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

Hello. Thank you, everybody, for joining us this afternoon. Tim Long here, Barclays Comm Equipment hardware analyst. With me is George Wang on my team. We're happy to have management team of F5 Networks with us. We have both Francois Donou and Frank Pelzer, with us, CEO and CFO, respectively. So, really appreciate Francois and Frank, you guys being on.

I'll throw off the first question, probably to you, Francois, you could read your disclosure and then answer the question. But I want to start off. In your time as CEO, it's been real transformation at the company, some larger acquisitions, real aggressive pivot to security and software and applications has worked really well, I think. So maybe just looking into '22, '23, talk a little bit about strategic priorities for the company.

Tim, thank you for having us and giving me the opportunity to read my statement first. So before I respond, I need to get our safe harbor on record. Please note 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 these risk factors. So with that, Tim, let me answer your question and give a little context around our strategic priorities. And the bigger context is what we see happening in the world of applications around us. As you know, F5 is entirely focused on applications, application security, application delivery. But the world of application is going for a very interesting change in that if you go back to the prevailing view of four years ago, it was that -- when it comes to where applications live in production that they would go from living in a single location called the data center to another single location called the public cloud. And what we see is that is not happening. We, in fact, at F5 believe that we have entered the era of distributed applications. And it starts with applications being in what we call hybrid cloud. So if you look at most enterprises today, they have some of their applications in public clouds, in AWS, Azure, Google, some in private cloud environments, some in traditional on-premise environment and increasingly starting to leverage the edge. So a portfolio of application is distributed today. And as we move more, as we start deploying more container-based so microservices-based applications, that phenomenon of distribution is going to accelerate exponentially as different containers live in different location and environment. And as we leverage the edge, that will grow even further. And so when customers leverage all these different locations and this different infrastructure environment, it enables them to create great, like amazing digital experiences, but it brings with it a lot of complexity around networking APIs together, networking applications together, providing security to all these different areas of applications in different environments with a bigger threat surface. And so at a simple level, we see our role in that to reduce the complexity for our customers by a factor of 10. And that's a big part of our vision for adaptive applications. It's in an era of distributed applications, bringing way more automation, way better security, way better performance for applications for our customers. So that is overall where we are going. As it relates to specifically our strategic priorities this year, well, the first one is continuing to build that vision. And so to do that, we've got a lot of integrating to do. The first phase for us was to be able to get in front of all these application environments, making sure BIG-IP did all the integrations in public cloud so we could support apps in this environment. making sure that we had a platform to go into the Kubernetes space container-native environments, and NGINX is doing that and strengthening our security posture with Shape and Threat Stack and then being able to support applications of the edge, which we're doing with Volterra. So that was kind of phase 1. But then we want to create a single software stack that is consistent across all these environments so that wherever your app or your container is, you can leverage the same software stack from F5. And so to do that, there's a lot of cross-pollinating between these platforms that we're doing, and that's a big priority for us. The second priority this year is we continue to evolve our go-to-market and the effectiveness of our go-to-market for a multi-domain company. If you step back, Tim, a few years back, F5 was really a single product company calling on a single buyer persona, NetOps, in a single location, a data center. And today, we are evolving into, obviously, a multiproduct company appealing to multiple buyer personas, SecOps, NetOps, DevOps, and with solutions across multiple form factors, hardware, software subscriptions or SaaS and managed services and doing that in a way that is location agnostic. And so being able to engage our customers across this broad range, we've done a lot of things around incentives for our front-end salespeople, building a real strong revenue marketing engine to understand really propensity to buy models and be more effective at targeting customers with multiple propositions. We're doing a lot of work on commercial vehicles to make it easier for a given customer to consume multiple F5 products without too much friction. So that's kind of this whole area of go-to-market, creating way more efficiencies is a second big priority for us. And then I would say the third one is continuing our penetration of modern applications, which are growing extremely fast. And NGINX and Volterra are a big part of how we're going to be doing that.

Okay. Great. Francois, thanks for the overview there. Maybe we'll get into some of the specific offerings here. We'll start with software. I think one of the big moves has been just security overall for the company, both application and other securities. So talk a little bit -- I think it's about 35% of revenues currently. So can you talk about how important this is to the F5 story? How are you winning share? And what are some of the real key verticals where you see that growth continuing?

Thank you, Tim. So yes, it is really important, as you saw partly from our last earnings call. Our growth in security over the last three years, compound annual growth rate has been around 38%. So very strong growth in security. The reason we think we're thriving in security is -- I think there are a couple of things. First is we are focused exclusively on application security. So we're not trying to be category leaders in multiple categories of security. But in application security, the breadth and depth of our portfolio is unique around application firewalls, [ block ] detection, fraud mitigation, API security, DDoS protection. We're unique in being able to protect both how an application is accessed and how it's used and increasingly being able to do that in a way that's location-agnostic. So that's a big differentiator for F5, and we use AI and machine learning models to have real-time sort of best-in-class efficacy around stopping attacks. The second factor is we're really focused on being able to deliver that capability to any application, whether it's container-based or not, whether it's in the public cloud or not, whether it's at the edge or not, but really being able to deliver to any application anywhere. And the folks we compete with are more vertical players that offer their solution in their infrastructure, in their points of presence. And so it's more of a vertical stack versus F5 going at it as a horizontal plane that cuts across platforms. And if you think about it, if in fact, the world is moving more and more of the distributed applications that are not in a single location. Then it becomes really important to have a software security stack that can be in front of your applications, regardless of where it resides. And that's where we're seeing traction with F5.

Great. Thank you. Francois, it's George here. Can you talk about the growth in the container-based applications? You touched on one of the pillars, which is the container-based environment, micro services-based as distributing environment in different containers, especially regarding to the NGINX. So do you see additional opportunities beyond NGINX in the next few years within the Kubernetes environment?

Yes, we do. We -- so I would say we love the growth of container-based applications at F5. And I'll say why. So the first thing is it is giving more flexibility, more efficiency actually for developers. So it's creating more growth in applications. So containers is going to be way many -- way more workloads to protect and to secure in the future, and that's a good thing for F5. The second thing is as these containers get distributed across multiple locations -- and even if they're in the same locations, but you have these clusters with multiple containers, the more security and delivery services east west within that application, within those cluster containers that need to be delivered. And NGINX is really taking a leadership in the market around these services, API service mesh, API security, egress controller load balancing, all of that in these Kubernetes clusters. And so we're seeing tremendous growth as a result of that. But it won't stop with just the growth in NGINX. One of the reasons that we made the acquisition of Volterra was because Volterra built essentially a distributed Kubernetes platform as a service. And so it allows people building container-based applications to deploy their containers to Volterra locations or other locations, but do so in an automated way. And so we expect to attract more workloads, more container-based workloads in the future to the Volterra platform. So I'd say Volterra and NGINX for us, George, are going to be the two platforms that allow us to take advantage of the exponential growth in container-based applications.

Great. Thanks.

Thanks, Francois. Frank, maybe we'll get you involved here a little bit. Could you talk about -- I guess it's a little bit different. You have all three different revenue recognition models in your software business, so it can be a challenge at time. But give us a little color on the impact you're seeing from the multiyear subscription renewals as you look forward and maybe combine in with the renewals, the true forwards? And how does that kind of play into the longer-term growth trajectory for the software business?

Sure, Tim, and thanks for the question. So as you've seen over time in the addition to sort of shifting from hardware to software for us, we've seen customers desire to shift from perpetual software to subscriptions. And a lot of that is based off the flexibility and assumption that those models offer our customers. And so in FY '21, subscriptions were 78% of total software revenue, I think, 80% in Q4. And as you mentioned, we've got multiple different models running through there. We have both ratable as well as term-based subscriptions. And the ratable while small, it's a portion of the revenue that is growing strongly, and that's driven by some of the managed services that we've got now with Shape and Silverline as well as going forward services that we'll be delivering over the Volterra platform. On the term subscription agreements, it's -- we include annual and multiyear subscriptions in that term subscription agreement. And those are comprised of true forwards, meaning for the multiyear subscription agreements, we look at the consumption that was used in year one, and that becomes a level for years two and years three and then we look at years two, and that becomes the level for years three. And so you get sort of a natural escalation in revenue, assuming that the consumption is growing within the base, and that's what we've been experiencing so far. Specifically on the renewals of those multiyear subscription agreements, you actually enter a new cycle of revenue recognition. And so there is an upfront component to that product revenue, again, which we said will be a bit more meaningful as we get beyond -- in the first -- into the second half of FY '22 and beyond, really reflecting 3 years ago when some of those consumption models really started to take hold. And so we like what we see in the true forwards. We like what we've seen so far in the ones that we have renewed for those multiyear subscription agreements. It does provide us visibility on consumption, which is a leading indicator for those renewals as well as the future potential usage. And so we are really, really excited by the growth that we are seeing. And we talked about in the Q4 call that FY '22 software growth, we did expect in that 35% to 40% on Horizon 2. And all of these factors bode well to what we talked about for our long-term model when we met a year ago from the Analyst and Investor Day as well as what we updated post the Volterra acquisition. So I think all of this bodes well for the long-term growth of software.

Okay. Great. Great. Yes. I did want to dig a little bit more on the consumption you're talking about. I think you've given some data about how long the average user would consume their annual traffic or usage or whatever, you could just update us on that. I don't think you guys really talk about retention rates, but if you were to kind of look at the consumption growing like it is in addition to these other services you're adding, maybe if you can just give some commentary around repeat revenues or something that can give us a sense as to how the value of a customer goes up over time?

Sure, absolutely. So yes, we haven't updated in a while, the sort of reduced amount of months for when customers get to 100% utilization of that initial term contract, I think a couple of dynamics are going on there, Tim. One, we've probably gotten better at the upfront level setting of what that initial consumption will be. And so I think we probably sort of steadied off in that regard. But the growth that we are seeing in these initial phases for the true forwards has been impressive. And I think that does bode well for the starting point for where you start the next term where you sort of ended in year three. So the second term or in year four of those renewal cycles, we're really happy with the initial ones that we've seen take place, and we'll have more data points as we move forward over the next, call it, 4 to 6 quarters. And so all of that bodes well to the growth that we see in those initial terms. I think what we've also mentioned is that we have probably 500 or so of these as of the end of Q4. And so with 20,000-plus customers, there's lots of greenfield in front of us to adopt additional multiyear subscription agreements within the base of customers. And so all of those factors go into the growth that we see over a longer period of time in software.

Okay. Great. Great. I did want to pivot for a minute to hardware. And obviously, a company like yours with 80-plus percent gross margins. Your hardware is very software-intensive anyway. But obviously, the last year or so, we've seen a big change in outlook there. So maybe, Francois, if you want to jump in and talk a little bit about the hardware business? And do you think it's a new paradigm where we're just seeing so much growth in bandwidth out there that maybe the industry thought a software-based solution was going to be adequate, but maybe it isn't. Maybe if you can just opine a little bit on what's changed there and how sustainable it is?

Yes. I think the biggest change, Tim, is the pandemic has accelerated the amount of time and things that we do online basically. And all of these things that we do around banking, exercising, shopping, collaborating and working, we all do that through applications. And these applications, a great majority of them run on F5, whether it's BIG-IP hardware or software, they run on F5, and they are growing faster than we would have thought. So I think the thing that has changed is the BIG-IP franchise is -- overall hardware software combined is doing better than we thought. And I think that's largely driven by -- take any bank.com, retailer.com, e-commerce is exploding and take a lot of the SaaS providers that provide the collaboration platforms that we use or some of the SaaS services that we use. A lot of these SaaS providers have their own cloud and F5 is in their cloud. And so now that generates overall growth for the BIG-IP franchise. We think it has skewed in fact, towards hardware in the early days of our growth because when the majority of your customers have a hardware installed base and capacity needs are sudden, the easiest thing is to increase the capacity in the existing environment. Over time, we think customers will continue to want to move to software because it's more portable, it gives them more flexibility. It's easier to consume. But that arc of shifting hardware to software for some customers is longer than what they themselves would have anticipated. But I think the macro change when you're asking is really for us the change in application traffic driven by pandemic-induced digital behaviors.

Thank you.

Thank you. First of all, Frank, I'd like to pivot to the services a little bit. So you guys get a larger percentage of revenues from services and maintenance. So how do you expect this business to grow over time? Particularly given the transition to [indiscernible] and SaaS-based consumption?

Absolutely, George. So yes, what we've actually talked about is that over a longer period of time, this is low single digit to flat. And it has nothing to do with the health of the services business declining, quite the opposite. It is an incredibly healthy business. But just the dynamics of the revenue streams that we see growing contribute less to services over time. And so when you break that down, the perpetual business from software as well as from our systems business continues to have a strong attach rate of maintenance. And for the hardware piece, that generally has got some life to it before you go through a refresh cycle and then that whole cycle starts back up. On the software side, that actually can have decades worth of maintenance streams that we're very early in that to sort of prove that out. When you take a look at the term-based software that we are signing, that has an allocation to services, but it's a lower allocation than the perpetual side and the components of us that are ratable have 0 allocation to services. So just the natural math as it flows out, is that, that services business ultimately goes to low single digit or flat, and I think we experienced that in Q4 of this last quarter. And that's why we talked about in our Horizon 2 and long-term model, the service growth decreasing. At the same time, you have a pickup in the product side of the business. And so the overall growth is not dependent on the services revenue stream.

Yes. Francois, I did want to touch on kind of M&A -- combine M&A and operating margins together. I think there's the plan to start recapturing some operating margin that was lost as a result of the several acquisitions that have been done. Could you talk a little bit about the balance between adding new technologies, which you can bundle and leverage across this platform that you're building with desire to continue to grow that operating margin?

Yes. So Tim, the -- first, overall, I would say -- I think as I was sharing earlier, we have a lot of integration work that we're doing across the different platforms to really create that consistent experience for our customers, which we think will accelerate the value of our platform and the value of a universal platform that delivers app delivery and security to any app anywhere. And I think a lot of those elements -- element of work on cross-pollinating are organic. When it comes to how we think about the operating margins, we said at our Analyst and Investor Meeting that we really wanted to use the Rule of 40 as a guide for how we balance our growth investments and yet maintain operating margins. We were able to -- we thought we would get to that Rule of 40 in FY '22. We were able to get there a year earlier. And I think going forward, we're going to continue to use that as our guiding principle and balancing the things we need to do to invest for growth with, of course, maintaining the level of profit that we want to have.

Okay. Great. Maybe just one more for me here. Francois, I would just want to go back to software and maybe you could talk a little bit about -- I think there was a comment about NGINX being in 50% of multiyear subscriptions. Can you talk a little bit about your ability to cross-sell all these different software solutions that you have and how the success of that has been so far?

Yes. So NGINX has had its own growth, if you will, in a stand-alone proposition, largely because we have -- because more and more people are putting these container-based applications into production. And inside of those Kubernetes environment, NGINX is really the kind of programmable software that cover multiple needs. A little bit like BIG-IP has done in a data center, NGINX does that in a container-based environment for multiple needs of an application. Now -- but if I extend beyond NGINX, what we're doing to be more effective at selling these multiple software propositions, I've talked about the things we've done with the sales and marketing teams to have the right account coverage, the right mix of specialist teams, the right engines, AI-driven engines to be able to generate the best possible leads for our teams and ensure that they have the best productivity possible. And we are constantly tweaking these things. And I think we're going to see even more productivity in the future. The other important aspect of this, Tim, is creating commercial and consumption vehicles, that allow F5 customers to consume multiple F5 products without too much friction. And we started these multiyear subscriptions with BIG-IP. We added NGINX, and we've seen that, that has also accelerated the growth of NGINX and they're part of a big portion of these agreements today. And in 2022, we're placing focus on adding Shape, adding Volterra to these commercial vehicles so that customers can add these capabilities without going through a big contractual cycle, a big procurement cycle. And that alone makes it much easier for the sales teams to engage and close deals with customers.

Francois, just the last one from me. Just kind of broadly on capital allocation kind of between buybacks and deal flow. You touched on the M&A deals in the past. Recently, you guys have been more acquisitive. I guess, as you guys digest those deals, any thoughts on the kind of shareholder return kind of especially on the buyback front kind of going forward?

Yes, you want me to take that one, bud?

Yes.

Yes. George, we haven't diverged from what we talked about at our Analyst and Investor Day last year, where we're very -- we're taking very much of a balanced approach to this. As we discussed, we've got a lot of work to do organically and M&A is part of our strategy, but not a fundamental part of our strategy at this point. We've got a lot of the components that we need. And we did an accelerated share repurchase program post the Volterra acquisition last year. We talked about this year doing another $500 million a bit more ratably over the quarters. And then going forward, FY '23 and beyond, that we would continue to do 50% of our free cash flow to share repurchase and returning capital to shareholders that way. Dividends have not been a strong component of our return unless something changes with tax policy. Our preferred method in a tax-efficient way is going to be through buybacks.

Okay, thank you.

Okay, guys, I think we're just bumping up against the end here. So I really appreciate the time and the insights here. Glad to hear things are still looking pretty strong for you guys. Enjoy the rest of the conference, everybody else, and thanks for joining and looking forward to seeing everybody in person soon.

Thank you, Tim. Thank you, George.

Thank you. Francois, Thanks, Frank. Thanks, Suzanne.