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

Great. Let's kick it off. Good morning, again, welcome. The next session is with F5, and we have the pleasure of hosting Francois Locoh-Donou, who's the Chief Executive Officer; as well as Cooper Werner.

Francois, I'll hand it over to you with the sort of first question. And these are questions we're asking every company to share their insights on and not necessarily the best question to start with. But what is the probability you would assign potential recession based on what you're seeing in terms of customer demand trends that either confirm or deny sort of a recession in the near term? And I know you have to read the safe harbor, so I'll let you do that first.

All right. Thank you, Samik. Yes. Hello, everybody, and I'll just 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 to differ materially from those expressed or implied by these statements. Please see our SEC filings for more information on these risk factors. All right, Samik. So on a recession, I'm going to disappoint you. I'm not an economist, so I'm not going to put a forecast on a recession I will say that we -- as we shared on our earnings call in April, we haven't seen a change in our demand trends or demand for F5 solutions in general has been pretty strong through the pandemic. I can share for refresher, generally how our customers have behaved in a recessionary environment, what we have typically seen if there was a recession is in the enterprise space, we would see a pullback in demand initially. But usually, that doesn't last very long because applications is what drives our business. And generally, applications don't know that there is a recession so they continue to grow. And we see typically, our customers reassess and then demand pick back up. Our business also has a stronger component of security today and fosters and hackers also continue to remain active in a recession. So we would expect that to also provide some elements of buffer, not to say that we would not be -- not to say that would be immune to a recession, but this is the behavior that we've seen from our customers, typically in this environment.

Okay. No, that's helpful, Francois. Supply. And I know you've had your challenges with supply in the recent quarters, but more specifically on the China shutdowns, how much of an impact is that incremental to the constraints that the industry was already facing?

Well, for us, we've talked about supply chain a lot in our last couple of quarters. So I'm not going to update from what we've said on our last call in April. The supply chain environment is generally very dynamic. We always have things getting better, some things getting worse. From our perspective, our contract manufacturers, generally, our contract manufacturing capacity, so the folks who assemble our equipment is not really directly impacted by China. But of course, some of our suppliers have facilities based in the regions that are affected by lockdowns. In general, what we've said about supply remains for us in that we expect supply to be better really in the last calendar quarter is where we expect to see improvement. And so we will see improvements in our revenue as it relates to our ability to ship systems in our second fiscal quarter of 2023. And our expectation is that we will be able to start shipping to demand in the second half of our fiscal year 2023.

Okay. Okay. Any predictions of when supply normalizes? Or is that essentially second half of fiscal '23 that you're thinking supply now comes back to a more normal level?

Yes. I think in terms of our ability to ship to demand, we think that will happen in the second half of our fiscal year 2023, which is April 2023 and beyond.

Okay. Got it. Okay. Let's move to more company-specific stuff here. And I think the transformation that over the last few years, we've seen F5 go through in terms of accelerating growth. I mean, most enterprise IT suppliers would be sort of envious of that transformation going from a low single-digit growth to high single-digit sort of getting close to low double digit, let's say. What was unique to F5 that enabled that growth transformation? How are you thinking about the expansion of the TAM and sort of opportunities you can address from here on?

I think in terms of our transformation, what's unique to F5 is that we have really anchored and focused our business on applications. And the bet that we've made is that the world will rely more and more on applications. And when we've seen in the pandemic and acceleration of that phenomenon from everything from work collaboration to banking, shopping, e-commerce, all of those things have become more and more digital. And if you go back to a few years ago, F5 was focused on application, but it was largely traditional applications that are big mission-critical applications, typically living in a data center. And so the acceleration for us has really come from our ability to do the same services, namely security and delivery, but for way more applications. So not just traditional applications in a data center, but also modern applications, traditional applications in a public cloud applications increasingly at the edge. Applications that are containerized and are in modern environments and to add more and more security to the services that we deliver for these applications. So it's really the focus 100% on applications and expanding our role and reach in front of these applications that has helped us kind of reaccelerate growth.

Okay. Okay. There has been an ongoing debate for a while about F5's relevance as customers move to the cloud. How is the current portfolio addressing the opportunity as customers move to the cloud? What are the opportunities you're seeing to expand your presence as customers sort of do that in active migration to either sort of one public cloud or multiple public clouds?

So, I think, Samik, there is kind of a Phase 1 or Phase 2. So if you look at what we've done over the last -- really over the last 5 years, we have made it increasingly easier for customers to consume F5 software on public clouds. And so we've done a lot of integrations with AWS and Azure and GCP and other public clouds such that customers can take F5 software, buy our licenses and use them in their public cloud environments, such that customers can also buy F5 software on public cloud marketplaces. We now have thousands of customers that are consuming F5 in these cloud environments. And we've added security capabilities to our software in these client environments. And so that has been a really successful and it's enabled a lot of our customers to do lift and shift or to deploy their applications directly in public cloud. We're now entering a second phase of that, where we want to make it even easier for customers to use F5 in public clouds by introducing as-a-service solution. So all of the things we've done to date, customers would use us on public cloud, but they still buy and own and manage our software. We want to give them the ability to do that as a service. So you're going to see more and more solutions delivered as a service. And that would accelerate the consumption of F5 in cloud environments. Today, we're announcing launch of NGINX as a service on Azure. So for customers that want to use NGINX in Microsoft Azure almost as a first-party service, they're going to be able to do that. with the collaboration and work we've done with Azure around launching that service, we are also -- we've introduced our distributed cloud offering about 3 months ago, which offers security capabilities from F5 as a service and also allows customers to deploy the security solutions in any public cloud and network some of these public clouds together. So those capabilities really kind of start entering a Phase 2 of F5 capabilities in public clouds, which is SaaS.

Okay. First I'll bring it back to a bit more near term. In our recent channel checks that we've done with distributors, VARs, et cetera. They are highlighting there's an increased appetite from customers to use the software version of what used to be traditional hardware appliances given some of the supply challenges as well that's triggering that. What are you seeing in terms of your customers and sort of shift maybe or substitution within your portfolio there?

Yes, I'll go ahead and answer that. We have not seen an acute near-term shift from customers for projects that were designed to deploy hardware, moving to software, pertaining to the supply chain issues that we've seen. What we are seeing is an appetite to accelerate their transformation in the software over time. And I think a lot of the things that we've done over the past few years in terms of rounding out our portfolio to address modern applications, new commercial models and make it easier to deploy software more quickly, will help with those transformations. But in the very near term, it's not always practical for customers to shift a project that quickly. If you think about our lead time for our products, it's in the kind of 3 to 4 months time frame. There's a lot of operational changes that customers need to make in terms of both were architecting their environment. There's other vendors involved. And so to address a project that's already in flight by shifting to software model that's not something we're seeing on the whole. On the margins, there may be cases where customers are in a hybrid environment, and they're able to more rapidly provision capacity with the software component of that architecture. But broadly, we think it's kind of a more medium- to longer-term shift that you might see or an acceleration, and we think that, that will really benefit what we've done with our portfolio and the growth opportunity pertaining to that.

Okay. Keeping on software, you outlined certain targets at the Investor Day for software growth. you've been largely in line to actually be a bit better in relation to your targets. But that's sort of the broader sort of way to look at it. Curious if you can give us a sort of a better look there in terms of how is BIG-IP versus NGINX versus like where you have more security offerings attached to it, how they're doing on a stand-alone basis if you can break that down?

Yes. So if you look at our -- so each of them have their drivers. BIG-IP, as I shared before, has been really the ability to consume the software in any environment, private cloud or public cloud and the ease for customers to consume the software has really driven an acceleration of growth of BIG-IP software. NGINX is really modern applications environment, Kubernetes deployments. And our security, including Shape has really been the attacks on applications that have continued to grow, including bot attacks, fraud increasingly and all kinds of attacks at Layer 7 on applications. So those have been kind of the drivers. But if you step back and look at the majority of the growth of our software has been driven by these multiyear subscriptions. And the success in these multiyear subscriptions really comes from the combination and the integration we've done of all these capabilities. So increasingly, a lot of these multiyear subscriptions are multiproduct. So customers are including things like BIG-IP and NGINX in the same multiyear subscription agreements. And with every renewal, we see more and more new products coming into these agreements. Now that's happening because we have also cross-pollinated the portfolio with capabilities where we have ported NGINX capabilities -- sorry, some BIG-IP security capabilities on NGINX, reporting Shape capabilities on BIG-IP. And so the consistency of the portfolio, the integration of capabilities is driving more of these multiyear subscription agreements across multiple products.

That's interesting. Okay. Yes. Essentially, you're doing a subscription that's multiproduct. And how is that different from like doing an enterprise license subscription in some sense? Because it's interesting to bring that out because I think one of the companies we were hosting yesterday brought up that subscriptions, the consumption that they're seeing now increasingly is at an enterprise level rather than at a product level?

Yes. And that is, in fact, what we're seeing. We introduced the multiyear subscription model about 3 years ago. Initially, it was BIG-IP was really the only offering that we had in that model, and then we introduced NGINX a year later. We've been seeing really good adoption of both NGINX and BIG-IP on that model right now. And this is where you see customers that are running both traditional and modern apps or very often traditional apps that have modernized components. And they found that having the full portfolio under one model is kind of the most frictionless way to deploy and expand their use of our solutions.

Okay. So going back to the software to -- sort of hardware to software architecture changes that are required. And maybe before we go into sort of the drivers of individually each of them, you've had the supply challenges on systems for the last few quarters. You're not seeing as much of an acute sort of shift from customers to the software versions because of the changes that are required on the architecture. Why doesn't -- is the right way to interpret this? Now you have a pent-up demand for systems going into the next year?

Let me just think through this. Do we have pent-up demand for hardware?

Hardware appliances because of the supply constraints that you have and you haven't seen substitution with software.

So well, we've seen -- we've talked about our backlog has grown as demand -- so I wouldn't say it's pent up demand as much as the demand has remained resilient. So we're on plan for our hardware bookings -- works behind on shipping. And so to that extent, there's a pent-up set of orders that we're looking to fulfill as soon as we can get up to full capacity from the supply chain.

Okay. Okay. Now going back to the longer-term discussion on this, what are the -- essentially, what are the sort of hurdles that you see from customers in moving from the hardware appliance to the either being at a subscription or just a software license. Like what are those hurdles that you need to help them clear what are the architecture changes that you need to be sort of maybe more involved in discussing with them before they sort of get over the hurdle there and move towards an easier architecture where they can be more flexible with their deployment?

Well, in general, we have been leaning in with our customers. We have a kind of strong workforce of what we call systems engineers or field engineers that really understand the trade-offs between hardware acceleration and software and for different use cases, can advise customers on what's the best way to go. And for those customers that are on the margin and could go either way, I think generally, we would work with them to move to software because it's a better long-term model, more flexible for them. For a large number of customers, though, that are not ready yet to move to software. It's generally because the operating environment is not set up for that, that they need to -- they don't have a software-defined architecture yet that they would need to move not just their F5 hardware, but other vendors also would have to move software. Sometimes that's available, sometimes not. So there are considerations that have to do with our operational and architectural environments that make that difficult. There are also customers, who are a number of F5 customers, who are hybrid today who have a hardware environment and a software environment. Generally, for those customers, their hardware environment isn't moving to software because of the life cycle of the applications that it supports. And they want these applications to continue to run on hardware sometimes for compliance or control reasons or sometimes specifications that are really on hardware and have to remain there. So those are the considerations that customers have which go well beyond the lead times for our equipment, which is why our lead times have grown from roughly 2 weeks pre-pandemic to averaging about 4 months today. But that alone isn't a big driver to see an inflection point in customers moving to software.

Okay. Okay. And -- on the system side, I think relative to the guidance that you had at the Investor Day, your bookings, or at least demand trends have been stronger than outlined at the Investor Day. I know supply has been an issue more near term, but how are you thinking about just those demand drivers maybe being different from what you anticipated at the time of the Investor Day, how sustainable are those that are driving this higher amount of demand at this point?

So I think the drivers that we did expect at the time of Investor Days that actually have proved out to be -- to have played out the way we thought was, a, in the service provider space. We have seen capacity upgrades related to 4G to 5G migration and more 5G traffic coming on. So generally, the service provider hardware demand has played out the way we expected. And also, I think from a security perspective, we expected our hardware security business to do well because of continued demand, and that has played out the way we expected. Where we have been surprised to the upside is really in the enterprise as it relates to traditional applications. Traditional applications have grown faster than we expected. In part because of the pandemic and in part because these applications are generating more revenue, more engagement, more customer loyalty, more transactions than anybody thought. And so we -- in the enterprise, we've seen it in 2 areas. One is directly from enterprise across a variety of industries, retail, manufacturing, health care, financial services, all of these industries, we're seeing just more usage of existing applications. And then we're also seeing it indirectly because F5 hardware is in the stack of several cloud providers or SaaS providers that have built their own vertical stack. And their applications, their SaaS offers have also grown very rapidly through the pandemic, and we've benefited from that in our hardware because we're part of that stack. So those are the -- probably the 2 areas where we have been surprised to the upside.

Got it. Let's see. So on the software, and we were looking at some of these software revenue numbers that you report and I think you gave some color around how much of that is subscription as well. However, if we look at the last couple of quarters, it does look like software licenses that approaches on a CapEx model are growing as well as accelerating. Can you provide some color on what's driving that? It seems like counterintuitive relative to subscription.

Yes. So our perpetual software has been kind of steady at the $100 million per year type run rate. We have seen some increases that I think are more particular to specific customers that desire a CapEx model as opposed to an OpEx model. But I wouldn't characterize it as a broader trend. I think that over time, the subscription mix of our software continues to increase. And that's our expectation that that's where the higher level of growth will be for software. So it's more a case of individual customer needs for their business model.

Okay. Okay. When you talk about the distributed cloud services Francois, as you mentioned earlier, you launched it recently, and I think you described it as the first major step in integration of Volterra. Can you outline what use cases, can the platform be used for? I mean the average investor, obviously, is not that familiar with Volterra and the use cases there. But how should investors think about sort of the milestones and the use cases that it can support?

So the -- so just to rebaseline everyone, the -- we made the acquisition of Volterra about almost 18 months ago now. And the rationale for it was really twofold. One is F5 had done a lot of work in making -- moving from hardware to software, but we wanted to have a SaaS consumption model because increasingly, a number of our customers were saying, we want to consume your capabilities as a service. And we did not have a SaaS platform at scale. So that was one reason. The second reason is we were seeing a number of edge use emerge where customers wanted to move their application to the edge or they wanted to insert security services at the edge closer to the user. And so that's what led to the acquisition of Volterra, which is now the base platform for our distributed cloud services. So you can think at the most basic level, as distributed cloud services being saasifying F5, if you will. It's the platform on which we will offer a number and eventually all F5 capabilities as a service. Now what are the capabilities of the platform today because that is an evolution that's going to take several years. But if you look at where we're at today, the first major, major milestone in the integration was porting our security capabilities, so things like API security, WAF, Web Application Firewall, DDoS protection, bot security from Shape making all of that available in a single bundle as a service on our distributed cloud platform. So we've launched that offering about 3 months ago. We're seeing already quite strong resonance with our customers for it, both existing customers and net new customers to F5 that want to consume as a service. But the really exciting thing about this is the platform has capabilities that go well beyond offering WAF as a service or DDoS or API security as a service. For example, it is capable of doing multi-cloud networking increasingly we're seeing a number of our customers that want to have applications in multiple cloud. But if you do that, you then have to work on the networking between those clouds and networking all your APIs together. And we have already done that essentially as a turnkey offer in our distributed cloud platform. So that's another capability that we're starting to see some traction on -- and over time, there will be a number of edge use cases that we will introduce to the market.

Okay. And can you quantify the addressable market or the revenue opportunity that you're looking at?

Well, the total addressable market that we see for F5 by sort of 2023 is around $28 billion. And the SaaS is an important part of that total addressable market. And so the distributed cloud is going to allow us to take a more important share of that market overall by having our offers as SaaS as well.

Okay. Got it. Let me do a check here, anyone in the audience with a question. Okay. Let me continue here. And I think, Francois, the other thing that I wanted to discuss is security revenue growth. And I mean, obviously, you've had strong performance in security, but help us sort of piece that apart in terms of how much of that has been driven by attaching security versus stand-alone security that you've been able to sell? And what are you generally seeing from customers as well in terms of willingness to spend on your security products?

Yes. So we talked about on our annual call the stand-alone security product revenue was about $350 million. They are overall security mix, including services and attached security is over $900 million, and that's been growing at a 38% CAGR over the past 3 years. And we continue to see a really strong growth opportunity with security, especially with the rollout of our distributed cloud platform. So we're really excited about security as a long-term driver to both our software and our overall revenue growth.

In relation to the transformation Francois, now starting to sort of think about how the sort of the revenue and the hardware and the software revenue mix sort of progresses over time. I think some of the challenge for the share price more recently has been the lumpiness in the software revenue that has got some investors unaware about sort of the quarterly trends there. I mean, how are you thinking about where you need to get to just based on sort of the transformation you're doing to subscriptions, how do you provide investors a sort of easier platform in terms of there's limited lumpiness on the subscription revenue in yourself? Where do you need to get to before you can provide that? And obviously, that's been a major concern, and we can see from investors on a quarter-to-quarter basis, right?

Yes. So I can start with that. We first launched our subscription business. We were effectively selling every subscription as a new project. And it was entirely term-based licenses, which are recognized largely upfront, as you know. And so what we've been seeing over time is as the software base grows, you're going to see less volatility in the growth rates just because you've got a larger base that you're selling against in terms of comps. We're also seeing a higher mix of our software business is going to come in the form of SaaS revenue, which is ratable that will help to continue to kind of normalize those kind of ups and downs, the lumpiness that you referenced. But we're also now at a stage where we're starting to see more of a recurring software business on those term licenses. So you're seeing the 3-year licenses that we had sold. It's coming up for renewals, you're seeing expansion each year. And so as that base continues to grow, it gets more diversified, in terms of when that revenue recognition comes in. And you're seeing that now in terms of those growth rates are becoming much less lumpy. There's still some variability quarter-to-quarter, but if you look back 2 years ago, you were seeing 90% growth rate one quarter, 50% the next, 70%, 25%. Now it's kind of much more steady what we've been seeing this year. And we think that over time as the base continues to grow, gets more diversified with the higher mix of SaaS revenue, the volatility on the software will be much less, and you'll see a more predictable growth rate over time.

Okay. And Francois, the next one for you, it seem on the transformation. But when you think about the transformation rate of the product portfolio versus the incremental or the next step being the go-to-market, obviously, you still have a ways to go on the go-to-market. But where do you think you are on the portfolio transformation?

I think we're very excited with the portfolio we have today because we have expanded our security capabilities. We have moved into modern applications, which we didn't have exposure to those applications. If you go back 4, 5 years ago, both are seeing a lot of growth. And now we have the ability to offer all of that as a service to our customers in any public cloud or in our own points of presence that are growing. So we really feel good about where the portfolio is at. And I think we'll continue to invest in security. We also want to make sure applications continue to get more adaptive. And to that, we have to be able to provide more insights into the performance of applications. And so that's where we're going to continue to evolve the portfolio. There has been, as you said, Samik, a transformation of our go to market. We have made kind of every year, we've made incremental changes to our go-to market. We've built a much stronger digital revenue engine with our marketing organization to drive better lead generation and continue to improve the productivities of our sellers. We have moved from being -- having a sales force that was really focused on a single product family to now being able to be a multi-domain targeting multiple biopersonas, and continuing to increase the effectiveness of the organization in being able to make that transition from single domain to multi-domain. So lots of work that has happened on the go-to-market, but that will continue over the next 3 years.

Okay. And it does appear like most of the plan here is to continue to build the portfolio to tap into the existing sort of addressable markets that you outlined at the last Investor Day. But if I sort of step back to the last Investor Day, you pleasantly surprised a lot of investors with the additional addressable markets that you could offer capabilities in relative to what the traditional alliances did, or the traditional applications that you supported. So as you sort of think forward, are there any more incremental addressable markets that you see associated with application services more broadly that you are not sort of capturing in the current portfolio or in the sort of Investor Day outlook that you had for your addressable markets? Are there more adjacencies that you think of expanding into?

I think if you go back, Samik, to the addressable market that we had, I want to say, back in 2016, 2017, which was the kind of traditional ADC market, which is roughly $2 billion, growing at single digits. Today, when you look at our total addressable market in the next couple of years, it will be closer to $28 million, $30 billion. Within that total addressable market, there are a number of adjacencies in there that we can go more aggressively at pursuing. So we think we've got a very significant opportunity for growth accelerating, delivering more services into modern applications. Today, we address I would say, a slice of this modern applications, app security and delivery market, we can do way more in there. We've got a lot of SaaS net new offerings to provide, which will enhance our addressable market. So there's a lot of opportunity in that $28 billion to $30 billion market for us to grow and continue to drive the growth rate of the company.

Okay. I do see couple of questions here. let me try to take one of them. The first one reads as the term licenses have been renewed after initial 3 years, what's the average uplift to average contract value?

So it's early, right, because we're really kind of in that first year. We haven't disclosed what that uplift is only because the early trends, not necessarily a long-term indicator. They've been well ahead of what our expectation would be. What we've seen is that the utilization rates have been going up across all of those agreements. We've been seeing the time to 100% utilization has been coming down in terms of customer getting to the full utilization of what they had contracted to, and that's good for long-term expansion opportunity. So our expectation is that it's going to be a material revenue opportunity on those renewals, not just from the renewal -- the revenue you get from the renewal, but the expansion in terms of the size of those renewals.

Great. we're almost up on time. So in the interest of that. Thank you for coming to the conference. Thank you for everyone in the audience as well. Thank you.

Thank you, Samik.

Thank you.