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

Well, thanks, everyone, for joining us for the F5 fireside. I really appreciate everyone joining us on the platform. My name is Alex Kurtz, equity research here at KeyBanc Capital Markets, covering infrastructure software. Really appreciate you guys spending time with us for the next 25 minutes. Before we jump into it, we have a really good Q&A platform that's part of the webcast platform. So as you come up with questions, please start filling those out and I'm looking at them real time, so we can integrate those into the discussion. For some really discrete unique questions, we'll kind of wait for those at the end and get to that after we go through some of these initial fireside Q&A. So with us is CEO and President, François Locoh-Donou with us from his home office, just like everybody else; and Cooper Werner, VP of Finance at F5. Good to see you, Coop and I appreciate you guys spending the time with us today.

Great. Good to be here. Thank you.

Good to be here.

Yes. Just good to hear from you guys. So François, you took a portion of the earnings call to outline that kind of a new strategic vision of the company that looks to integrate some of the key acquisitions from NGINX and Shape along with the underlying core platform. Maybe take 3 to 5 minutes to give us kind of the reader's digest of what you're after in the prepared remarks on the call.

Thank you, Alex, and I appreciate the opportunity. It was, in fact, from the earnings call, we talked about our vision for adaptive applications, which perhaps is less of a new vision for us but more of a culmination of where we are and what -- where we see the world of applications going. So I'm going to take a minute to explain what we mean by adaptive applications, kind of explain how they work in practice and why they're going to make a big difference in the industry and for our customers. So we see a world where applications kind of like living organisms; in the future will scale, will defend themselves, will heal themselves basically on their own and in an automated fashion. That, by the way, does not happen today, but that world for applications is largely manual for most enterprises around the world. And so this will be a game changer in terms of the kinds of digital experiences that large enterprises can create for their customers, will create better end-user experience and much lower operational complexity for large enterprises. So if you think about it, in practice, how does this work? And I'm going to take a simple example of a, what goes on between applications and their users? So today between the code of an application and its users, there are a series of what we call application services. But it's really if you simplify it, it's really down to application delivery and application security. And those are things like web application firewalls, load balancers, things like DDoS protection, Ingress controller, all of these things are part of that chain of services that exist between the users of an application and the code of an application. Now each of those things are managed in large enterprises by different teams and there are significant silos between each of these application services. And as a result, when you need to modify an application, change of security policy or change the scale or the capacity of any one of these services. This is largely a trial and error effort that is very manual. Unfortunately, more and more to create the kinds of digital experiences that customers want, applications need to be more and more dynamic. So you need to make more and more changes to these things. And I'll give you a concrete example of that. You probably -- if I use your favorite coffee provider probably has a digital application that you're using to figure out where the nearest store is, use your reward points, pay online, order online, et cetera. Well, that application is not going to need the same capacity at 8 a.m. in the morning when everybody is rushing to get their coffee as it needs at 10 or 11 a.m. or even in the evening. And so you want to scale the resources available to that application at a certain point in time and descale them later on in the day. And if you're a global player, you may want to scale them at 8 a.m. in New York and do the same thing in London, later on, et cetera. So all of that today would be manual, but we see a world where we are going to be able to automate all that. And even create a richer set of experiences and understanding about the applications. The way, technically, this is going to happen, how we're going to make that work is, if you -- F5 has the broadest set of application services. So I mentioned application delivery and application security. These things that make the applications work and secure them. All of these things, these technologies underneath the application are now providing a lot of telemetry. And if you take all of that telemetry and you leverage analytics and AI algorithms to really analyze and understand what's going on, you can gain insights about an application that tell you whether or not you need to scale some resources, tell you whether or not you need to change a security posture. And those insights basically can automate into a loop that reconfigures the application services. And that's really where you see the emergence of adaptive applications. An example of that is, if an application is under attack, you can get some insights into that attack. And automatically, we can figure the application services to protect the gates, the next attack based upon what you're seeing for certain actors. So all of these are kind of manifestations of adaptive applications. And we, as a company, have started to build the technologies that will make these adaptive applications a reality in the world of our customers. So we've announced a number of products in the last 6 months. NGINX Controller being one, a solution called Beacon being another, that starts to make this adaptive application a reality. And ultimately, I think, this vision of what digital experiences our customers will create is not only driving the investments for F5, but increasingly driving the conversations and engagements with our customers.

So how does an F5 salesperson take this road map is the kind of vision and out to customers? Is it different for an existing versus a new customer? And are they just implementing different positioning on different outcomes and different applications with different products? Like how would you expect that sales kickoff to be presented to the sales org?

So essentially, Alex, I think the vast majority of customers who will, at least in the early stages benefit be able to take advantage of these capabilities are existing F5 customers that have implemented a portion of our solutions, but perhaps not all application services. So we -- our sales team typically will sit with a customer and evaluate where a customer is in that journey. And what is the next best step to get to that kind of Holy Grail I'm describing. So it isn't something that I think is going to happen overnight. It's, I think, something that is going to take time. We have -- with the acquisition of NGINX and the acquisition of Shape and the effort we've done organically, we have a lot of the components of being able to build these adaptive applications. There's still some organic work we need to do in bringing all the components together. But we have a lot of it. So we can truly sit down. Our sales teams are enabled. They've been trained on this. So they're able to sit down with customers, paint and agree on a picture of where we want to be, look at where we're at and take the next big step in starting to move down this path.

Okay. And so let's transition a bit into this current operating environment. And what COVID is meant for new pipeline development, right, and especially for platforms like NGINX and Shape? I think you may have mentioned on the call that you guys are in a good spot because you rely more on installed base customers and newer customers, right, at this point in the life cycle of the company, and you have this advantage where you have a large global installed base. So have you been surprised by kind of the resiliency of the pipeline? And kind of how do you think about it as you put together the September guidance?

Well, Alex, I think we -- if I go back to where we were in March, sort of March, April, I think we had a lot of trepidation looking at everything like the world around us around where we were going to be. And so to some extent, yes, we are very pleased with the resiliency of the business. And what we are seeing with customers is that the -- what's key right now is the solutions that are operationalized is what customers want to use to tend to the immediate priorities. And so our incumbency and the breadth of solutions we have operationalized is a big advantage for F5 in this environment. If I look at where the pipeline has been affected, going back to what we said on the earnings call, I think the areas are: a, the verticals where spending has dropped dramatically. So it's retail and transportation. But those verticals altogether represent less than 10% of our revenues. And then there are some specific geographies, specifically in Asia and India, where we have seen a sudden stop or big delays to projects. So we have been affected but in certain segments and in certain geographies. And then the third aspect of it, that aspect, I think, is temporary, but it's that new big strategic initiatives have taken a back step, if you will, have been delayed in favor of attending to more immediate priorities. So we have some big new strategic, typically more software projects that we were working on that have been delayed because folks have to use their limited resources to attend to the immediate priorities. And specifically in terms of NGINX and Shape, we've not seen any more effect on NGINX and Shape than on the rest of the business. NGINX, we continue to see great traction, especially with the security capabilities was brought on to the NGINX platforms in modern applications. And we also continue to see a lot of traction with Shape because in this environment, more and more people do things on their digital platform. So more and more of the engagements, you think about all large enterprises, a lot more of their engagements with their customers now come via digital experiences. That was the trend anyway that has being accelerated. And as a result, the fraud against this digital experience is also being accelerated. And so we are accelerating the pace at which we protect customers against fraud leveraging their Shape Security platform. So overall, I think the general momentum is there with the exception of the 2 or 3 areas that I've mentioned.

Okay. Cooper, we're going to weave you in here. I wasn't going to let you off that easy. So first just want to talk to you about the subscription strategies, I think, 73% of software is now subscription. Where is F5 and your -- and the longer-term goal to transition the license model to subscription? I guess beyond that, just that metric, what are the other signals that investors should be watching? And by the way, I say this in the context that we didn't get an Analyst Day with F5 this year, right? So we didn't get the opportunity to get this all laid out neatly, right? And maybe we'll -- something -- we'll do something later this year or next year, but where -- take us where are we right now in that development?

Yes. Okay. So the way I think about it is, it's kind of 2 -- there's 2 elements. One is where we are with the transition to software, and then within that transition, where are we in terms of the mix of subscription versus perpetual offerings. And I think first off, what we're seeing is that the software transition has happened much faster than I think we initially anticipated when we unveiled the kind of the new strategy. We've had really good success, not just with some of the newer offerings, but also just as customers are migrating into multi-cloud environments, they're bringing F5 with them very consistently and very often, that's expanding the opportunity both in the kinds of applications we can address in software, where it's kind of a more flexible model, but also the number of services they look to consume, especially with application security becoming more at the forefront of their security strategy in a multi-cloud environment. And so we're seeing a higher mix of software than -- given where we're at right now than we initially would have anticipated. And then we've been seeing really good traction with customers that like the flexibility and the agility that comes with some of the newer commercial models. So these are things like term subscriptions and multiyear kind of consumption-based subscription offerings. And so we've been seeing a big shift in the latest quarter -- last 2 quarters, 73% of that mix came in the form of subscription offerings. And we -- that's a trend we expect to continue so that over time, you would see the majority of our product revenue come in the form of subscription-based software agreements.

And what does that mean to your ability to upsell later on versus the older approach to selling your products? I mean has it helped with expansion opportunities or better visibility into cash flow? Just what is it meant as you transition to subscription for the overall model?

Yes. Well, so it's really interesting. If you look at one of the models that we have, which is a much more flexible consumption subscription agreement, where we give customers the latitude to choose whichever services they want to use over the period of the subscription. So they commit upfront to a certain value of F5 services, but they don't have to have perfect line of sight as to what they're going to be using. And so it's made it easier for customers to move forward because they don't feel like they're boxed in with what they thought they would need upfront, rather they have the flexibility to adjust. But with that flexibility, it gives us a lot more opportunity to engage with the customer over the term of their subscriptions. So we've got a customer success team that's talking with our customers, trying to understand their challenges, the changing nature of their application environment. And hey, here are some other services that we offer that we think might be a good fit for what we're seeing with your application. And so we're seeing a really good early uptake with expansion within those agreements where customers are consuming more and more of our services. And so as they get to the second or third year of these agreements, their -- the agreement is expanding in terms of the scope of what the customer is using. And what's interesting, what I think is even more interesting is with NGINX and Shape, these are customers that have no familiarity prior being F5 acquiring NGINX and Shape. They have no familiarity with these models. And that -- it's been surprising to me at least how quickly our sales teams have brought those customers into some of these agreements. And I think they're recognizing that there is value to having that flexibility to run NGINX, an example, alongside some of the more traditional F5 offerings under these subscription agreements. And so I think we have a more engaged customer and then I think what you're going to see in the next year or 2 is a lot of these agreements are coming up for at the end of their term. You're going to start to see those layers of that subscription revenue building. And I think that's what's exciting to me because as you said, the visibility gets better and better each year as more of our customers are under it. The subscription model, the engagement continues to go up. And I think it really is kind of the core element alongside with all the services we've been adding, but just moving to the subscription model. It's a core piece to how we drive our software growth in a sustainable manner.

We could spend the rest of the time talking about that, but we're going to move on to some other topics. We will get that in a minute. François, on the last earnings call, there was good question about CloudFlare and Fastly and how does F5 kind of sit into that conversation. They're extending application services and network edge and not exactly one-to-one to what you guys do. But just kind of curious how you see those platforms developing relative to your own products and what you outlined as the new strategy of the company earlier in this call?

Yes. I think the kind of the -- at a fundamental level, Alex, the brand proposition of F5 is that we are infrastructure agnostic. And so our focus is on creating the best suite of application services, application delivery and security solutions for our customers that they can use on-prem in a private cloud, in a public cloud, AWS, Azure or use it even if they're hosting their applications at the edge on edge cloud infrastructure. And so we are -- unlike others, including CloudFlare and Fastly, we're not a vertical stack. We're essentially a horizontal stack, and that's the play that we've made. And we're seeing a lot of customers really latching on to this multi-cloud value proposition, and one thing to decouple their application logic from their -- from the underlying infrastructure. And this is where F5 is really strong. I think that plays really well in large enterprises. And F5's focus has been -- take the top 10,000 enterprises around the world, they have been the core of F5 customers. And I think perhaps the more integrated factor that plays more into the commercial market. Maybe over time, there will be more of a convergence. But I think today, that's kind of the difference that I see between the platforms.

Okay. I'm going to jump into some questions here that have popped up. There are a couple of very thorough questions. I'm going to try to do the reader's digest on them. But just the first one here around the organic growth in the business longer term and kind of where -- and I know it's hard to put that all together during COVID, but what's the aspiration of the business, right, organically longer term? And maybe that has to wait for another Analyst Day where you can kind of better outline that to the market. But what's the goals internally about how fast you want to grow on organic versus the acquisitions?

Well, so you're right, Alex, I'd like to reserve a full and thorough answer to that question to when we finally get to reschedule our Analyst Day. But I do want to say that we want to be growing faster than what we're doing right now. And we have positioned our company to be on secular growth trends that are pretty powerful. So if you look at -- on the earnings call, Alex, we've talked about Act 1, 2, 3 and 4. Act 1 was really about the transformation of F5 in our core business of application delivery in front of traditional applications moving to software-first environment. And I think we're seeing the execution of that now. Act 2 and 3, I think as they play out, are going to provide additional drivers of growth. So we have not been in front of modern applications historically. But the market for traditional applications is going to grow way faster than double-digit growth over the next 5 years. And so we are going to have an accelerated driver of growth from what we're doing in Act 2 with modern applications. In security, if you look at the security market that we're going after, which is application security and fraud, that market, I think, it is going to grow way faster than double-digit growth over the next several years. And I think we're going to continue to gain share in that space. And we've positioned ourselves for that with the acquisition of Shape. And the things we're doing with Shape integrating across the whole F5 portfolio. So that's going to give us another opportunity for accelerated growth. So we are -- and that's, by the way, that's our Act 3 is application security. And then beyond that, I think that's more down the road. The things we're starting to do in application analytics, that's a whole new growth market and opportunity for us. So we are pursuing a growth strategy. And we have made significant investments to position ourselves against the right category and secular trends to accelerate growth for the company. And I will talk more about what that means in our kind of next couple of years when we get together for the Analyst Day.

I imagine the durability of the systems business, right, is a big factor in all of this. And I think maybe your systems business did a little bit better than we were expecting in our model. I can't remember last quarter exactly, but what's the current view on the traditional systems business as you guys try to land the plane per se as far as transitioning people off of those products and into software?

I think the systems business in the near term is going to continue to decline as it has. Because more and more of our customers want to be in a software-first environment. And fortunately, we've done all the things to -- they're making essentially that transition with F5, but I also think there is a floor to this declining on the systems business because there are many segments of our business that want to continue to use hardware either because they want to physically control their environment or because that's the way they want to go or certain segments and geographies where our hardware business is actually growing because people find that more attractive. So I think there is a floor to the decline in the hardware business. If you ask me to predict where it is right now, I wouldn't be able to tell you. But I think over time, you will see that plateau and stay at a certain level. And I think our software is going to continue to grow. And I think that's also a point at which we will see acceleration in our overall revenue growth.

A question here around free cash flow use in the buybacks and kind of what the strategy is right now as far as being more aggressive or less aggressive and kind of your posture around the buybacks. It's obviously driven a lot of leverage in the model over time. So how do you think about buybacks on the time of COVID and post-COVID, what's the strategy right now?

Well, Alex, we -- as perhaps a number of other companies, but we have been very cautious in this pandemic with our use of cash, given the macroeconomic uncertainty. Now if you look more into the future, I think for us, there are essentially 2 kind of strategic uses of our cash. One is potentially share buybacks and resuming that. And the other is, if we feel down the road that we want to accelerate some things inorganically with our adaptive application vision, that would be another potential use of cash. So over time, we will balance that in the way we need to. But for now, in the pandemic, as you've seen last quarter, we've been very cautious about preserving our cash balance.

Okay. We've only 2 minutes left. And one that -- one we've been doing with all the other fireside chats that we've done today has kind of asked this recurring question about, what it's been like to run these companies -- run your companies internally during this pandemic, working from home and collaboration with teams and kind of what surprised you a little bit? And just any kind of anecdotes that sort of have popped up as you guys travel less, do a lot of Zoom calls, what's really stood out to you? Whether it's productivity or improved collaboration across teams that you didn't think would collaborate?

Alex, I think we've all learned a ton. I'm sure for the folks listening today, we've learned a ton in the last 5 months of doing this. The learnings for us are, I would put them in kind of 3 categories. The first one is our productivity levels have been pretty incredibly high. They have surprised. And I think a lot of people -- and so we've been very, very pleased with that. I feel we're very fortunate that a lot of other things we do can be done digitally, whether it's research and development or customer engagement or marketing and so forth. So productivity levels have been great. The second learning which really has been a surprise is, you would think that the kind of togetherness, F5 is a company that really has a soul and enough intensity to it and we will nurture that in our culture. A big part of our value is what we call helping each other thrive. It's a very collaborative organization. And I was worried that, that would suffer in this time. But I think we kind of re-learn the lesson a lot of times that going through adversity together actually brings people together more than it pulls them apart. And this has been a giant piece of adversity that everybody we faced in our own ways with our families and friends, but we all face the same adversity, and it has brought the whole company even more together than we have. So the engagement levels in the company are at the highest than they ever have been. And I think the third and last learning is that the way -- I think a lot of companies right now were no different, but we are truly taking this opportunity to step back and rethink how we work. How much -- like how much struggle do we need to make going forward, how much do we really want to be in our -- even post pandemic, how much do we really need to be in our offices, how much does each function need physical locations to work and really taking an opportunity to perhaps redesign how we work in a way that maintains or even increase our productivity levels, but also gives people perhaps more flexibility and quality of life as they go through this. So I think there's an opportunity that the sun behind this cloud and we are working to create that future altogether.

That's really helpful. Those are great points. I really appreciate that additional context around how the company has operated through this. Well, I want to thank François and Cooper for your time. Thank you very much, and that was a great conversation, and thank you for your time with us the rest of the day. And have a great rest of your week. But thank you very much.

Thank you for having us, Alex.

Thank you, Alex.

All right. See you guys. Bye.

Bye-bye.