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

All right. Thanks, everybody, for joining us. With us today, we have F5, and thankfully, we have CFO, Frank Pelzer, and GM of App Delivery, Kara Sprague. So thanks for joining us, guys. Format here. I've got a bunch of questions kind of run through. One of the first ones that I really want to get into is around supply chain, Frank and Kara. And when you think about supply chain, are you guys starting to see that it's normalizing as it pertains to business? And how are you thinking about this elevated backlog over the next year or so? And what may have been kind of from the space a pull-in of demand for networking generally? Like how are you balancing all of this together in terms of how you're expecting things to play out?

Yes, I will get to that. But Kara...

Yes.

All right, the safe harbor, my apologies.

So our discussion today may contain forward-looking statements, which may involve uncertainties and risks. Our actual results may differ substantially from the expressed or implied by the statements. And if you want to see more on these risk factors, please visit our SEC filings. Thank you.

[indiscernible] in FY '19, that was what we thought was going to be the last time we actually put in a backlog number into our [indiscernible] because it was becoming such [indiscernible] portion of the business, it was down [indiscernible] million. And obviously, starting in -- even back to 2020, but more so in 2021, we've seen throughout 2022. We've actually started to see a material sales in that backlog. And we talked about setting up a metric that it's going to be more than 10% of our product revenue, we will release that on an annual basis. So I would expect that we will be releasing that in the October timeframe to talk about the growth that we've seen from last year. Last year, we reported it as [ $124 ] million, the majority of which was all hardware and it has been growing from there, and we've talked about that quarterly. The component side of the [indiscernible] has really been a huge issue for us going back to the January timeframe, and it forced us to reduce our outlook in what we expect the total revenue to be because we weren't able to shift to the demand that we are seeing each quarter since then from the dry up of supply chain and we're delegating more broadly of our components that are needed to build up our products. We've got over 2,000 components that go into each one of our systems, but it's been probably a couple of handful of key components that have [indiscernible] the strengths. And starting really in that January, February timeframe, we look to dual source, both for the ISeries, as well as our newer platform, the rSeries, these highly constrained chips and power distribution. So we've acted such that we are able to not necessarily depend on an improvement in the supply chain, to start booking out, and we talked about how we expect that to flow in each of the quarters coming in FY '23. And that Q1 was going to be our low point, Q2, because of the changes in the designs that we are making and are made. We'll start to see some improvement. Q3, we actually expect to actually shift to the demand, and so we look to build the brand and then maybe start moving into the backlog in Q4 of FY '23. And so that's our expectation. It's not necessarily that we're seeing an improvement in the supply chain. I think we talked about stabilizing the operating, which is better for us, but it's not been [indiscernible] or elongation or much fewer than what we had ordered being delivered to us, but much more about resourcing some of these critical components that are giving us some new problems this year.

Got it. And Kara, I brought up the rSeries here. So first, what's the advantage of rSeries over the iSeries? And how should we think about the acceptance of that substitution effect because that had more readily available components at least at a point?

Yes. So the rSeries is our next-generation appliance offerings, iSeries was the prior generation. And rSeries has a number of advantages for customers over the iSeries. We talked about supply chain just now, rSeries, in general, is using newer components from newer process nodes. The components are generally a bit more available. And so our lead times on rSeries are actually better today than what we offer for iSeries. From a technology perspective, rSeries offers a generational jump in price for performance. And so we are offering a 2x improvement on that. And then aside from that, the part that I'm most excited about with rSeries is the innovation that we put in it. So in terms of data center automation, rSeries is highly automatable. This is the first time that we have offered a platform that customers can effectively fully automate the monitoring and provisioning of the actual hardware elements. And then the second thing that I would highlight on the innovation side is multi-tenancy. So our prior generations of appliances could offer and run only a single -- effectively a single version of our software in them. And that created challenges for customers operationally as they were trying to upgrade some of those components. So they have to go through a difficult choreography of steps to basically fail traffic over to a backup device, upgrade the one that was previously active and then sail over again and then do the upgrade on the back up. With multi-tenancy that changes that operation dramatically, because you can offer 2 different versions of our software, and customers can run those side-by-side and basically bleed traffic over in a very graceful way. And so it's a big paradigm shift in terms of how you actually operate your applications.

Makes sense. And one thing that came off the quarter here was around F5 taking a price increase. So how was that price increase message to customers ahead of time? Was there any net pull into demand? And how has that translated here into the last couple of months, what you can say?

Yes. So I'll take that one. We did message that there will be a price increase that was going to go [indiscernible] July 1. And we talked about on the call that there was probably a small amount of demand that was pulled in from what would have been Q4 demand into Q3 based off of that. But the way we've talked about the business, it was smoothing for that effect. It's generally, thing what we're seeing, but it is on top of, obviously, the inflation particularly in international markets that we are seeing. And so for some customers, it looks like more than a 15% price increase, and we essentially do that. I think that they do certainly understand the component cost increase and the reason why we're pushing it through, and we are still absorbing a lot of that ourselves today. It's going to take probably 2 to 3 quarters more from where we are now before the effects of that price increase start to offset some of the component costs that we are seeing in the business. We're not in the business of replacing our backlog. Once we were committed, we stand by that pricing to our customers. Quotes that are in place. We generally stay with those place, we don't increase those. And so you've got sales lead times that have built in about backlog that is going to be worked down [indiscernible]. So it will be probably until 2 or 3 quarters from now before we start seeing the gross margin positively impacted by the price increase. But from a customer pushback standpoint, that's not something that we're hearing. I think most of them do understand, our necessity for the 100x, 1000x increases in some of the components that we are seeing just supply demand dynamic.

Got it. Now one thing I'm trying to figure out and kind of the theme of the conference here is around automation of technologies. And so first off, how is F5 playing a role in automating my infrastructure environment? And then another thing we're trying to figure out here at the conference a little bit is around this idea of elongating sales cycles. So what are you guys seeing with the long leading sales cycles as well at this point?

So I'll start on the automation one because that one is very near and dear to my heart. F5's value proposition is 100% aligned with automation trends in the data center. We have a value proposition or our vision is this idea or concept of adaptive applications. And that means bringing intelligence and real-time changes to the world of application deployments, which today are largely static and manual. And so think about like good analogies might be, we've seen the impact of CRM offerings like Salesforce in a way that is automated and brought a lot more analytics and intelligence to the world of selling or how other tools like a Workday brings a lot of intelligence and automation into the world of talent management. We're looking to offer a similar amount of intelligence and automation in the world of IT and application deployment. You see that show up across our portfolio. And so we offer a range of multi-cloud or distributed cloud-type solutions that let customers offer L4 through L7 services to their applications regardless of where those applications are deployed. What that means is load balancing security services such as Web App Firewall, anti-denial of service, anti-bot. These are all effectively must-have services that must be attached to applications, and increasingly, companies recognize they're important for all applications. And we have a portfolio that can address both traditional apps, as well as modern applications and applications on-prem in the public cloud or at the edge. And so if you think about IT organizations today, they're just getting swaps with creating a huge amount of complexity in trying to manage their application portfolios across all these different environments, and F5 is there to provide a consistent layer and simplify a lot of that math. So that's where we are on infrastructure automation, and I would say, we're highly aligned with that trend. In terms of sales cycles, second question, I just want to say, we're not updating anything that we shared from our Q3 call. And what we shared at that point was we have not seen any evidence of any kind of macro impact in our demand. But we did see higher back-end linearity and in some cases, more approvals in EMEA specifically. And so that's what we had shared in Q3 and that's what we're seeing.

Yes, got it. That makes sense and helpful. Frank, for you, a big reason investors have been getting involved in the stock has been on the software center. And you've made it pretty clear, eventually, we'll get more disclosures around software. Is there a way to think about either the timing or what sort of metrics we could expect over time from F5 as it relates to the software side of the business?

Yes. So, Jim, I do think it's more moderate when -- if we are going to be disclosing more on the software business. And we want to do it at a time when the metrics that we released, particularly that are predictive of future things, are going to just see that predictive future things. And right now, we are just starting to enter the second term of some of our flexible consumption programs. A consumption model that really got going in FY '19 has started to hold in the back half of FY '19. And so there's some early metrics that we are getting now, but we probably need more quarters of run rate before that becomes meaningful in a predictive way. There may have been things that were done early to see deals that create a higher net retention on the forwards to happen through the course of those contracts. But we just want to see that play forward in [indiscernible]. So maybe a separation of the breakdown of the software revenue, and then metric to come in later periods around how all of that plays out and what that means. And so more to come on that, but we will be sharing more about the business. We will be sharing additional disclosures on the components of the business. And then the rates of each of those components, that's going to probably take a little more time just so that we get run time with them so that they are predictable [indiscernible].

Got it. F5 as a service is pretty new here. It's kind of a different go-to-market approach, too. So how is -- how has that really changed, how F5 approaches a customer with F5 as a service? Is it more geared at getting new customers that maybe are more mid-market and lower that weren't trying to go after that mission-critical application with a box and over time, graduates and virtualize, and that eventually F5 as service? Or is it meant for your big enterprise that actually went through that journey that now has F5 as a service for a cloud-based application that fits in Amazon or something like that.

Both. And so as with most question about F5 is always about the power of the end. And so we see our F5 distributed cloud offering, which is effectively for SaaS and managed services portfolio. We see that as targeting both newer customers that have maybe strayed away from F5 a while ago or new customers that are building out greenfield modern applications and want to deploy their L4 through 7 services and attach to a managed service model, as well as those customers that are long time F5 customers and maybe use BIG-IP for their more traditional applications, but are looking for a more modern, more flexible SaaS-based offering for the long tail of applications. And so we very much see it as an end. And that dovetails very nicely with the rest of our portfolio where we go forward with a value proposition around purpose-built hardware and software appliances and SaaS and managed services. We offer perpetual models and subscription and consumption. And so very much to optimize for the flexibility that customers require for the application portfolio that now address all of these different environments.

Got it. And one of the things that we always hear when we're talking stocks and companies is around catalyst. And one of the things that you guys have talked about a little bit more recently is around 5G core spending, I believe, starting to pick up. How are you guys even thinking about this cycle versus the 4G cycle? And is there a good way to think about which specific products you guys are really seeing that's strengthening?

Yes. So I would say the service provider. The point on service provider is pretty exciting. On the one hand, you have these providers that have invested a ton in their 5G edges. And that is now starting to drive a ton of their thing back into their cores. And in many cases, those are their old kind of legacy 4G cores or kind of sometimes are called a 5G non-standalone. And in many cases, the stuff that they are buying for that is just basically capacity build-outs of technology that they've been buying for many years. So that's one dynamic that's happening. There's another dynamic that's happening where service providers are building out their 5G stand-alone cores, which tend to be entirely modernized infrastructure. Oftentimes, they're skipping over hardware, they're skipping over VNF and they're moving straight to cloud native functions. And that's another place where F5 is ready with the portfolio to address them. And so we've spent the last few years developing specific container or cloud-native solution for service providers in their 5G standalone. One of the offerings, for example, is called SPK server proxy -- services proxy Kubernetes addition. So in shorthand, it's SPK. And that's an offering that is offering customers an ability to use container-native, cloud-native load balancing offerings, very similar to what we offer with our BIG-IP offering today in 4G networks. And then your question about what kind of functions are they buying? They're buying functions at both, what I would say is the traditional world of App Delivery as well as security. So there's a lot of things around traffic management, traffic steering, policy enforcement on that traffic, D&S type solutions, and then layering in the security, specifically around firewall capabilities and a lot of more advanced kind of inspection type offerings.

Makes sense. I do actually want to follow up on what you're saying here where -- and by the way, if anyone has a question, feel free to raise your hand, and I'll call on you. But with security in mind here, I know we get the annual disclosures around security, and we'll get that probably at the end of the September's quarter. How should we think about that security growth, and specifically security software growth? I know you're on the app delivery side, but how is that playing a role on F5, especially because one of your competitors saw a slowdown, and it's also bringing into that question around who you're competing more against? And it's been a conversation we've had that it's more the traditional CDN edge guy. So how is that competition level kind of playing out?

Yes. So I would say security overall has been a tremendous lift for our business. And on both security that is more historically attached to our application delivery products. We have -- our secured business got its starting point in Web App Firewall, which is very near and dear to a load balancer. It just often makes sense to consolidate a few functions together. But we've since expanded our security portfolio into a lot of functions that are much more specific and we even call out in some of our reports, something called stand-alone security, which is meant to represent our business of what is purchased by customers that is meant as a stand-alone security use case, unattached to any kind of application delivery component. And frank, I'm not going to venture with what the numbers were, but they were good.

We talked about 38% -- the last time we disclosed that, we talked about it doing 20% of our product revenue and it had a 38% growth rate over a 3-year period of time. And so it's been a great addition. When we look at the totality of the security business, I think it was over 1/3 of the total revenue business as of last year. Again, as we mentioned, we'll be disclosing more about that in the [indiscernible].

And then, Jim, I mean, I think you made a point earlier today, which is in certain cycles, you have to think about how companies prioritize what kind of spend. And security is one of those places where I think the growing relevance and importance of security in a corporate spending environment is only increasing. The risks are only getting more sophisticated, more broad, and the need for protection is increasing. And even if you think about some of the biggest trends today. So for example, one of the things I keep hearing from CSOS, they ask about ransomware. What are you guys doing about ransomware? Well, F5 has some of the most sophisticated traffic break and inspect technology that enables you to detect attacks that are coming even through encrypted traffic flows. And that plays right into our sweet spot, because with purpose-built hardware, we have some of the best hardware acceleration for decrypting and then re-encrypting that traffic and passing it along. We also have one of the leading solutions in terms of web application firewalls, which is a tremendous way for a company to attach a capability to an application to block malware attacks and malicious attack into the application. And so it's exciting because F5's portfolio continues to grow in relevance as the security threats continue to grow. And I think what we've said in the past, and I think the evidence is clear, this next decade is going to be the decade of application security, and that's right where we're strong.

Makes sense. Definitely some trends that Rob and I are picking up on here at Piper Sandler, at least. Frank, switching over to you. the cash usage is really where I want to go. And so for some time, you talked about we're going to use some of the cash we generate to pay down the debt. But how are you thinking about balancing that debt paydown versus we've been doing about a deal a year or so on the M&A front and then sort of the buyback program?

Yes, so broadly speaking, let me just take it up a level. In November 2020, I think we got to a place where we would done at that point a couple of acquisitions, we sort of have a sensible failures on the way. And we have sort of stopped the share repurchase program, and knew that we had sort of swung the pendulum much more broadly towards inorganic than we have towards returning the capital to shareholders. And we wanted to try to find a balanced approach for that. So at the time, we did announce in Investor Day presentation, we reiterated the [indiscernible] acquisition, which is $500 million, in January of '21, but we weren't going to take a more balanced approach, and that's what we have lived up to. And so we talked about $500 million of accelerated share repurchase in FY '21. That's what we did. We talked about a more ratable approach towards $500 million in FY '22. That's what we did, but we did accelerate $125,000 in that into last quarter, we have a total of [ $250 ] million given where the stock price was. And we said that we're going to be opportunistic from that point going forward. I'm not going to update anything in that regard. But in FY '23, we have made the commitment of what we intend to do is that 50% of our free cash flow is going to continue on for share repurchase. We obviously at that -- the debt obligation that's coming due in January '23, we've got flexibility of paying that down or refinancing, we're in the process of [indiscernible] we're going to go there. And then the balance is going to be for inorganic activity. And our [indiscernible] is still double-digit EPS growth. We took a hit on that this year for revenue reasons from systems. But over a period of time, when you take a look back, that's what we really said we're going to deliver on. And so that becomes our stock. And [indiscernible] is our balance. And so how do we balance the growth and the margin expectations that are going to go into that double-digit EPS to such that it is sustainable over a longer period of time. And we feel like we've got a great set of portfolio, a great set of products in our portfolio today. But there will be tuck-ins or other things that we want to add along the way, and that's with that other [ 50% ] is for, for inorganic activities. And so not updating on any acquisition we may or may not do, but I think that will still be part of our strategy going forward. We're just doing it in a balanced approach.

All right. So you're not buying Google tomorrow [indiscernible] ...

I don't think we're buying Google tomorrow.

Okay. We've got a couple of minutes left. Maybe time for one last question, otherwise, I can squeeze, I can get another 1 or 2. Go ahead.

[indiscernible].

Yes. So a great question, and I wish I had a crystal ball. What we talked about at the end of last quarter, and I'm saying this [indiscernible], we've stabilized in the mediocrity, which is not a great place to be. But the reality is that was better than what it had been before. Our confidence level on what we see and what we've talked about for FY '23 is less about what's going to happen in the broader supply chain and more about what we have done internally to be able to do source the components that have been highly constrained for us. And so more of that is going to come online with redesign if you end up Q1 and it's why we feel like in Q2 and beyond, we're able to start to get back to our abilities in new demand. I think that we're seeing a supply chain, obviously, that will go against that expectation. But that's not what we are seeing right now. With the critical vendors that we work with, we do see additional capacity coming online. But that's more in the first half of calendar next year than it is any time before then. And so our confidence level on FY '23 is much more about what we have done as opposed to what we see extremely in the market for chip supply. My [indiscernible] chip supply normalize into a state in FY '23, we'll get a reduction in some of our component costs that increased dramatically in either the raw material of the component or the expedites fees that we've had to pay in the broker market and other factors.

Well, I think we're out of time. Really appreciate the time, Frank and Kara, and thanks, everybody, for attending.

Thank you.