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

Great. Good afternoon, everyone. Thanks very much for joining us. Today, I'm hosting Francois Locoh-Donou, President and CEO of F5; as well as Frank Pelzer, EVP and CFO. I prepared a list of questions. And as always, if you want to ask your question, please log into the Veracast system that you got a link through e-mail and just submit your question there, and I'll be very happy to deliver the message or deliver the question to management. So with no further ado, I'd like to first start welcoming our guests, Francois and Frank, and ask the first question.

And the first question is high level. Last year, you outlined for us the steps you're taking in order to move the company from an ADC business to an application infrastructure software business. Can you elaborate on what does it mean? Why is there a need to migrate the business from one, kind of the legacy, to the new area? I'm addressing here maybe those investors that are not familiar with the move that you have taken over the last year. So what is the change that, Francois, you're taking the business through? And can you give us an update on the progress?

Yes, Tal, absolutely. Thank you for having us today. And Tal, before I respond, I need to get our safe harbor on record. Please know that our discussion today may contain forward-looking statements which involve uncertainties and risks. Our actual results may differ materially from those expressed or implied by these statements. Please see our SEC filings for more information on those risk factors. With that, Tal, let me talk a little bit about the transformation of F5. So if you go back, I want to say 4 to 5 years ago, F5 was really in the ADC market, what's called application delivery controllers, which was a $2 billion market that had started to plateau, the traditional ADC market. So it was flat to very low single-digit growth. And there was an interrogation, Tal, around F5, around what was the future identity of the company? Did we want to become an ADC -- continue to be an ADC company? Were we going to be a security company? Were we going to be a networking company? Were we going to be relevant in the cloud? There were all these questions surrounding the company. Then the thing that became very clear for us at the time was that if you stripped all these categories to the side, the thing that F5 does best, and I think better than any other company on the planet, is deliver and secure applications. And our strong feeling was that if we continue to do that, not just for traditional big applications in a data center, but for every app anywhere, F5 would have very significant growth opportunities ahead of it, and then the company would transform substantially. And so our transformation is really about that. It's really about securing and delivering every app anywhere. And of course, as we embarked on that transformation, the world of application is changing rapidly, right? Applications are moving into public cloud. Increasingly, they're going into multi-cloud environment. Applications are becoming more distributed because they move into containers and microservices. And applications are moving to the edge. In the world of security, the types of attacks on applications are changing, the types of fraud on applications is evolving quickly. And what you have seen over the last 4 years, Tal, is that with every one of these changes in where applications is going, F5 has adopted, either organically or through acquisition, to become quickly relevant to these new application challenges. And so if you look at where the company is today, we're basically becoming the leading player in app delivery and security for all environments, basically for any app. Whether it's a containerized app or a traditional app, whether it's an up in the cloud or not, whether it's an app at the edge or not, we're basically now have the portfolio of assets, of technologies, that allow us to deliver these security and delivery services to all of these applications. So if you translate into what that means for our business model going forward, it means, first of all, that we are now -- we used to be in a $2 billion market, we're now exposed to a market that is $14 billion and will probably double by 2023. And as we grow into that market, we're becoming -- the majority of our revenues are going to be software and SaaS. In the past, there were hardware. We're going to continue to become more security-centric because more of these challenges are security-centric for the company. And it also positions us to have sustainable double-digit earnings growth in the future. So that's kind of the category evolution of the company and what it means for our financial performance over the years to come.

So I want to zoom in on certain things you mentioned. What's the future for hardware? What's the future of your appliances? Does it have a life 5 or 10 years down the road? Or is it going to be replaced completely by software solution?

It will not be replaced completely by software solutions, Tal, because there will always be demand for a number of use cases where customers want to have physical control of their infrastructure, and in a number of cases where they actually want to have hardware acceleration. So if you look at the demand trends that we're seeing on hardware, this year, our hardware started growing again. Frankly, we were a little bit surprised by the extent to which it is growing. But -- and I think when you unpack that, there are a couple of transient effects that I would call one-off, but there are also some longer-term effects that are sustainable and are going to be there for a while. The one-off effect is there's a little bit of snapback because, in the early days of COVID, customers really suppressed the demand because of the uncertainty. And also, I would say, especially in 2019, there were a lot of customers that wanted to rethink their architectures, and they thought maybe they were going to be all in on the cloud, and so therefore they may not need hardware again. And I think some customers are rethinking that now. They're much more comfortable with the fact that the world is going to be multi-cloud or hybrid cloud, and they're going to have apps on-premises for a very long time for the vast majority of enterprises. So that's created a little bit of a snapback in demand from depressed hardware in '19 and '20. And I would say that snapback is, I would say, transient. But the things that are -- there are other factors that are more longer term. And I would say there are 3 big factors there. One is the growth in usage of applications is just, post-COVID, we have all gotten used to consuming, shopping, banking, consuming more online. And so both external-facing applications for an enterprise and internal-facing applications, like collaboration tools, are being used way more than they were in the past. And I don't see that stopping. That's not a thing that's going to stop with people returning to the office. It is a way of living and a way of working that is going to persist well beyond this year. The second effect is that more of our hardware business has shifted to security, and the demand for security hardware continues to grow for F5. And then the third effect is that we are also seeing a transition from 4G to 5G in service providers, and that's creating capacity upgrades on service provider networks which creates demand for hardware for F5. So those things are more sustainable drivers, which is why even though we're only 2 quarters into an 8-quarter, into our 2-year horizon, we have already said that we expect our hardware performance over 2 years to be better than what we thought only 6 months ago.

Is there a number to the hardware? Last quarter, it grew 17%. System sales grew 17%, which is way, way higher than what we have seen in the previous 3 years. And you said some of the factors are temporary, some of them are longer term. I'm sure that -- and again, just from listening to you, I'm sure that the minus 5% or minus 7% we've seen before is too low and the plus 17% is too high. Is there a number in between where you think that hardware could sustainably grow in the long run?

Well, no. We haven't said that, Tal, yet. I think we want to see a little more runway in terms of these new dynamics around our hardware to really unpack how much is a bit of a one-off and how much is -- are the things that are going to go on for a long period of time. Clearly, for this Horizon 2, which is FY '21 and FY '22, we feel it's going to be better than the minus 5% that we thought would be. That's very clear. But I think beyond that, we need a bit of time to put a position on that.

So the flip side was software grew 20% this quarter. Investors were a little bit disappointed because you expected for the year, 35%. So can you talk about, first, the drivers for growth? 20% on its own is good. Maybe it's below expectations, but it's a high level. So can you talk about the drivers for software growth? Where do you see the strength? And second, how do you go back? You reiterated your target for the year. What are the drivers that drive you to go back to the 35% for the -- to end the year with 35% for software?

Yes, Tal, let me take that one. So as you said, that growth came on the heels of 70% software growth in Q1 and an extremely tough comp last year of 96%. So the 20% is very respectable. As we said on our call, it may have been $5 million to $10 million light of where our internal expectations were given just some of the dynamics that we saw between the businesses. We also reiterated that -- at or about that 35% for the full year, which implies 30% in the back half of the year, and there are several factors that lead us to that. We will continue to see some lumpiness in the software business until we get to scale and complete that transition to a more ratable model, and that's still going to take some time. But we made tremendous progress in our transition. I think 3 years ago, when you look at software as a percent of product revenue, it was in that 10% to 15% range. And over the last 4 quarters, it's averaged about 38% of product revenue. So great, great transformation in that regard. And the software business has grown from about $100 million of run rate 3 years ago to over $450 million where we sit today. So while we're growing, and we're going at a rapid clip, we're still at that point where $5 million or $10 million can swing that growth rate, which was the case in Q2, where we just had some larger opportunities that were pushed out while our customers were facing some of their needs to grow more rapidly on capacity for what they know, which was in the hardware side of the business, as opposed to some of the new architectures on the software side. You asked on where do we get that visibility or where do we see those growth factor's coming from. Well, we look at it, we build it up each quarter before we talk about what we -- what our expectations are for the coming quarters. And we start with what's ratable. And while that's small today, this is the portion of the revenue that is growing quickly. And it's driven by Shape and Silverline managed services, as well as going forward, will be more by the Volterra platform when we look out kind of beyond Horizon 2. Then we add on top of that the renewals and the True Forwards coming from the multiyear subscription agreements. Now the renewals really don't take place substantially until the back half of FY '22, and I've said that a few times. But on the True Forward side, we're already in year 2 and starting in year 3 for some of these, and we really are seeing continued growth in utilization for the elements of the services that are contracted as part of these multiyear subscription agreements. And so that gives us a lot of insights into how these will shape in the renewal cycle coming up in FY '22. The True Forwards help in FY '21, but it's really the renewals that help more in FY '22 and beyond. And then the last component is the pipeline. And there's always going to be a certain amount of business that's identified prior to closing the quarter, and we get that visibility through our sales force and our customer interactions. But when we look ahead to FY '21, in addition to the opportunities related to the ratable and multiyear subscriptions, we do expect to see a material growth in contribution from product innovations that we introduced over the last few years that are starting to reach scale in the market, such as NGINX Controller and NGINX API Gateway Solutions and the extension of some of the web application firewall offerings in our modern apps environments through NGINX App Protect and edge delivery models on the Volterra platform, again, when you look beyond Horizon 2. So all of those are things that factor into our confidence in the software growth rebounding from where we saw at the end of Q2.

Got it. Got it. So I want to go back to a higher-level question on this because it's important. I think if I ask the average investor or analyst as myself, where -- what are the concerns? What are -- we understand a few things. Number one, F5 is the leader, and this is not being in dispute. Number two, there is a need for the product, this is also not being disputed. When you develop applications, you need the solution. I think there are 2 areas where we are -- we need answers or we are kind of looking and researching the market. Number one is, the migration from appliances to software, what are the implications for revenue? So when you look at your customers, when they migrate from appliances to software and they stay with F5, what happens to contract sizes? What happens to revenues with you? And the second, what is the risk from cloud-owned tools for load balancing or for basic ADCs? So maybe I'll start with the first question. What are the implications for revenues or for deal sizes for those customers who are staying with you but migrate from one type of solution to another type of solution?

Yes. So why don't I start with that one, and then I'll let Francois pick on in the back half of your question, Tal. So we've been successfully growing our revenue while we've been transitioning to a more software-oriented model over the past several years. So in fact, when you take a look at our product revenue, it's gone from flat in FY '18 to 3% in FY '19 to 5% in FY '20. And first half, we're delivering 21% product revenue growth. And that's while we've been in this transition, as I talked about, from 10% to 15% of our product revenue coming in the software, to now 38% over the last 4 quarters. And it's true within our BIG-IP family that we price software at about 85% on the cost of a similar system to be gross profit neutral. But what we have seen is that the actual deal sizes are larger in some of these software deals, and so it more than makes up for that revenue delta and actually has more gross margin contribution. So that's for the first half, but I'll let Francois address the second half.

And I think you covered it well. Tal, what was the second part?

The second part was, is there any new competition to your solution? If I look backward, you killed the competition, let's say it in a simple way. You're the market leader, no doubt. When I look forward, the question is, as traffic migrates to the cloud, what about the tools provided by the cloud companies, by GCP, by Amazon? Are they competing with the tools that you are providing?

Okay. Very good. So let's break that down because, Tal, we are now no longer just in the ADC, the traditional ADC market. We play across a broader range of markets. And so competitive dynamics are different from one to the other. So let's start in -- where you said we killed the market was originally with BIG-IP, right, and that's the platform that supports all traditional applications out there. That platform does not compete at all with cloud providers. And as evidenced by the fact that the vast, vast, vast majority of enterprises, when they are on a BIG-IP platform on-prem and they're migrating to a public cloud, they absolutely stay on BIG-IP. And it's a very quick decision because there is so much around the way that the application is architectured and features that are needed, et cetera, that the business case for just staying on BIG-IP is very strong. which is why our cloud business is growing so fast, which is why we have these partnerships with cloud providers because customers just want that consistency and they also want the security that comes with BIG-IP. So there is no competition there. And frankly, the competitive dynamics for us are no different than they were on-prem in that scenario. And we've done all the work of integration with the cloud providers to make that transition very easy. Then there is the scenario, it's more for where modern -- so new modern applications, kind of greenfield scenario where they are built in the cloud. And I think when a modern application is built in the public cloud, there is -- there are plenty of those applications for which the native tools from a public cloud provider will be sufficient and it will be good enough and they will use that. But there are a number of applications, typically for large enterprise customers, where they don't necessarily want to be locked into a set of native tools and they want to be able to go multi-cloud down the road, and/or they want consistency of, say, their security policies between on-prem and public cloud. And so for those applications, our solution is NGINX, and it's an alternative to the public cloud native tools. And NGINX is growing very rapidly. By the way, 50% of the deployments of NGINX are, in fact, in public clouds for customers that want a lightweight service, easy to deploy, but also want the multi-cloud capabilities. So that's the only scenario, if you would say, where NGINX is an alternative or public cloud-native tools are an alternative to NGINX. By the way, when somebody is using a cloud-native service for the public cloud, that is typically built on NGINX open source anyway. So it's really NGINX commercial competing with NGINX open source, and that's kind of the solution set for this part of the market. And then in security, we compete with a number of other players for application security. But again, we have the broadest portfolio of application security solutions, both for on-prem and cloud applications. So we're a pretty significant player there.

Got it. I'll ask you about security separately in a second. I want to just go back to NGINX. You bought it about 2 years ago. Can you give us an update on the integration?

Yes, Tal. So NGINX is fully integrated in F5 now. And I would say I would -- I make that statement on 3 categories. Number one, in terms of systems and IT and an ability to track all things, that integration is complete. On the go-to-market front, F5 sellers have fully embraced the NGINX solutions, and so that's the cross-sell into F5 accounts is happening with strong velocity. The same is true in terms of the marketing motions that support all that in terms of demand generation and pipeline. So that integration is fully on. The product portfolio, we've done a lot. It will continue to evolve because there's so much more opportunity than what we've captured so far. So if you remember NGINX, when we bought the company, they were very early in their monetization stage, and they had a very strong open source community and a very thin layer of features that NGINX was monetizing. We made some investments into NGINX earlier to expand the breadth of monetizable offerings. We've added security. We've added a controller now that makes the deployments easier. And so we're essentially -- if you think about the BIG-IP playbook that "killed" the competitors and was very successful, it's because we consolidated a lot of functionality on that platform. But we're also consolidating a lot of functionality on to NGINX, but for modern applications. And so we have done a lot of work there, and we'll continue to add more capabilities and grow the portfolio and also continue the integrations with BIG-IP. But overall, that's going very well now.

Got it. One of your -- one of the opportunities you highlight is on security. And I want to define the addressable market. What are the areas of security that you're positioned at or you are targeting? And why? Why these areas are not others?

So we are -- Tal, we're exclusively focused on securing applications. Why that is, it's because we feel -- first of all, historically, we feel that where we have been the most valuable to our customers as a company is helping our customers solve their biggest application challenge. The biggest, most complex, most difficult application challenges, large enterprise customers have relied on F5 to solve those challenges. Increasingly, those challenges are security-related. And when you go to containers to microservices, when you go to the edge, when you go to the public cloud, those security challenges are exponentially greater. And so we're bringing all that DNA and that heritage to solving the security challenges. But we also feel that, that's where most of the value is going to be. If you look at how enterprises create customer loyalty, how they transact, how they deal with their supply chain, all of that is through applications. And so -- and by the way, you can see that also in a lot of the news around ransomware and what people are having to pay to keep their applications running. So we feel that, that's where most of the value is. And as long as we can be the leading player to secure applications, we're going to have a great growth opportunity in front of us. So we are focused on application security. That market was about $4 billion pre-Shape. We now feel that the addressable market is about $8 billion just on that. And again, that market will grow to probably $14 billion in the next 3 years. And so that's our focus. And with the combination of Shape and F5, we can now protect access to applications, but also protect how applications are used and stop certain number of fraud vectors from happening in a number of verticals, including finance, e-commerce and other verticals.

How do you measure your success in security? Is it a certain market share target or certain revenue targets?

No, we measure our success in security in 2 ways. One, of course, is growth in our security portfolio, whether that -- by the way, whether that be -- and that's in -- it's in hardware; it's in software; it's in software subscription; and increasingly, it's in SaaS and managed services. And we continue to see security become a more important part of the mix of F5, and then we also measure our success in terms of attach rate of the number of F5 customers that are going to F5 for our security solutions. And both of these metrics have been pointing north.

Got it. Sorry, Frank, you wanted to say something or no? I heard noise in the background, sorry. Another question on security was, from someone that looks to this market from the outside, it looks like what the CDN players, whether it's Akamai or others, what the CDN players say about security and what F5 is saying about security is kind of the same. Are you viewing CDN players as competitors? If not, who are your competitors? Who are your real competitor?

So I'm going to parse this into 2. In the world of packaged software and packaged hardware, meaning a customer for a number of operational reasons, which is still the predominant mode of, I would say, consumption of delivery and security technologies, that a customer wants to own their software, and whether they decide to deploy that software on-prem, in the private cloud or in the public cloud. In that world, we don't compete with CDN providers because they don't have a solution. Okay? They only deliver this as a service. Now in the world of security delivered as a service, we do compete with CDN providers. And I would say our approach is different in that, in a lot of cases, their approach is they're incumbent with a CDN and security comes as an add-on. Our approach is that large enterprises don't necessarily want to tether titer their security strategy to whoever happens to be their CDN provider, that best-in-class efficacy matters to stop sophisticated bot attacks, sophisticated fraud and so forth. And so we compete with, A, best-in-class security; and B, as you know, we now have an edge platform with Volterra that is also focused on applications. So our focus, and where we think a lot of the big issues are going to be in the future, it's going to be less about content distribution than it is going to be about application distribution. Because more and more, customers want their application to be distributed to create this dynamic experience, and the requirements for application distribution are different than just for content distribution. And so we're positioned for app security and app distribution as our primary areas of focus and differentiation against -- versus the CDN providers.

Got it. Okay. You also acquired Shape. Can you give us -- just first of all, the background. How does it help your overall effort in security? And give us an update on the progress of Shape.

Shape helps our progress on security because what we've seen with our customers over the last few years is that there were fraud vectors that I would say are horizontal or universal in terms of attackers trying to exploit vulnerabilities to get into applications. The way they do that with a retail company or financial company or health care companies is kind of the same. But there are fraud vectors that are different. When customers -- or sorry, when attackers have access to credentials and they're able to get into an application, then the way in which they use that application to fraud is very different in financial services than it is in retailers and e-commerce and other verticals. And so Shape helps us not just protect access to an application, but protect how the application is used and protect against the very specific fraud vectors in each of these verticals. So in many ways, helps us create more intimacy with the business models of our customers, but it also doubles our addressable market in application security. And so that's kind of the rationale for Shape. Shape also brought very strong AI and analytics capabilities to F5 which we are leveraging across our entire portfolio. And the progress of that integration, it's happening, it's going well. And then the progress in acquiring more customers with Shape is also going well, leveraging the F5 installed base.

Got it. We're almost running out of time. I have a question for Frank. Margins. Discuss the balance between the need to invest, and basically, your gross -- or margin targets. Can you discuss your margin targets basically? What are they? And how do you get there?

Absolutely, Tal. So after -- and we talked about this a bit at our Analyst Day in November. But after several years of deliberate strategic investments, where we brought down the margins to absorb some of the acquisitions as well as make some of the fundamental organic investments that we needed, we guided margins to actually start increasing in FY '21 and beyond. So for FY '21, we obviously talked about 31% to 32% as our guidance. And then FY '22, 32% to 33%. And ultimately, we envision operating the business sustainably at the Rule of 40. And we define the Rule of 40 as revenue growth and operating margin, not EBITDA, so we have a higher hurdle. And we want that to be over 40%. And so far, we're tracking well in the first couple of quarters, even though that was not our expectation going into end of the year when we talked to people in November. And so we're performing a bit better. And so if we see ourselves outperforming substantially on the revenue side, Tal, we do expect to sort of get the permission from our investors to continue to invest accordingly such that we can sustain that revenue growth. But ultimately, the Rule of 40 and double-digit EPS growth is what is the North Star for the business.

Got it. I have to ask you a question about the very short term. Your 3Q revenue guidance was wider than normal, and you reduced the low end of the range to account for uncertainties, that's basically -- that was the phrasing. Can you discuss the current environment? And what kind of uncertainties are you seeing in the market?

Yes. So we specifically, Tal, called out that it was supply chain uncertainties. And so with the chips that we, like any other technology vendor that's dependent on chips, we're seeing a shortage. And it was more acute going into the quarter, which is why we brought down the low end of our range by $10 million to account for that. And so far, our supply chain team, manufacturing team have managed through this well. But during our Q2 call, we noted this specifically to provide a $30 million range, not a $20 million range, to account for the reduced supply chain visibility that we saw going into the quarter and effectively lowered that bottom end by $10 million.

Got it. Great. Time is up. We have 30 seconds left, and I think we can let it go. Thank you very much, Francois and Frank. Thanks for the clarity on the numbers and the drivers. And hopefully, the rest of the year will be much better than the uncertainty that you're highlighting.

Well, thank you, Tal. We appreciate you inviting us.

Thanks so much, Tal. Thanks, everyone.

Thank you. [ And have a good day. ]