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

Hello, everyone, and thank you so much for joining us here today. My name is Jim Suva. I'm the IT hardware and technology supply chain analyst at Citigroup Investment Research. This fireside chat, we are focusing and hosting F5 Networks, ticker, FFIV. A few housekeeping items. First of all, this is intended for Citigroup institutional investors. If you are media or press, you are hereby requested and ask to drop or disconnect. If you're a media or press and you don't, we will also disconnect you as we look through the lineup of who is connected and who hasn't. We also want to note there are disclosures associated with this and any clients who are subject to MiFID II, please ensure you have those agreements into place. I'm very pleased to have joining us here today live from Seattle, virtually, F5 Networks' Executive Officer, François; as well as SVP of Finance, Cooper. We're going to go through some prepared questions quite meant to be interactive. If you do have questions, you can e-mail me, jim.suva@citi.com, and if there's time permitting, I'll get them to you. We do have a very packed investor set of meetings throughout this day also. So gentlemen, thank you so much for joining us here today.

And maybe François, to take a big picture, can you talk about demand trends and what you're seeing as we entered 2020, as the coronavirus and the pandemic spread globally and now what it looks like, say, for the next 6 to 12 months?

Jim, good afternoon, and thank you for having us today. Let's talk about demand for F5. So overall, if you look at what demand has been relative to our expectations at the beginning of COVID, our business has performed better than even as expected when we really got into the pandemic and the ensuing crisis. Relative to our pre-COVID expectations, so if I go back to where we were at the beginning of our fiscal year, we are a little off relative to our own expectations. And I think it's primarily because of 3 factors: The first factor is geographic. There are a couple of areas, specifically India and ASEAN in Asia that were hit by the pandemic and where the business was affected. The second factor is vertical. There are a few verticals, as you imagine, specifically in retail and travel, hospitality that have been seriously affected by the pandemic, and our business there has declined. Of course, those verticals combined represent a small -- less than 10% of our overall business. And then the third factor is that some of the software, digital transformation, big type of projects, that customers would have naturally undertaken at these times, have been delayed because customers have tended to go to the most urgent. And I think they'll come back to these projects in time. If I look at the 6 to 12 -- or the next 6 to 12 months, in terms of demand, I think we're going to continue to see drivers in security, specifically in application security as more and more customers want to shore up these digital experiences and make sure they are secure. And I think we'll continue to see adoption increasingly of modern applications and customers moving to software-first type environment. So I think both factors, we feel well-positioned for the demand that we're going to see over the next 12 months with the assets that we've built, both organically and inorganically.

So François, it sounds like you actually dovetailed directly into the second question about, has the pandemic actually changed the drivers of growth or products? Whether it be more software oriented or a change in the way that you talk with your customers and do business. Can you talk with that a little bit?

Yes, Jim, I think -- overall, I think, the pandemic has more accelerated. If you look at the next 2, 3 years, the kind of mid- to long-term demand drivers for F5 have been accelerated by the pandemic because -- I would say, because of 2 factors: Generally, more and more customers want to move to accelerate their digital transformations. If it was an aspiration before the pandemic, I think more and more of our customers realized it's a necessity. And so you'll see acceleration of these transformation projects. And I think it has 2 implications for F5. The first one is as customers try to create these more real-time dynamic digital experiences, they need to adopt modern applications and modern application architectures and they often need to combine these modern, highly distributed applications with traditional applications to create a single end-to-end digital experience. And we feel we're very, very well-positioned with this with a combination of F5 BIG-IP and our NGINX technology assets, which together span modern applications and traditional applications. So we're going to see accelerated adoption of that combined value proposition of F5 and NGINX. The second implication is, as more and more of our customers' work, in terms of work from home as well as transactions and value creation come from these digital experiences, there is unfortunately a focus from criminals and fraudsters on attacking these digital experiences, finding a way to do account takeovers, and we have positioned ourselves to help our customers address this growing challenge of application security. And so we are now -- of course, with F5 solutions, we have been addressing application security from protecting the traffic that comes into an application. Now with the acquisition of Shape, we can also protect how an application is used and stop fraud in real-time with the use of their AI and analytics capabilities. And so when I look at the next 2 to 3 years, I think adoption of modern application architectures and growth in application security are 2 big demand drivers that we will see accelerated and that we've positioned ourselves well for.

And those security issues and those positions that you've positioned yourself well for, I want to make sure we talk about them maybe in like 3 or 4 more minutes. And first, kind of, finish off about the COVID-related issues about that plus tariffs. Had you had to change your supply chain? Have you had to go more local? Have you had to change your operations and the way you deal with things? And have you sorted it all out? Or how should we think about the operational challenges and how F5 -- I believe you also recently changed headquarters to a new headquarters, how you've kind of worked through all these various dynamics with some external factors of coronavirus and tariffs that are not really easily anticipated?

Jim, over the last 3.5 years, the F5 teams have worked very hard, under the covers, to really create a more agile business and a more agile company, and we're starting to see the benefit of that. And I'm going to give you some examples of things we've done to create that agility in the business. So firstly, as it relates to tariffs and such, in 2018, we moved a large part of our manufacturing from China to Mexico. We actually did it largely for cost reasons and efficiency reasons to serve the North American market. We still have manufacturing in China, but it's serving primarily the Asian market. So we were not -- really, our supply chain has not really been impacted by the trade war between the U.S. and China. We also, over the last 3 years, really, rebalanced our workforce. We created centers of excellence in India and in Mexico, which gave us the ability to grow our engineering and IT capabilities pretty quickly and at a lower cost base. And we've created kind of flex working in the company within that 2 years ago really to start enabling our employees to work from home more. And so when the pandemic hit, we essentially didn't miss a beat in terms of productivity. Everybody was already able to work from home. So these elements of agility in our business have helped a lot in the last few months as we've gone through the pandemic.

Now investors who have not been up to date on F5 sometimes think about F5 Networks as like an ADC physical vendor only, doing physical all the time. Can you just talk about the company's transition from a hardware-focused company to more of an application service provider company?

Yes. Jim, the -- so let me go back in time to give a little bit of context to your question. And I think you're right. I think we're still perceived as an ADC company. I think we're well past that, and I'll explain why. We are -- if you go back to the founding principles and then beliefs of F5, we have always been about collaborating with our customers to solve their biggest application challenges. That's the essence of F5, that's kind of our purpose and it will continue to be our purpose in future in years. So if you go back to the early days of the company, solving our customers' application challenges when we came to market in the late '90s, when the Internet were just getting started, that meant really helping the dot-com scale their websites. And the technology that we pioneered at the time was load balancing primarily to load balance -- to balance loads on servers that were hosting these dot-coms. In the early 2000s, the dot-coms went away, we made a big pivot to the enterprise market. And the enterprises were, at the time, were -- they were starting to have mission-critical applications that were now starting to face the web as the Internet grew beyond dot-coms to all enterprise infrastructure. And so solving our customers' biggest application challenges in that era, if you will, meant really finding ways to optimize the traffic and manage the traffic for these applications and secure them. And this is why F5 pioneered ADC technology, which was really a programmable technology that allowed our customers to optimize the traffic and secure their mission-critical applications. Our ADCs have been largely done in private data centers and consumed in a hardware form factor. And I think that's been the predominant consumption of F5 technology up until, I would say, 5, 6 -- 4, 5 years ago. Now if you go to what is the next biggest challenges for our customers? Going forward, it's really the need to create these real-time dynamic digital experiences through which they create value for their customers. And if you look at what our customers need to do to be able to achieve that is, they need to combine both their traditional applications and new modern, highly distributed applications. They often need to do that across multi-cloud environments. They need to provide more and more application security against fraud. And ideally, they also need to automate all of this because they don't have enough skills to do all of that manually, and that they can't really create this dynamic experience if it continues to be all about human intervention. And so the company that we are becoming is a company that addresses these new sets of challenges, which is really about application delivery and application security in multi-cloud environments. And so that's what has led our transformation to become a software company. And so if you look at where we are today in this transformation, we have already helped our customers move their traditional software -- traditional applications to software-first environment, whether it be public cloud or private cloud, that movement is well underway and will continue for [Technical Difficulty]. We have married those capabilities with a new set of application services for modern application environments, largely through the acquisition of NGINX and the organic investments we are making on top, which now allows us to help our customers with traditional and modern application environments. We have doubled down on security, adding to the original F5 security capabilities, with the anti-bot and anti-fraud capabilities from Shape. And we're building automation that helps our customers both analyze their application environment and automatically scale and shrink their applications where needed. And so if you look at the company we're becoming, it's more about application delivery, application security in software combined with analytics. And that's -- so that's why we're -- but I wanted to give you context around why we're making this transformation. It's still remaining true to solving the application challenges of our customers, but adapting to where the challenges are going to be going forward.

Now you alluded to or mentioned earlier, security to stop those who are out there doing bad things, whether it be coronavirus or noncoronavirus, you working from home, me working from home, lots of people are trying to steal information or data or money or things like that. Can you talk about F5's security offerings? What they do? And a lot of us may not be programmers, but help us understand what part of the system you're in and maybe some examples of how you stop the bad actions or at least alert the IT professionals of some potential bad actions.

Yes. So Jim, I would say, in terms of a category, if you think about the various areas of security, where F5 is focused is on application security. And by that, I mean, protecting bad actors from accessing an application or making fraudulent use of an application. So we are not focused on endpoint security, we are not focused on network security, we're really focused on application security. Again, it comes from our just fundamental purpose of helping our customers solve their biggest application challenges. So what form does that take? The investments that we have made organically over time is to protect applications from bad traffic. And that really is in capabilities called web application firewalls as well as protection against DDoS attacks. On traffic, this is traffic that's coming into an application that really shouldn't be accessing the application either because it's going to crash it or it's because people trying to exploit potential vulnerabilities in an application to attack it. And so F5's organic offerings have historically and will continue to provide that for customers. In the past, these offerings were primarily in hardware. And increasingly, we have made these offerings available in software -- in packaged software as well as SaaS security offerings. And now our SaaS, for example, our web application firewall is available as hardware, it's available as software, and now it's available as a self-service SaaS service or even as a managed service for customers that don't have the skills and don't want to own the technology. In addition to that, we acquired a company called Shape Security a few months back, which doubled our addressable market in security. Our addressable market was about $4 billion. Within Shape's addressable market today is about $4 billion, but that I think will grow substantially. And what we can now do with Shape is not just protect the traffic coming in application, but protect how an application is used. So increasingly, Jim, you have -- because there have been so many breaches out there, you have a number of people who get access to credentials because they can go buy these credentials on the dark web, so username and passwords. And they will use bots to bombard a website or retailer's front-end or any enterprise front-end, bombard with these credentials to find a legitimate way to get into the application as if they were a legitimate user. And once they are in that application, they do what's called an account takeover, and they can do all kinds of fraudulent behaviors once they are in as a legitimate user. And so we want to block that. And so Shape's technology leverages AI and analytics to detect bot traffic and block all these bot traffic that is trying to come in. And in addition to that, we are able to leverage their AI and analytics once the bot traffic has been blocked to detect even within human traffic, what human traffic is actually fraudulent. And so that's the core of F5's offerings. Our offerings are now extending beyond that, though. Because of the power of our AI capabilities, we are able to get very low level granularity on individual users accessing an application. And so we are now offering capabilities that help a company potentially increase the revenue from their applications by removing the friction that exists between a user and an application. And so that's where we're going next, and it's all powered by the analytic capabilities of the Shape platform.

Well, your company's characteristics are a lot different than what they used to be years and years ago when I've been covering the company for so long. Speaking of those characteristics, can you talk a little bit about your software revenues? Like is it mostly recurring or subscription base? And any observations you can share with us about the transition from, say, perpetual to subscriptions and things like that?

So Jim, we have about -- so today, about 60% -- as of our Q3 revenue report, about 66% or so of our total revenues are recurring. And that includes both maintenance -- services maintenance revenues as well as software revenues. Our software revenues represented -- so our product revenues represent about 44% of our total revenues. And of those, software revenues represented about 38% of the total in the last quarter. By the way, up from less than 10% of product revenues if I go back 4 years ago. So there's been a substantial shift in the business, now approaching almost 40% of our product revenue is actually software. In our product revenues, we have about, I think, almost 3/4 -- in the last report, I think it was about 73% of our software revenues that were recurring software revenues. And these come from 2 sources essentially. In our -- kind of our core BIG-IP business, we have a lot of customers that are opting to take term subscriptions, either 1-year or 3-year subscriptions. And they're doing that because they like the flexibility, the ability to port their licenses to different kind of multi-cloud environment, the ability to up their consumption as time goes on without having to go through another procurement cycle. And so we've given these term subscriptions, based on a certain throughput. And then if they exceed that throughput, we true forward the agreement after a year. And so we can see a nice revenue increase even within these term subscriptions as they consume more of the software. And then the second source of recurring software revenues is more ratable SaaS software revenues that comes largely today from the Shape and NGINX acquisitions. And so -- but when you combine those things, if you go back 3 years ago, none of our software revenues were recurring revenues. If you look at where we're at today, about 73% of our software revenues are actually recurring revenue. So it's a staggering transformation of our software business. And keep in mind, our software product revenue business is now approaching about $400 million run rate, excluding services, so just product revenue. So it's a pretty sizable software business now.

That's a big transition, and I'm sure it took a lot of effort, impressive. Can you talk a little bit about -- I can't remember if it was you or AWS, Amazon Web Services, put up a -- some commentary around your relationship, your partnership, shall I call it, can you give us some context about that?

Yes. So Jim, we are -- as you know, we announced AWS -- strategic collaboration agreement with AWS, I think, it was in October of 2019. So we're still in the first year of execution of this agreement. We are ahead of our plans. We set some financial goals for the year, and we're ahead of these plans. So we're really happy with the way things are progressing. AWS has been generating a lot of leads for us. So one of the benefits for us of the agreement has been that AWS is bringing us into a number of opportunities that we did not have visibility to before. But we're also working with some product integration with AWS, and we're very excited about what's to come from the combination of our offerings, which will give AWS' customers a more complete solution and give F5 more visibility into customers that would not have had naturally a visibility to F5. So it's a very, very promising engagement. I would add to that that we actually work with the major cloud providers. So Microsoft Azure, of course, as well as Google and we also have some very strong collaboration with these partners in the market that are going to grow in the near term as well.

Now for someone like me who's not a programming expert, but more of a hardware guy or a network guy, you mentioned AWS gives you some leads or some visibility that you didn't have before. I'm used to using Amazon to deliver groceries to my front door and things like that. So when you talk about new leads, can you talk to us just in generalities, not a specific customer experience, but maybe just some generalities of what you mean by generating new leads because I'm used to either storing some of my family files and pictures up into their cloud or ordering some groceries to my doorstep, and I just quite don't think everybody grasped what you mean by some new leads through AWS.

Yes, of course. So Jim, AWS is not involved in your orders and your doorstep, that would be amazon.com. AWS is focused more on all types of either developers or enterprise customers. And so where we are getting new leads is, there are lots of engagements that mid-market and even some large enterprise companies have with AWS, where they're thinking about what their architecture is going to be in the cloud, what's the best way to instantiate new applications in the cloud. And because AWS has a much broader market length, it's a much broader go-to-market force than F5, they're able to have many more of these engagements than we are able to have at any given time. And so in the past, we would not have been brought into these engagements proactively in the early stages of the engagement when the architecture is being designed. And today, we are by AWS with customer conversations that they've had and then bringing us in to help a customer with their cloud journey. So that's what I mean by new leads is enterprise customer conversations being brought to F5.