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

All right. Welcome, everybody. If you just came from the best ideas panel, I pitched F5. So you had competition with Amazon being pitched, but I think we gave a solid pitch. So hopefully, you enjoyed that. Today, I'm Meta Marshall. I cover the networking space here at Morgan Stanley. We're delighted to have F5 network or F5, not networks anymore, here with us today with Francois Locoh-Donou, CEO; and Frank Pelzer, CFO with us.

So part of what I was just talking about is the best ideas panel is the software transition that F5 has taken over the past couple of years. Obviously, you are a leading provider in the hardware ADC market. But as customers have increasingly moved workloads to the cloud, you guys have found a way to keep F5 relevant. What do you see as being F5's core value proposition in the modern application ecosystem.

Meta, thank you for having us. So let me talk a little bit about what's changed about -- in the modern application ecosystem first and then come to F5. If you go back to the belief system that most -- let me say that a lot of people had a few years back was that applications were in a single location called a data center, and they would all move to another single location called a public cloud. What we are -- what we have seen is not that. What we have seen is increasingly for most enterprises out there, applications are in -- continue to be in private data centers, either in traditional environments or more automated kind of private cloud environment, and they are also in multiple public cloud. More than 80% of our customers tell us that they are using multiple clouds today. So applications are already distributed. And what we're also seeing is that in the future, there will be more and more distributed because of the emergence of the edge and edge computing and a lot of applications being at the edge. And because increasingly, as applications get developed in containers and microservices environment, these containers themselves are deployed in different types of environments to create the more dynamic experiences that end users want. So the modern application ecosystem is really an era of distributed applications. Now to F5, the way F5 plays into that is essentially, we have turned F5 from effectively what was a traditional ADC player 5 years ago into the location-agnostic application services platform. By that, I mean, we are now able to take all of F5's software and deploy that on any cloud, including our own trial with the launch of the F5 distributor cloud, and for large enterprises, we think this is potentially a game changer because as a CIO, you can, from a central location, deploy a software delivery stack for all your applications, whether they're in Azure or AWS or on your own data center, and it's a consistent security and deliver stack, and it eliminates a ton of complexity. And so to do that, of course, we've had to do organic work. We've done acquisitions, but the net result of that is we have really positioned F5 for this era of distributed applications and being able to be the software that supports any application anywhere.

Got it. That's super helpful. One of the things that we hear from resellers is kind of the impressed ability to sell NGINX, which I think a lot of investors tend to think of as we get questions about it being freeware or open source software. And so how do you get people to pay for that. Can you just walk through what is kind of leading to the success of NGINX, what's leading to the success of the transition to kind of paid subscriptions for that?

Yes. I think the -- I understand the perception because when we made the acquisition of NGINX. NGINX, of course, has its origins in open source and which is why it's gotten such a wide adoption. I think we're approaching 500 million websites that are served by NGINX. And at the time we made the acquisition, NGINX was early in its monetization. There are a couple of things that we have done that have significantly accelerated the commercial adoption of NGINX. The first is that we have -- well, I should say, first of all, is what's going on in the marketplace, and it's really the ramp in production of Kubernetes-based applications. And so a lot of folks have -- these micro services type environment have done test and development. But as those things move into production, Kubernetes is great at container orchestration. But if you move container-based application in production at scale, you start to encounter networking and delivery and security issues that Kubernetes does not address. And so if you don't have NGINX to address these issues, you have to basically start using multiple different tools to address the API gateway problem to secure your API traffic to load balance between containers. And all of these are different tools and it creates complexity. What we've done with NGINX is consolidate all these tools into a single, very lightweight software package. And so NGINX is emerging as a natural complement to Kubernetes for deploying container-based applications at scale. So that's -- and that's driving the success of NGINX. And as a result, of course, we've seen a lot more deals over the last couple of years. And also the deal sizes are increasing. So it used NGINX used to be tens of Ks per deal when we did the acquisition, and over the last year, we've now seen a number of deals that are fixed figures and increasingly, some deals with a 7-figure deals with NGINX.

Got it. I mean it's something that is unique to F5, I think within kind of the networking or sector space is that your sales channel has been able to sell a lot of different products, even when you were just selling ADC and some of security features. How do you think that, that success factored into the decision to kind of expand the set that you were addressing whether that be shape or Volterra versus how much of that is kind of -- like, I guess, I'm trying to say how much has it factored into the decision to expand the product base versus just development that you've done internally?

So I'll start with that one. So the -- Meta, when we -- so one of the big decision factors when we're looking at making acquisitions, we've been very disciplined about making sure that we feel absolutely confident that the assets we're about to bring into F5 is more valuable into F5 than it is outside. And the bar for that is there are 2 things. Number one, that in fact, our sales channel can accelerate the distribution of the new solution. But number two, that the integration of that solution into our portfolio creates exponential value for customers. And so we've not made these acquisitions with the view that, hey, we're going to -- we were just selling 1 product, we're now going to sell 3 different products to our customers. It was with a view that all of that has to amount to a vision of how customers can deploy their applications, that's different. So if I take those 2 things, yes, you're right. On the sales and with our channel, our go-to-market teams have done an extraordinary job of taking these products that were very nascent and starting to scale them fairly rapidly. We've done a lot of enablement for that. We've modified our go-to-market. We've created new incentives for our sales teams. We've had specialists in our technical teams to help address the new biopersonas in these accounts. And we've made quite a bit of investment in marketing to have better data capabilities, better AI capabilities to basically have very strong lead generation, we call it a digital revenue engine for our go-to-market team. All of that is creating momentum on the new proposition. But the other work we've done is a lot of engineering work and integration. So for example, I mentioned the distributed cloud earlier. The distributor cloud that we just announced 2 weeks ago is the product of: a, the acquisition of Volterra, the 12 months of integration of porting the best security capabilities from BIG-IP, from Shape onto Volterra to create that vast security offering that is pretty compelling. And we've done the same thing in porting BIG-IP security onto NGINX, for example, to solve more problems with NGINX for our customers. So the organic work of integration to create 1 plus 1 equal 3 is also a big part of how we create value with these new products.

Got it. That's helpful. You've won a number of large deals with Shape. Just want to get a sense of from a security piece of the portfolio. Clearly, you guys have been very successful, but that change in buyer from maybe a network buyer to a security buyer, just how that evolution has taken place and maybe how it's changed with the acquisition of Shape.

So F5 was always addressing with BIG-IP and NetOps buyer and the security buyer, SecOps buyer. And I would say, if you go back in time, 4, 5 years ago, the motion would be that somebody would buy F5 for an ADC and then we would upsell security on top of that. Over the last several years, that has changed where buy even some -- a lot of folks buy BIG-IP security, at first, and then maybe they buy the other capabilities on top of that. So the security buyer is a buyer that F5 has been addressing. When we brought in Shape into the portfolio, we've been still addressing the same security buyer. So it wasn't a huge jump for our teams to address security -- it was a different use case and a different consumption model because it's managed services, but it's a buyer that is well known. Now Shape also brings some anti-fraud capabilities to the table. Sometimes that's the same buyer, sometimes it's a different economic buyer. But overall, what we're -- where we're focused in security is in application security. So our focus is not so much on endpoint security and network security, but we feel that the big secular forces kind of the next decade are really the explosion of applications because we're all kind of living, working and exercising digital e-mail and the critical nature of security for all these digital interactions. And so we've positioned the company to be at the vortex of these 2 big secular forces. One is applications and application growth and the other one is security. And that's where the focus of F5 is.

Got it. And maybe turning to Volterra. You guys have spent much of the last year kind of engineering that into portfolio. Just can you speak to kind of the use case for Volterra as it's getting rolled out and just how it integrates into the overall portfolio.

Volterra, now called the distributed cloud, is really -- the way it plays into the F5 portfolio is if you think about F5 pre-Volterra, our customers, if they wanted to consume F5 technology, they had to buy basically our software or our hardware. And only in the case of Shape, they can buy a managed service, but what they could not do is consume F5 as a SaaS, as a Software-as-a-Service offering. And of course, we have seen the SaaS market grow very rapidly, both in ADC and in security. So the first big kind of new thing with Volterra is F5 now has a SaaS offering and specifically a SaaS security offering for all of our application security. That's kind of the -- and frankly, we haven't been a player in that market. So we are -- we're newer to the market. We're an attacker and a disruptor, but it's a big TAM expansion for F5. The second change with Volterra is that not only we have a SaaS offering, but we can now insert our security essentially in any location. It could be an edge location, our own as points of presence and edge location or it could be somebody else's cloud. whether any one of the public clouds or somebody is on-prem. And so that -- the ubiquitous nature of where we can place our technology, it makes us location-agnostic. And for large companies that have applications that are going to live in multiple environments, having a single location-agnostic layer for the security and delivery technologies is absolutely critical because it takes away a lot of your complexity.

Got it. I mean you've spoken about a lot of different entry points kind of into a customer and a lot of different ways in which you're servicing. I guess traditionally, people think of F5 as centered around BIG-IP. And so I guess I wonder, as the company evolves to any application, any method anywhere, do you see BIG-IP still kind of being the center of the F5 ecosystem? Or how does that -- what becomes the center of the F5 ecosystem?

Yes, that's a great question, Meta. So BIG-IP is going to continue to play a very big role in the world of F5, whether it's the technology world of F5 or the -- or even the financial world of F5, but I think the way I would think about the center of the future identity of F5 is I would really think about applications and security. And essentially, we've transformed the company to be a multi-cloud application security and delivery company. And so what's going to be central to everything we do organically or inorganically is continuing to provide better delivery and better security capabilities, but for all applications as they continue to evolve. And that will come in the form of sometimes it's hardware on-premise, sometimes it's self-managed software on-premise or in public cloud. In some cases, increasingly will be SaaS or managed services. And we're now the only player in our space that covers all these consumption factors, which allows us to have a better reach of applications and broader reach of enterprise customers.

Got it. And when I prepared these questions, it was kind of before Russia-Ukraine. But the next question is just on -- I think we've heard a lot from a lot of the security vendors here about the strength in that market today. And just want to get a sense of how you are seeing kind of F5 customers increasingly turn to you for security use cases and just how the current kind of threat environment, whether geopolitical or otherwise are kind of impacting the security piece of your business?

Yes, I'll start and then certainly jump in. So I think, look, it has certainly increased, I think, the broad concern over what security means. It has not -- we haven't seen it yet really outside of government get to application, where that's been the threat vector that has been attacked. Not to say that it won't. But I think it's starting probably in the perimeter of probing and then figuring out how to actually access on application layer. And so we have not seen that be kind of a major driver as much as some other things such as Log4J and other factors that probably drive it more at the application level. Broadly speaking, though, certainly, there is a much higher level of knowledge and concern over cybersecurity.

Got it. So maybe turning to just the core hardware business for a second. That business is -- has had a phenomenal kind of couple of years and outperformed. And just how do you think about either anniversarying some of those very strong quarters or just kind of the evolution of that hardware business as we kind of move towards a more distributed environment kind of post-COVID?

Yes. So specifically between hardware and software, we got that question a lot a couple of quarters ago when we came off of a year that had 12% systems growth and even more when you take into account the backlog build that we had in the course of that. We think of it generally as more of the BIG-IP portfolio and the increasing durability that, that either the hardware or the software solutions will have. There are still use cases where a hardware form factor is -- it makes a difference on the milliseconds of time for those specific applications, and those will continue to drive demand. Over a longer period of time, we increasingly hear from our customers and have heard this going back 4 or 5 years, that we want to move to a software-first environment. And so it's why when we set the expectations back at our Analyst Day in November of 2020, the negative single to high single-digit decline in hardware and 4 quarters later, 5 quarters later, found ourselves with 12% growth within business. This year, on a demand basis, we continue to see flat demand for that business even off of a year where we grew 12%. And that's really kind of what we talked about a flat to slightly up for the hardware business, except for the supply chain concerns.

Got it. So maybe just spending a second on supply chain. I mean, certainly, it was an area where you guys saw an impact last quarter, can you just walk through kind of over the last year, why you were maybe impacted a little bit less and then that impact grew and just how you see that supply chain environment resolving itself over the next couple of quarters?

Sure, sure. So what we talked about in the quarter was that there were 2 things that were driving sort of a shortfall, 1 in Q2 and then the balance of the year for the other. In Q2, specifically, we had a standard component that shortly before the earnings call, we got notice from the vendor that they were going to miss the delivery for the quarter and what we were going to get in the future quarters, we're going to be a fraction of what we otherwise thought we were going to receive. And so that forced a redesign of that standard component. Redesigns within the standard components happen all the time. We've got over 2000 commodities from our boxes. And so it's not uncommon for us to have to redesign around that. What's uncommon is to not get any notice and then having that big of a decrease and a commit from a vendor, so that's impacting specifically Q2, but we think we'll make up for that in Q3 and Q4. For the specialty component chips, we have been seeing that as an issue probably going back 5 quarters, but we've been able to balance that with the secondary market and the brokerage market are for finding those components at better -- at a higher price and with exit fees and other factors. And that's really what we saw dry up completely in the January time frame and led to the $30 million to $90 million of decrease in our expectations for the year, all associated with the systems revenue. And so that's the delta of what we've seen. If we're getting kind of retrospective about it, any changes that we probably would have made, I think in the summer of 2020, we're a couple of quarters into COVID. We had just come off of a couple of years of double -- high single-digit, low double-digit decline in the hardware business. It's not a time where you think, okay, now I'm going to buffer my safety stock for the next 3 years to come, given that. But what we did see, right after our Analyst Investor Day in November 2020, is that we're seeing a lot more demand than that negative mid- to high single-digit decline. And for things that were moving from 16 to 32 weeks to 52-week lead times, we put in those orders. And those are the ones that have been a challenge to get filled even 52 weeks later. And so that's the broader issue that we've been seeing. For us, I think specific issues around our iSeries portfolio is the higher nanometer chip, so 28- and 40-nanometer chips, where those have had the most demand with probably the least amount of investment in new fabrications over the last 3 years. And so that's really where we've seen the crunch. Some -- a lot of that is solved by the move to our R-Series product, but that takes time both to get feature parity and as well to get certified by our customers on that new platform.

Got it. I mean I think we had, had a conversation that you expected kind of that qualification or certification time that customers would need to move from iSeries to rSeries to kind of the shorter this cycle than past cycles. Can you just explain why that might be?

Sure. So we were something we haven't done in the past new platform releases is make the operating systems backward compatible. And so we generally, in the releases, it was somewhat of a forcing function for our customers to sort of migrate up to the latest operating system. And that is not an insignificant IT effort for our customers to do. It will get easier with the modularization of some of the technologies that we put in place. But that was a major concern for us in releasing this platform. And so we went backwards compatible, a couple of different operating system versions such that the vast majority of our customers don't see that as a barrier. They still have to certify the hardware but the software is not an issue for us.

Got it. I mean just given supply chain limitations or even people being back in really getting more towards rearchitecting decisions. Just are you seeing either supply chain or that rearchitecting changing the way that people want to consume F5.

So I think the options that we are giving on how to consume F5 is probably more the driver of what we're seeing. The decisions around am I going to have this application on a hardware or a software form factor is very much client independent decisions. And the impact to them of switching those types of environments are not just F5, but a lot of different vendors across their infrastructure landscape. And so it is something that when people make that determination, it's probably at least a couple of quarters of redesign work, if not longer. And it is something that's probably much easier do in person and over Zoom. And so those are all factors in how people will choose between a hardware and a software solution. I think as I mentioned, Francois mentioned earlier, there are still use cases where those milliseconds of difference between hardware and software do make a difference for that particular application, think of a financial banking application.

Got it. A big question we get from investors is, okay, I buy the story as I -- the market position, I buy the evolution, but I don't get how to think about the software growth and some of the lumpiness that you can kind of see from quarter to quarter. Frank, you've noted over time that, that should start to level out. But can you just walk investors through kind of what are some of the puts and takes that have led to some of that lumpiness and then what should kind of decrease that going forward?

Sure. So I think the primary driver probably to that lumpiness was the move from 605 to 606. And with our multiyear subscription agreements that we formally call ELAs, those have an upfront revenue contribution to them when they happen and a lower base of revenue, some of those deals can be spiky in terms of what the growth rate is. I don't anticipate any changes in accounting regulations around how you how you adopt a term license. But what you do see is just a much bigger denominator in the base of revenues that we're talking about, $500 million this last year and growing, obviously, in our expectations to $700 million, $700 million plus. And so that means that 1 particular deal or a couple of deals aren't going to swing the growth rate in a quarter and it just starts to normalize. Also, we have a growing base of SaaS revenue that is ratably recognized and do have a consistent measure. And so those combinations of things start to bring down that volatility and growth rate that we've experienced in the past. And in the back half of FY '22, which is what we've been talking about for the last couple of years. That's the first real lapping cycle, if you will, of the second terms coming in for some of those multiyear subscription agreements and they've continued to grow from there. And so you just have that effect not as a onetime thing, but an ongoing thing where that waterfall is sort of built upon itself.

Got it. I mean maybe last, to end with Francois. What gives you confidence just in the software growth objectives that you've kind of laid out? Is it just that you guys feel like you have the portfolio and the need is there? Is it the sales force? Just like what gives you confidence in the 35% to 40% kind of target this year as well as kind of the double-digit growth expectations you have going forward?

Do you want to start?

No, go ahead.

All right. So where we take our confidence, I think a couple of factors. Let me start first on with traditional applications, which are still today the majority of our overall business. What -- the growth that we are seeing in traditional applications in terms of traffic and usage and the amount of revenue they're generating, is pretty strong, and we think pretty sustainable. And that's driving growth in BIG-IP software. And I think on top of that, the dynamics that Frank just talked about in terms of having moved that business to be largely a software subscription business and kind of the early signs we're seeing in terms of true forward and renewals and kind of consumption of these agreements are a very good sign. So that's one aspect of our confidence. The second aspect is the growth in modern applications. These apps that -- we've talked about Kubernetes for several years. But in terms of container native applications going into production, we're still in the early innings of that and we're catching that wave at the right time with NGINX. And then the third factor is that our security -- application layer attacks are the most damaging breaches and the things that people want to protect the most against. And we now have the broadest portfolio of application security for that. We're seeing heightened awareness around security from the breaches and the new vulnerabilities that have been announced and we're ideally positioned to address these security issues in our software, whether it's software subscription or now in our SaaS or managed service, and we think we've got good traction. So you take those 3 factors together we feel pretty good about the trajectory of the software business.

Perfect. Well, I have growing confidence in my top pick, but I just -- so thank you so much, Francois, Frank, for being here today.

Thanks.

Thanks for having us here. Thank you.