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

Okay. Great. I think we're getting started, right? Okay. Perfect. We're getting started now. I'm Sami Badri with Credit Suisse Equity Research. Thank you very much for joining us. Just some housekeeping is, if you have any questions, please shoot me an e-mail directly to my e-mail inbox, and then I can channel the questions indirectly. Today, we have the CEO of F5 Networks, Francois Locoh-Donou. Thank you, Francois, for joining us today.

Thank you, Sami. It's a pleasure to be here.

Great. And then so, Francois, to kick it off, following your AIM 2020, can you outline the 3 key areas of growth that will help you achieve the top and bottom line targets you set up for Horizon 2 and the further out long-term targets? And then maybe thinking about the way you want to frame your response. When you think about your business model and customer engagement, what needs to transition other than revenues going from transaction-based or perpetual to recurring and subscription alongside kind of in the context of some of the targets you've laid out?

Well, thank you, Sami. So let me start off. The 3 key areas of growth, Sami, are number one, this transition to multi-cloud deployment. So specifically, with our BIG-IP franchise that has supported and continues to support traditional applications, customers are moving to the software-first environment. And as we laid out at AIM, that transition is actually accretive to F5. And so that's kind of the first area of growth, going to software-first in private cloud and public cloud environments with our BIG-IP software. The second area of growth is security. We have placed a significant focus on application security. We have an addressable market in security now that is about $8 billion and growing. And so we see substantial growth there as customers continue to focus on protecting applications and increasingly, and this has been accelerated by the COVID crisis, fraud. Fraud on digital channels is a big -- and it's a growing issue. And it's just a market that is emerging now, and we have hit this market at the right time. So we expect a lot of growth to come from security and fraud, in particular. And then the third area of growth is modern applications. Historically, F5 was not really in front of modern applications. So these are cloud-native and container-native applications. With some organic work and with the NGINX platform, we are now getting in front of a lot of modern applications, and that is, again, something that's growing. People have experimented a lot with cloud-native and container-native. Now these things are moving into production, and we are there at the right time to support that. So multi-cloud, security and modern apps are the 3 areas of growth. I would add, Sami, because you mentioned, the target that we laid out for Horizon 2, not all 3 of those things have to go perfectly for us to hit the targets that we've laid out at the Horizon 2. Basically, we have multiple ways to get to these targets. And so we feel pretty good about our top line accelerating into the 6% to 7% range that we laid out for Horizon 2. In terms of the business model transitions, look, hardware to software, I think we've just -- as you've seen, we've executed relatively well on this. The bigger transition has been moving from a perpetual model to a subscription model. I think as you will have seen from our Investor Day, now more than 70% of our software business is, in fact, already subscription. So that transition is already underway. And so the things that we are placing a lot of focus on right now is things like having a strong customer success capability, and we're seeing the benefits of that in terms of the true forward and expansion opportunities on our subscription business as we now have a much broader base of subscriptions. So that's one of the transitions that we have been executing, is having a strong customer success motion and that will continue to grow. And the other one is ensuring that we are efficiently addressing multiple buyer personas inside of a single large enterprise. Most of our customers are very large enterprises. Historically, we were only dealing with the network operations kind of persona. Over the last several years, we have built strong relationships with SecOps, so the CISO organization. And more recently, with the NGINX acquisition, we have built a position and relationship with DevOps. So we need -- we now address 3 personas, and that's the other transition inside of our model, is continuing to do that but doing it more and more efficiently.

Got it. Got it. Thank you for hitting all those on the head. When you think about the post Analyst Day meetings you've had with investors, have any areas of your business strategy or targets kind of gone underappreciated since laying out the plans, the acquisition updates and any of the financial model projections? Are there things that consistently come up that you say, you know what, they're asking these questions, but they're not -- there's not necessarily any appreciation for other elements that we've already laid out?

I think, Sami, so the feedback from our Investor Day generally from our conversations with investors have been positive. I think in terms of being underappreciated, look, I think investors will look more and more at F5 as a software company as we continue to execute on our transformation. And I think that part of F5 is probably underappreciated and undervalued. But I think as we execute on the plans we have laid out, that will -- I think that will correct itself over time. What I think is better appreciated after the Investor Day that was prior is the fact that we as a company have reached an inflection point. And I think there are 2 dimensions to that inflection point. We are at a strategic inflection point, but we're also at a financial inflection point. So in terms of where we are strategically, the reason I say we are at an inflection point is F5 is a business that has now a software business that is at critical mass. We had a $360 million software business in 2020 that grew 50% year-on-year. And as you've heard, we expect it to grow 35% to 40% per year in the next 2 years. So it's a big software business that's probably growing at least as fastest not faster than our peers in software. We have reached critical mass in security. We're the second largest application security player in the world with over $750 million in security. And now a material portion of our business is outside of the $2 billion traditional ADC market that we have been historically associated with. And so because of that different strategic position, I feel we have reached an inflection point in terms of the opportunity that's in front of the company. It's also an inflection point in terms of our financial performance because our top line is accelerating. We saw that from the guidance we gave for Horizon 2. Number two, the early investments we chose to make in the last 3 years are paying off and giving us an opportunity for operating leverage expansion. And number three, because of where we are with our balance sheet, the resilience we've seen from the pandemic, we've also been in a position where we can resume strong capital returns. So for all these reasons, Sami, I feel strongly that -- and I think that's better appreciated after the Investor Day, that we have reached an inflection point in the journey of this transformation, and I think investors see the potential for that.

Got it. Got it. And then at the Analyst Day, when you were presenting, you outlined pricing and quantity impacts for BIG-IP when customers were transitioning from systems to on-premise software, cloud-hosted software. Can you walk us through those dynamics for customers transitioning from systems to as-a-service models?

Yes. So I would say, Sami, the vast majority of the transitions that our customers, large enterprises are making is not hardware to SaaS. It's hardware to software. And the software -- the hardware-to-software transitions really come in 2 flavors. Either transitioning to a private cloud environment, so keeping software on-prem, but with a lot more automation because automation is really important for our customers in terms of productivity and speed of deployment of changes through applications and creating more dynamic experiences. And also, for infrastructure teams, it's a way to give a better SLA to their customers, which are the app developers. So that's one. Or the second mode is cloud-hosted software, which is not SaaS, but it's packaged software essentially sitting in a public cloud. So those are the primary transitions that we see. Now we have said those transitions are accretive to F5, and you saw at the Analyst Day, Kara laid out why, and it's actually quite simple. It's -- If you look at the price that customers pay for a software solution of F5, it's a little less than for a hardware solution in terms of an apples-to-apples comparison by, say, 20% to 30%. But the gross profit dollars to F5 are basically similar. But what we see in software consumption is because the consumption model has more flexibility in terms of portability of where the technology can be deployed, whether it's on-prem or in the cloud, in this type of virtual machine environment or another type, because there's more flexibility around the licensing, there's less friction in the procurement. What we see is people actually consume more units. So overall, between the increase in unit consumption, also the fact that the security attach rate is higher in software and especially in public cloud, the net result is that transition when we see it is accretive to F5.

Got it. Got it. You did touch on a point I was going to bring up, which is the lower revenue, but very equal type of profit generation. So that's good. Now shifting over to NGINX. And I think one thing we'd like to know is, how competitive is the environment for NGINX to compete? And do you expect deal sizes to continue to increase there? And then maybe just touch on what are the key differentiating factors for NGINX and what it offers core customers.

Yes. So let me -- so you've seen, Sami, that the revenues for NGINX have already doubled since the acquisition 16 months ago. And the deal sizes have actually increased by roughly 57% from before the acquisition. Now I actually do expect the deal size to continue to increase because we have just released new vectors of monetization for NGINX, including security modules and a controller that makes the deployment of NGINX instances much easier and therefore, gives a broader range of people the opportunity to use NGINX. But because of that controller capabilities and the new security and API Gateway modules, I expect the deal size to actually increase and increase pretty substantially. In terms of the differentiation for NGINX, it's fairly simple. And it gets to the root of why we chose to acquire NGINX. Is NGINX is a --it's a platform that can take on multiple personalities. It could be an API Gateway. It could be a load balancer. It could be an Ingress to a Kubernetes cluster or a side car inside of a Kubernetes cluster. It's a web server, it's an app server. And so it consolidates a lot of tools that DevOps personnel would otherwise have to procure from different vendors. And so it reduces this issue of complexity and tools for all that a lot of customers have been dealing with. And that is the biggest differentiation. When you combine that with the scalability of NGINX, remember that NGINX has helped a lot of people scale their website by 10x without ever having to raise -- rise their cost by 10x. And so when you combine that scalability and that kind of multi-personality of NGINX, there is really nothing else in the market that comes close to that, which leads me to the -- I think the last part of your question is, what is the competitive environment. I would say in -- probably the biggest competitor for NGINX at least in the early days has been NGINX Open Source. You have a number of customers who are using NGINX Open Source and it's used in -- now in 500 million websites. But some customers don't feel they're at a point where they're ready to take on or they have a deployment that's large enough that they need to take on a commercial solution. So that, I would say, has been the biggest competition. But as we add more and more functionality like controller and security, et cetera, I think that the differentiation is becoming much greater. And then the second competition for NGINX is, when somebody is building an app in a public cloud, there's, of course, the alternative to use the native tools from the public cloud provider. And so that's the other competition in certain types of deployment. Where NGINX is differentiated there is, number one, that it consolidates multiple tools, but also that, of course, it is a multi-cloud solution, a cloud-agnostic solution. So anybody that wants to be across on-prem plus cloud or multiple clouds, NGINX is a great way to have consistency across all environments.

Got it. Thank you. Thank you for addressing all those. I wanted to shift gears to Shape Security. And I think many investors were surprised by Shape when it was announced. And I was hoping you could outline how Shape fits into the F5 strategy. And what I'm really trying to get at here is the degree at which Shape can be integrated in both F5's current product portfolio and how F5 customers would want Shape capabilities. So if you could kind of bridge those 2 things together from the fit within F5's current portfolio and then, into why customers of F5 currently would want it, that would be very helpful.

Yes, absolutely. So let me tackle that perhaps in 3 phases. So first, starting with -- the strategic opportunity or rationale for us doubling down on application security is that more and more, what we have been seeing is that customers, large enterprises are creating more and more of the value from their applications, these digital channels, where they transact with our partner or they transact with our customers and create customer loyalty. And COVID has only accelerated the importance of this digital channel. And so as that happens, cyber criminals are focusing more and more on attacks on the application layer, either trying to -- either entering an application via brute force or leveraging credentials to enter an application as a legitimate user, but then making fraudulent use of the application. And we see this type of fraud growing extremely fast. So it's a fast-growing market opportunity. And we believe we have really doubled down on that market at the right time. Now why Shape and the synergies with F5? So in order to be able to detect fraudulent use of an application, you have to have a proxy that is in line of the traffic. So you have to be able to inspect the traffic coming into an application. Shape without F5 has to insert their proxy technology in line of the application, and that's somewhat disruptive for a customer. So the customer has to know that they're going to get so much value from Shape that they're willing to go through the pain of inserting and deploying the solution. The beauty of the combination with F5 is F5 is in line of the millions and millions of applications already. And so with F5 in line, we are able to show the value of Shape to our customers without creating any disruption. And this is where you see the value of the combination is we can, a, show the value to our customers of Shape and anti-bot capabilities and the anti-fraud capabilities without disruption. And then the insertion of deployment of that anti-fraud and anti-bot technology is just much easier for customers. So that's why -- and by the way, we have -- one of the things we said at Analyst Day is that we have made early investments to double down quickly on the synergies so our customers will see the benefit. And we have already done that with Shape. So on our Silverline solutions, for example, customers can already get basically anti-bot technology on top of WAF and DDoS technology without any -- without having to change anything to their configuration, their setup, et cetera. So it is effectively frictionless. So that's one very concrete example of how that manifests itself. And then the other benefit of Shape, we talked about unlocking application insights. This is being able to look into the user experience of an application at a very fine and granular detail and being able to provide -- with the right analytics and AI engine, being able to analyze that and provide value to the application owner in terms of what -- how their application could be used better or differently to create more revenue, for example. And Shape has brought this technology to F5, and we have already productized that -- we have already products in the market only in the last 9 months that do just that. So for example, we've worked with several retailers where we are now in line doing this application insight work and helping them actually improve the user experience and increase the revenue on their applications.

Got it. Got it. That was -- those are very good, solid examples. I want to shift gears a little bit in your business, and I wanted to shift over to services. So one thing from the Analyst Day is, how should investors be thinking about the long-term guidance of low to flat services growth? And as you continue to expand and penetrate new customers, how should we be thinking about the growth rate algorithm as you become -- as there's more software sales being executed?

So what you'll see is our services growth -- what we said, our services growth will slow over time. But that will come with an acceleration of our product revenue growth, and you're going to see that in our fiscal year 2021 already. And this is basically a function of our shift to subscription models in our software-driven business in terms of how revenues get accounted between services and product revenue.

Got it. Sorry, must have broken up a little bit. We actually -- Francois, we had one question come in from the audience. And the question is mainly relating to win rates for Shape Security vs other application security vendors. And I just wanted to know, I guess, the question is getting at, how are you guys going about market share or just kind of addressable opportunities against other smaller start-up or growing company -- growing private companies?

So I think we probably have to parse the question. I think specifically in the area of sort of anti-bot protection, web application firewalls, DDoS protection, where I would say, who we see most in this area is Akamai as a competitor. And of course, they have -- their vantage point is customers that use their CDN, and they bundle that with their CDN. Our vantage point is really coming from a best-in-class efficacy on all 3 of these technologies. And I would say that's who we see most. We don't see as much kind of start-ups in that space. Probably we address a large sort of cross population of large enterprises, but I think that really won't -- proven vendors. In the area of anti-fraud that I mentioned, so where we do more granular analysis of fraudulent usage of an application, I think -- right now, I think Shape is pretty unique in its capabilities there. And so our competition there often is a customer who's not being aware of the amount of fraud that they are, in fact, experiencing until we put Shape in line of the traffic and then they discover how much fraud traffic they have really and how much fraud is really going on behind that traffic. And so that's more of an awareness issue that's changing over time. And I think overall, we have a lot of success in both areas in part because the efficacy of Shape is so unique and so advanced in the market that we have had a lot of success actually displacing even existing players and existing solutions even in accounts where we were not incumbent.

Got it. Got it. Thank you for addressing that. I wanted to shift over to a potential M&A activity. And when you think about potential investment areas, and this could be M&A, this could be organic, what type of businesses are you going after at this point? Are you going after software, hardware, chip, security, AI-focused? Where should you -- I think you guys did make reference to how big you guys would be willing to go or even probably how small we should be thinking about them given some of the capital allocation guidance you've already given us. But which areas across the spectrum should we be considering you guys or be thinking about you guys going after?

Well, Sami, I just -- I can't really speculate on that. But I can -- what I can say is our focus is on bringing that vision for Adaptive Applications to life. We really believe that our customers are in a difficult situation, where the bar for digital experiences is very high and it's set by the hyperscalers and the volume of cloud launch consumer tech companies. And for every other enterprise out there, you have to put together this very complex web of technologies across multiple environments to try and put applications together that can compete. And we think F5 is really the only company that is well positioned to address that complexity for multi-cloud application security and delivery and create these dynamic digital experiences. And so our focus, whether it's organic or inorganic, is really about bringing that to life. And it's continuing to make multi-cloud deployments a lot easier and a lot simpler for our customers. It's continuing to provide best-in-class application security, and it's helping our customers really deploy these modern applications at scale. Those are the 3 kind of things we're doing today, but we want to continue to do more. And then gradually, being able to bring these insights to application owners such that they can create more value from their applications, and we started doing that with Shape. So that's going to be the focus of where we are. And increasingly, because you asked about hardware, software, chips, et cetera, increasingly, more of that value proposition is going to consume more and more on software and in service or software-as-a-service form vector. So that's really our focus. I would say, Sami, since you touched on M&A, we have said that, we may pursue targeted M&A to continue to pursue that Adaptive Applications vision. But that if we do so, we wouldn't do anything that would affect negatively the targets that we've given for Horizon 2 around op margins, earnings per share and growth.

Got it. Got it. One quick last question before we sign off is, can you just talk about your decision for the share repurchases for Horizon 2? I think some investors were a little bit surprised to see that being kind of crystalized, but maybe just kind of some comments on why you thought this was the right time to be very formal with forward-looking guidance and Horizon 2 capital allocation and repurchases.

Well, we thought that was the right time, Sami. We had a strong capital return program in the past. We thought that when we did the NGINX and then Shape acquisitions, then we said, look, our priority was to rebuild our balance sheet. And over the last several quarters, we have done that. Then in the last 6 months, we were in a situation where there was a lot of uncertainty in the macro environment. And we felt, especially after our Q2, I think it was in April, we're in the middle of the pandemic in Q2 and Q3, we didn't feel that it was the right time to resume this. But given the resilience of our business through the pandemic, the position -- the strong position of our balance sheet today and frankly, the strategic position of the company, we thought this was the right time to go back to a strong capital return program. We'll do $1 billion over the next 2 years. $500 million in '21, $500 million in '22, and then 50% of cash flows thereafter. So we think the timing was right for that given where we're at on our balance sheet and the position of the company.

Got it. Got it. Well, Francois, thank you very much for your time, and thank you very much for participating in our conference, and we look forward to catching up with you in the near future. Thanks. Thanks a lot.

Thank you, Sami, and thanks, everyone, for joining us. Thank you.