a Kubernetes environment. So those applications are going to continue their life and we're going to support their lives and their growth. The new environments like the Kubernetes type clusters are a big opportunity for us because of NGINX. NGINX fits in those environments. We are -- today, we are making investments in service mesh technology that allows us to get inside the Kubernetes clusters and play a role, not just in load balancing in these clusters, but add some of our security capabilities in these clusters. So we see it as a substantial growth opportunity. And it's in part because of that belief system that we made the acquisition of NGINX a year ago.

Got it. No, that's helpful. Let me move to the security aspect, which has been a key driver over at least kind of the last 12 months or so. I mean traditionally, F5 was seen as a load balancing kind of company. You've always kind of stayed away from quantifying the security revenues. But based on the software growth you're delivering, it does look like there is a lot more security attached with all the products you're delivering. So just help us think about the use cases and kind of what your aspirations are with the security part of the business longer term?

I think today, the use case -- you're right, the security attach rate, especially in public cloud, is double what it has been on-prem. And in software, we're seeing a very strong security attach rate in parts because it's easier for our customers to add security capabilities to the software. And so the use cases today have been around authentication, web application firewalls, identity and access and some networking security capabilities that are attached to our ADCs. Going forward, we've really placed a big bet on application security, both protecting against group application attacks with DDoS protection and WAF, our web application firewall, but also increasingly protecting how an application is attacked. And that really is why we attached Shape is because we realized that more and more the most valuable assets that enterprises can possess are their applications or the digital experiences they create. And if anything, this crisis that we're going through is going to accelerate that. And because there's so much value going through these applications, the most sophisticated attackers are now attacking applications and finding new way to create fraud from all of these digital experiences that people are driving. And so Shape really gets at the heart of that of protecting against this type of fraud. And we think that's going to be a very substantial growth vector for Shape and for F5.

Just following up on Shape, just to kind of close the topic there. Is there a way to quantify the revenue opportunity for the use cases that Shape addresses and particularly kind of what your targets for that addressable market when you kind of did the acquisition?

Yes. Our estimate, Samik, is that the acquisition of Shape doubled the addressable market for F5. So we thought our addressable market in security is about $4 billion. And with the addition of Shape, it extends the addressable market to $8 billion. With the current portfolio, now we also have intentions of developing additional products with Shape's technologies that potentially will take it beyond that. But it is a -- I think it's a big market for us to address. Already before the Shape acquisition, I would say that the majority of use cases and customer conversations that have been driving the F5 business today are security. And so that only accelerates with the Shape acquisition.

So let me kind of take all of that together and now take you back to kind of the broader competitive landscape that you're in. If I were to compare then F5 with the broad capabilities across security, across load balancing, how is F5 now positioned, particularly after the development, organic and inorganic, you've done on software and virtual instances? How are you positioned against incumbents like Radware or Citrix, also like newer competitors that were emerging in the space like Avi Networks? How do you see the competitive landscape right now?

So we see all these players on a one-off on a deal-by-deal basis. But where we are -- I think we're -- our differentiation is I think in 3 areas. Number 1, with a combination of F5 organic developments, NGINX and Shape, we now have the broadest suite of application services of anybody in the market. So all the application services that are between the code of an application and the user of that application, all the things in application delivery and security that are needed to create that experience, F5 has the broadest suite of it. And so if you think about large enterprises wanting to simplify their environment and kind of consolidate vendors and simplify the complexity of building these digital experiences, that is a very appealing value proposition and that's where we're seeing great traction. So that's one. Number 2 is we also offer this broad suite of application services across any type of infrastructure. So we are not just offering that on-prem in hardware, on-prem in software, and we're not tied to a type of infrastructure -- we're not tied to a CDN or we're not tied to a public cloud. We're not tied to a form factor on-prem. But we deliver that across any public cloud, on-prem, private cloud as a managed service. And so that multi-cloud infrastructure-agnostic part of our portfolio sets us apart also from these players. And then the third factor is that because we now have data and telemetry coming from all of these environments and this broad suite of application services, it's now starting to enable to create application-centric insights for customers that allow them to better understand what's happening with their application. And we are in an ideal position to provide that because of the breadth of application services that we've created across these infrastructures. In fact, we just released today -- we did a press release about a platform we call Beacon that does just that, provide this visibility and insights that are application centric. And again, it's very difficult for any other competitor to replicate that because they don't have the breadth of application services and the number of applications that would support to get all that data, that telemetry, that intelligence.

Right. So now if I move back to the plan you had outlined at the 2018 Analyst Day, which included Horizon 2 targets of mid- to high-single-digit revenue growth. You -- if I kind of take the time period between the Analyst Day and now, you've done a lot in terms of acquisitions, you've done a lot in terms of organic product releases. Are you now at a point where those Horizon 2 targets, particularly relative to revenue growth, are very achievable on organic basis?

So as you know, we were about to go at our Analyst Day, Samik, in March and it got canceled -- postponed. We want to reschedule it and have this conversation with our investors and provide, in that Analyst Day, our Horizon 2 guidance. So I don't want to go and steal that thunder and talk about this now, but we will come to that and -- as soon as we get to our Analyst and Investor Day. And look, our -- the combination of the acquisition of Shape and NGINX has put us in a great position. I think it literally has future-proofed our value proposition, expanded our breadth of application services and given us a very different vantage point. So our focus right now is on creating the value, getting the leverage from these acquisitions. And we'll talk more about that at the Analyst and Investor Day.

Got it. Let me -- first of all, let me just remind investors, they can send questions again through the Q&A feature. I have 1 more that's come in. So let me kind of go ahead and tackle that, which is -- the question is how much overlap does F5 have with application performance management products or companies including AppDynamics, New Relic or Dynatrace?

I would say today, it's minimal. However, the -- as we deliver more and more of these application insights that we can get from the telemetry and the data that we have, we are going to deliver value that one could otherwise seek from application performance monitoring vendors. I think that the kind of the difference is I think we're going to be more focused on the insights we can deliver far across multiple applications stitched together into a digital experience because we are in the data plate -- in the data path of all these applications and that's really our focus. We don't look into the code of an application. We look at how the application is delivered end-to-end, and we will look to deliver insights onto that. But that's basin for us. I think today there's not a real overlap with APN vendor, and we really don't intend to go and compete head-to-head with -- in the APN vendors. That's not our plate.

Okay. Got it. Moving away from the discussions on the top line. The recent investment acquisitions you've done have kind of limited some of the gross margin opportunity, particularly with Shape being onboarded. And then if you look at the operating margin impact of some of that, it does imply that you've kind of taken a step down in terms of operating margins as well. So as we now think about the road back in terms of improvement, how would you kind of outline the trajectory of that improvement? What are the key drivers? And do we -- is it primarily driven by cycling past a lot of the investment that you've made recently?

Yes. I think, Samik, on the road to improvement, I think the #1 drivers are getting leverage out of our acquisitions that we have made. And that comes from top line growth. So adoption of these technologies into the F5 customer base and top line growth from these acquisitions. I -- we also intend to continue to be disciplined about our operating expenses. We have a very strong operating model, and we want to maintain a very strong operating model going forward. And so I think you will continue to see us disciplined about how we invest. In the context that we will not compromise on the investments we're making for the long-term value of F5 and leveraging these acquisitions, making sure that we realize the vision we have, and so we'll continue to press ahead with these investments. But you will see us being disciplined around that.

Okay. Maybe just kind of to finish off here. You've raised debt to fund some of the recent acquisitions, but prior to the recent acquisitions, you did have a more kind of structured buyback or more of a consistent buyback. So if you can just outline what your priorities are in terms of capital allocation at this point? And can investors kind of -- if the pace of acquisitions moderate, can investors think about a return to kind of a consistent buyback program?

Samik, so if you look at our priorities, we were -- if you had asked me the question about 3 months, 4 months ago, I would have said the priority was to pay down the debt that we took, about $400 million into the Shape acquisition. The cost of that debt has gone significantly cheaper. And so right now, we're essentially focused on restrengthening our balance sheet. And we've said, we're always ready opportunistically to buy back some shares if it makes sense. And you saw that in our second fiscal quarter, we bought back $50 million of shares. So that's, I think, the state of play on how we're focused. Right now, our real focus is on digesting our acquisitions, continuing the momentum we have with NGINX, making sure we successfully integrate Shape, delivering value for these acquisitions. Really, that's where we are focused.

Okay. Last question, just to wrap it up. I mean you mentioned digesting the acquisitions are your priority at this point. But if you did get the right kind of asset at this juncture, what are those kind of technologies or capabilities you're most interested in still onboarding as part of acquisitions?

Well, I said on the call in April that right now our focus was not on M&A because we were -- we wanted to really focus on the 2 acquisitions that we have. And we feel very, very good about the strategic position that we have now when you combine the assets of F5, NGINX and Shape. And you'll see that at our analyst and investor meeting, we'll kind of share with you the vision that we are pursuing and how a combination of these 3 asset bases really create a powerful platform for applications -- for application delivery, application security, application insights for the future. So I feel very good about that position. That's the focus right now, is on executing on them -- on that.

Great. In the interest of keeping everyone on schedule, I'll wrap it up there. But François, thanks a lot for attending and making the virtual conference happen, and hope you get some rest and your back feels better.

Thank you, Samik. Thank you for having me. Thank you, everybody.

Thank you.