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

Rod Hall, I'm the hardware analyst and networking analyst at Goldman Sachs. So thank you for joining us here on our -- really our third day of our TMT Conference with the first day in February. I've got the honor of having with me F5 Network's both the CEO and CFO. So the CEO, Francois Locoh-Donou; and Frank Pelzer, the CFO. So welcome to both of you. Thanks for joining us.

Thank you, Rod. Thanks for having us.

Yes, it's great to have you virtually any way. It'd be nice to see you in person. But -- so I wanted to, I guess you guys just reported earnings. I thought, Francois, I'd let you take a couple of minutes, summarize earnings if you want to. Or we can jump straight into questions. But feel free to give a quick summary of kind of what your takeaways from earnings were, and then we jump in with some questions.

Well, thank you, Rod. No, I think we had a strong performance since. We reported our first fiscal quarter for 2021. A strong performance both on top and the bottom line. We reported double-digit revenue growth for the first time in a number of years. Strong operating margins as well. And driven by continued very strong software growth, we reported 70% year-on-year growth in software as well as strong resiliency in systems. And our systems business returned to growth in the first quarter of 2021. So overall, we were just generally really pleased with the performance of the business. And we shared both on our October earnings call and our Investor Day in November that we felt we had reached an inflection point in the trajectory of F5 that we had made investments, both organic and inorganic in the last 3 years, and that we felt that those investments would start to pay off. And the data point for Q1, I thought was a strong validation of that change in trajectory, and the strategy is progressing in the right direction.

That's great. Okay. Thanks, Francois. With that being said, I think what I'd like to kick off with is just the strategic vision here. I think the question on F5, and you've started to execute on the vision for future is what is the future of ADC. What's the future of the company look like given the cloud's coming in, we have hybrid cloud and so on? So I wonder if you could talk a little bit about NGINX, Shape and Volterra, these acquisitions you're doing, and how they stitch together into a strategy for the company?

Yes, Rod. So let me pull up a little bit talking about the future of F5. Our future is really about the future of applications, and the opportunity is enormous as far as we see it. If you look at the world of applications today, Rod, it's a little bit of -- think of the old -- I come from the telco world as you know so think about the old Public Switched Telephone Network what we call the PSTN and how we made phone calls 60 years ago. You'll have scores of people in rooms, switching literally manually switching your call to get to the right destination. And if we were still doing that today, we would not be making the billions of calls we make from our mobile phones every day. While the world of applications, in some ways, live a little bit in that manual world that we had in telephone networks 60 years ago in that behind the pretty applications that we see on our screens, there are scores of people that are manually stitching these applications together, and app developers and app owners spending 70% of their time worrying about this firewall, this language here. If I want to go into that cloud, I have to switch this cloud to this private cloud and this network and this BGP configuration. And that's kind of the world today. And the world that I think we're going to be, if you fast-forward in 5 years, is a world where there is a lot more automation that is brought to this and when you think about F5, we aspire to be the company or one of the companies that bring a lot more automation to deploying, delivering, securing and increasingly enhancing the performance of our applications. And that's our vision for adaptive applications. But in doing that, I think we will serve a much larger ocean than the ADC market that we talked about before. So that's kind of where the company is going, and you'll see how these acquisitions build up to us being able to fully live that vision. So if you look at what that means in terms of the role we will play in application, one is, we will continue to be, I think, a major force in the delivery and security of applications. Except that, we will do that for any application anywhere and we will do that in all consumption formats whether it's hardware or software or SaaS or managed services, we will have a breadth of offering for security and delivery that will be much larger. Number two is, we will probe a strong force in the delivery of security of modern applications. So if you look at F5 history, we were very strong in traditional applications. But we will be playing that role increasingly for modern applications, and that's already playing out today. And number three, we will increasingly become more of a platform play that leverages AI consistently to consistently improve the security posture and the performance and even revenue performance of applications going forward. So our role is going to change substantially. And if you look at the business model, Rod, it will be majority software subscription in SaaS. We will return to double-digit earnings and double-digit revenue growth on a consistent basis. And that's how the business model is evolving. And so the role that the acquisitions to date have played into this is NGINX has accelerated our presence in front of modern applications and is allowing us to offer all these new services specifically for APIs that modern applications require. Shape has accelerated our ability to protect not just access to an application but how an application is used, and we use machine learning with Shape and AI to constantly improve the security posture of these applications. And Volterra will allow us to deliver all these great capabilities on a SaaS basis at the edge of -- and closer to users, where increasingly, our customers want to insert security and delivery. So it will fundamentally give us ease of insertion in SaaS. So that's kind of how the company is transforming and how these acquisitions are playing into that transformation.

Okay. And then one thing I wanted to ask you about, Francois, is as we've gone through COVID and all these lockdowns, one of the things that's really emerged from this is this focus on security. Like every company we talk to, every borrower we talk to says that security just continues to get more and more important, particularly as the threat surface has changed, and we're all working from home and so on. I'm curious, when you think about the balance between delivery of applications and security of applications, has COVID changed that for you at all in terms of balancing? Can you talk about -- is it a 50-50 split between the 2? Or is it more delivery with 2/3 delivery, 1/3 security? How do you think about the split of those 2 things strategically?

Well, the first way in which -- so F5 is unique relative to other companies in that at a core, we are -- we have built the best, frankly, the world's best proxy technology. And proxy being as a technology that enables us to look at application traffic at the finest grade level at the most granular level and manipulate that application traffic to make sure applications are always on and always secure. And so you use proxy to build delivery capabilities and build security capabilities. And frankly, those things are actually synergistic. So the data and telemetry we get from our delivery engagement increasingly make our security better and also vice versa. So we see both are really critical for the future of applications. And our customers don't think of it so much as delivery versus security. They think of it as application experience and how they improve the application experience. Now if you look at the last 12 months in the pandemic, yes, we have seen an increased demand in security because as most customers move to digital channels for revenue retention, for customer loyalty, for all of their basically interactions with the outside world, fraudsters always moved to these channels, and so the stakes are higher, and fraud continues to accelerate. And so we are seeing faster growth in our security business than in delivery, if we were to split it that way. And that's been a trend for the last few years, but certainly, COVID accelerates that.

Okay. That's great. And could you -- on security, there are just so many -- it's such a broad topic. Now you're talking about applications security, but could you dig into that in a little bit more detail and kind of help me understand or audience understand what parts of security you might be interested in? And what parts maybe wouldn't interest F5 at all, it wouldn't really fit in with your strategy?

Well, Rod, our belief system around that is we think that the most important problem in security over the next decade is about application security. In the same way that endpoint security and network security in the last 20 years were really important and it's because there is so much at stake in the applications that we think the most sophisticated and most damaging attacks actually happened at the application layer. So that is going to be our focus. You're not going to see us go focus on endpoint security or go attempt to be -- to try and dominate in network security. That is not our focus. We also don't intend to try and become the security supermarket where, hey, you can come at F5 and buy all things security because we don't believe that, that's how large enterprises buy and that we don't believe that's how they look at the problem. In the case of large enterprises, highest efficacy matters, and they don't want to compromise on that. And we think they're going to go to the players that give them the highest efficacy. So what you will see from us, Rod, you will see us continue to focus on protecting application traffic and protecting how applications are used once people are in these applications. Now that problem, by the way, is about $8 billion today, and it's growing fast. So we expect it to be $15 billion in the next 3 years. So it is a very large ocean for us to surf on, and we think the problem is going to continue to morph. So that's where we intend to focus and continue to -- but make gains in that market and, hopefully, grow faster than the market.

Okay. That's great. And then the other thing I wanted to dig into is the Horizon 2 target's a little bit -- just talk a little bit about particularly the software growth targets because I guess it's easier to see how those growth targets could get hit in the short term, although you guys are admittedly, you're doing well on software, as you said, in the quarter -- in the last -- really the last couple of quarters. Growth has been good there. But could you talk a little bit about visibility on that? Like maybe not visibility, but how do you think about that growth coming together? Anything you could say that would help investors feel like that's an achievable target as they look out the next 12, 18, 24 months?

Yes, Rod, let me start with that one and then see if Francois wants to add anything. But I'll start just recapping what we actually said about our software targets that we outlined at our Analyst Day in November, and that was that we split things between Horizon 2 and over a longer period of time. Within Horizon 2, we expected a compounded annual growth rate of 35% to 40%, so that's including FY '21 and FY '22. And what we talked about in Q1 is that, that was going to be 50%. We actually ended up doing 70%. And so that was fantastic. We also talked about software as a percent of our total product revenue mix getting beyond 50%. And so in the last quarter, we did 38%. A lot of that came from a very strong hardware growth rate of positive 5%, but we're really happy with the direction that, that is heading. Over a longer period of time, so circa around 2025, we talked about software growing at a compounded annual growth rate of 20%, with the vast majority of our product revenue at that point coming from software, are being 75% of the total product mix. During the Q1 earnings call, we wanted to highlight to everybody that coming up in this quarter, we expected to be below that range, really mostly driven by the challenging comp that we had from 96% growth in the year ago quarter. And so nothing to do with any of the dynamics where we're seeing great momentum in the software business, but just because of the difficult comp, we wanted to make sure that we let investors know that we were likely going to be below that range, even though we're trying to be above. But this is not an indication of anything longer-term trend going forward. We still feel very comfortable about the Horizon 2 and the longer-term guidance that we've given. You talked about some catalysts, and I'll split those out between near-term and long-term catalysts. So near term, NGINX is performing quite well for us, and that's coming off the back of both the legacy as well as some new products that we've been working on since the acquisition. And so Controller, we're seeing a lot of momentum in the pipeline with Controller as well as App Protect. We're also seeing strong growth in our subscriptions. And we talked about that we hit an all-time high in terms of number of multiyear agreements in the latest quarter and then very strong public cloud growth as well. Some of the new catalysts that are near term are subscription True Forwards that we talked about associated with our multiyear subscription agreements. Modernizing our BIG-IP portfolio and splitting that monolithic codebase into a modular codebase. New Shape use cases that are starting to emerge, and then also beginning to touch on edge services that we really expect more out of the long term, but some of that will come in Horizon 2. With the growing application, security demand that we're seeing, that continues to be a fast contributor to the overall product revenue growth in software. And so all of those are more near-term catalysts. Over a longer period of time, we do see expanded use cases for NGINX that include security and API management. We see new Shape offerings, particularly using some of the Shape technology to expand our analytic capabilities and some application performance management capabilities. And then finally, we are expanding the reach of our entire portfolio through Volterra that Francois mentioned before. And so all of these are long-term catalysts that make us feel confident in both the 35% to 40% in Horizon 2; and longer term, 20%-plus growth over a long period of time. Francois. I don't know if...

And just to clarify -- oh, did you want to say something there, Francois?

No, no. I think -- well, Frank, you covered everything so well. Just on BIG-IP, I would -- because that has carried the majority of the software growth in our Horizon 1. And so to the question around, hey, can this continue? We absolutely see BIG-IP software growth continuing, largely because what we have found, Rod, I think one of the learnings over the last 3 years is, as we have removed the friction in consumption of BIG-IP in software, it's just customers are consuming more of it and finding use cases, and we've removed the friction, a, because of a bunch of things we've done on the technology, making it lighter weight, reducing the footprint, easy to configure, easy to automate, easy to consuming to cloud, doing all these cloud integrations, but also because we've made it easier to consume from a commercial and procurement perspective where customers just have a lot more flexibility to port their licenses from this environment to that environment, don't have rigid forecast, have moved from CapEx to OpEx. So all of those things have just removed a lot of the friction, and we're seeing just customers consume more. And that trend, I think thing is just going to continue in the case of BIG-IP.

Okay. Great. And one thing you said, Frank, I wanted to come back on was the True Forwards. You said that's a short-term driver. Do you mean the next couple of quarters? Or how long do you think True Forwards sort of are a part of the picture?

Actually, Rod, I think it's just starting more, call it, over the last 3 quarters and a trend that will continue, but something that will be a near and a long-term catalyst, but just something that we see more immediately in that regard as utilization continues to outperform that initial year and you get a True Forward in the second year and then the third year.

Okay. That's great. Thank you. You guys sounded positive on the earnings call on enterprise demand, what you're seeing in the enterprise environment. And I thought, well, maybe that's isolated to F5, but Cisco's sounded pretty good today, too. So just wanted to circle back on this and see if you could elaborate on your feelings on enterprise demand. What you're hearing back from enterprise CIOs about their budgets this year? And maybe also kind of how you think the trajectory of spending goes this year? Does it accelerate a lot at the end of the year? Does it stay pretty strong at the beginning of the year? How do you see that going?

I think that generally, we think the macro environment has been healthy in terms of spending. We -- I wouldn't say that we have seen particular pressures there. But I think it also has to do with not just how much enterprises are spending, but where they are spending it, and we feel we have positioned ourselves in critical areas of spend. So if you -- first, if you look at security, customer -- like fraud is increasing. Their attack on applications is increasing, and so we don't feel that our customers are really constrained by budget. If we have any constraint, it's really the -- getting the physical access to customers, getting with them, doing proof of concept, so they can validate the technology, those kinds of things. But security budgets, I think, are healthy, and we're seeing that. And if you look at NGINX, we're -- in NGINX, we're in a market that is growing at 30% per annum. And so the -- and we're a disrupter in there. So the spend opportunity from macro -- on the macro is there. And in the case of BIG-IP, what we see less of is a couple of years ago, we were seeing a lot of customers really pause around their architecture. And well, if we want -- if we think everything is going to go to the cloud, well, then we shouldn't buy another piece of hardware, again, and we should stop all that. And we see a lot less of that today, where we see customers have kind of figured out their go-forward architectures. Yes, there are things that are going in different cloud environments. And there are things that they strongly feel are just going to remain on hardware. And so they're more relaxed about kind of continuing with that trajectory. And so all of that translates to environment as we see it, from the lens that we have. Cisco has obviously a much broader lens. But from the lens that we have, it's pretty healthy.

That's great. I wanted to dig in NGINX a little bit and talk about integration. I understand kind of what you're doing, you're looking to monetize it more with enterprise customers. But where are we -- can you just walk us through where we are with integration today with the existing products? And then how that should -- how we should see that proceed over the next couple of years?

Well, so Rod, we're very happy with the way the things are going with NGINX. And I would kind of start from -- at the Investor Day, we shared that our revenue at NGINX have more than doubled since the acquisition and that the deal size has increased substantially. All of that has been achieved, essentially with NGINX Plus, which was the proxy that NGINX had started monetizing before the acquisition of F5. So none of that really came from new products that we have built since. And it really came from the F5, Salesforce combined with NGINX, starting to get more penetration into the F5 customers. That catalyst, if you will, of monetization of NGINX, which is purely basically bigger distribution, that catalyst continues to grow. Because every quarter, F5-ers get more comfortable positioning NGINX with their customers. You see the participation rate of account reps that is growing, et cetera. So that is a vector of growth for NGINX, that's going to continue. Even more exciting aspect is, as you know, we made some deliberate investments when we bought NGINX, we knew that it was a platform that had enormous potential that it could be a load balance or it could be a WAF. It could be an egress controller. It could play inside Kubernetes clusters with service mesh. It could be an API Gateway. It could be all these things. But what NGINX had monetized was a very thin slice of that. And so we knew that we wanted very quickly to build the enterprise-grade modules for the other -- the 90% of other things that we could do with it, do it very quickly, so that our customers would benefit for that, and we will monetize faster. Now we haven't finished that, but we have built the Controller, as Frank mentioned, the security piece. We have now an offering in API Gateway and API management. And so now we have a new catalyst on the growth of NGINX, which is these new products that are adding to the deal size and adding to the addressable market of NGINX. And so that is essentially an accelerator on NGINX, which is one of the reasons that the quarter we just had in Q1 was the largest quarter ever for NGINX. And despite that, it's still early innings in terms of monetizing these new capabilities.