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

Great. Thanks so much, Lucky. My name is Alex Henderson. I'm the security networking analyst at Needham, been following F5 since the tech bubble, I think we started picking up coverage of it. One of the best companies in the networking space for a long time, stalled a little bit for a while, but is now gotten back on a good growth and strategy curve. And heavily because of the performance of this current management team. So welcome to the Needham conference. We have F5 networks -- excuse me, F5, Inc., I got to get that network part out of my language. Francois Locoh-Donou, CEO; and Cooper Werner, SVP, Finance. We also have Suzanne DuLong, a long standing friend from her Ciena days, in the background as well. So for people who are on the call, if you have a question, I have the dialogue box up. I'd be happy to pass it along at any time during this fireside chat. If you prefer, you can e-mail me at [email protected]. I do have my e-mail up and will be monitoring it through the session. And with that, welcome, guys.

Thank you, Alex. It's a pleasure to join you with Cooper.

So let's start from kind of the broader background. The company was known as the application delivery controller company that sold appliances and then virtual versions of those appliances running on appliance -- as a virtual software running on appliances for the long time, delivered very good growth for a number of years, then kind of stalled out for a little while, and you've come in and reoriented the company. Can you talk a little bit about that strategic journey?

I can, Alex, just before I start, if you bear with me for a second, I want to make sure I get our safe harbor on record. So 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. Thank you, Alex. So yes, on the journey that we've been on, Alex, if you think about F5 of 5 or 6 years ago, we were really focused on basically application delivery, focus on most mission-critical applications, so very large applications that sat in private data centers and were supported entirely by hardware appliances. And that sort of the business model was large applications. The consumption model was hardware, primarily that. The licensing model was perpetual license and only that, and the location is private data center. What we saw at the time was that increasingly, our customers where -- the good news was that the number of applications was exploding. There would be many, many more applications, 100x more applications in the future than they were at the time because of digital transformations and our customers investing more in going digital first. But that more and more of these applications will be distributed and that a CIO of a large enterprise would maybe have way more applications in the future, but some of them in public cloud, some of them in data centers, some of them in private cloud and now some of them at the edge. And so we embarked on a journey to say, look, if we cannot just deliver applications in large applications in private data centers. But if we can secure and deliver every application and every API anywhere, then the opportunity for F5 is more than 10x what we had at the time. And so the evolution of the company has been to pursue that 10x opportunity and be able to secure and deliver applications in private cloud, in public clouds, at the edge in private data centers to do that for both traditional and modern applications, to secure applications against all kinds of sophisticated security attacks and to do so in the consumption models that a customer choose, whether it's hardware or software or SaaS or managed service. And we have now built a lot of the assets to be able to deliver on that vision. There's a ton of integration and work that we still need to do to really consolidate on a platform that customers can use for all of that. But that's really where the company is going and the opportunity for the company is very significant because it has become very clear over the last 5, 6 years that the future of enterprises is hybrid and multi-cloud. And we feel that as an infrastructure-agnostic player and the platform we're building that's infrastructure agnostic, we are increasingly very well positioned to serve the multi-cloud reality of our customers.

So our investment thesis in the company has been that the software/services piece of the business, the subscription portion of your business over time would gradually drive its share higher and higher as it's just a much higher growth business than the systems business. And then as that happens, the top line will accelerate and that ultimately, that allow you to drive your margins back up towards the 35% type level that you produced for years and years. Within that context, we were a little surprised that the systems business did as well as it did for a while, and then the supply chain stuff happened. But on this side of the coin, your software was growing at 30% to 40% plus CLP, and we were pretty pleased with that. This year, it's been a little bit different in terms of the supply chain and most recently in terms of the software because -- can you kind of lay out what happened over the course of the year?

Yes. Let's do just a quick recap to level set everybody on this -- a little bit of a special year we had in 2022. So as we started the year, we had very strong growth in software, of course. And when we started the year, I'm going to start actually with hardware. When we started the year, we had expectations that our hardware demand would be kind of flat to up for the year. But in the end, you looked at hardware revenue for the year declined, I think, 13% year-on-year. But when you look at our backlog, you'll see that actually if you normalize for backlog, demand for hardware was pretty much in line with our expectations. So what happened there? Why did revenue decline? Well, 2 factors. In January, we saw a significant worsening of the supply chain for F5 specifically some semiconductor components and especially networking components that we saw would significantly get our ability to ship products for the rest of the year. And then again, in our second quarter, we saw another step function decrease in availability of components. This time affecting power distribution components that affected both our iSeries and our rSeries, our next-generation kind of new platforms. By then, by the way, we accelerated -- two things about the rSeries. One is bringing it to parity with the iSeries so we could cover all the use cases and a lot of engineering work to design out the most constrained components. And that work is starting to bear fruit now because a lot of that engineering work is going to be completed in the next quarter or so. In Q3, we didn't see a material change in the supply chain. It didn't get worse, but it didn't get better. And then in our fourth quarter, we finally saw some opportunity -- the broker market kind of opened up for some of these more constrained parts.

Let me interrupt you there. So that's fiscal Q3 ending June and fiscal Q4 ending September.

Yes. Thank you for the clarification, Alex. Yes, 100% fiscal quarters is what I'm talking about. And so that's where we are. Now what we have seen, I think, in our fiscal fourth quarter call in the quarter is, I would say, incremental improvements on the supply chain, a little more availability of components in the broker market, more progress, I would say, from suppliers in terms of building capacity, and that's given us more confidence for FY '23. But I would say the factor that gives us most confidence for FY '23 is more of the work that we have done with our engineering teams to design out the most constrained parts and have access to components that would allow us to ship more, especially in the second half of our fiscal year. So the April to June quarter and June to July to September quarter. Now in software, we had a strong year overall for software. Software revenue grew 33%. The marked difference was, of course, in our fiscal fourth quarter where software growth decelerated. That was heavily impacted by international -- the international business, Europe and Asia, where we saw customer behavior changed largely because of the macro, where a number of projects got delayed or sized down by customers or went through extraordinary scrutiny because of currency variation, inflation, energy crisis and just uncertainty around the macro. So I think that's been the big effect on our software. And it's been notable when you take into account that kind of what we've said is for 2023, that more than -- about half of our business is still new business. And so we still have to go and get these new software projects to drive the growth in the business. And where we saw in Q4 kind of a marked difference was not on the existing business. So all the renewals and so through forward and expansion in existing business actually are very healthy, very solid, but it was more in the new project that we saw these customer patterns change. So that's kind of what we saw in 2022 on hardware and software.

So putting that into context, the -- I think for the full year, what -- it was 55% of revenue came from software and...

51%, I think.

51%.

Keep me honest here, but I think it was 51%.

Higher than that in the fourth quarter, though, right?

I don't actually recall the number.

49% software in the fourth quarter.

49% software in the fourth quarter, right. So okay, so that software business, you've given guidance of it slowing sharply into the seasonally stronger fourth -- seasonally weaker fourth quarter calendar fiscal first quarter for next year, I believe, how do we think about the mechanics there? Is it going to be strictly driven by macro? Or is it able to reassert itself because of the strategic value of the security and the nature of the criticality of digital transformation moves that are out there. How do we think about the trajectory of that business?

Yes. I mean, I could start, and then Cooper, you may want to add to that. But Alex, we think that the deceleration that we've talked about in software is, in fact, largely driven by the macro environment because we think that customers -- and not just in Europe and Asia, we think to some extent, in America there will also be effects of the macro in terms of starting new projects and these new transformational projects that are often a multimillion dollar projects that there will be more scrutiny and probably less of them in our fiscal '23. But we've also said that we feel comfortable with the -- we've given a long-term target of having kind of a 20%-plus growth, software growth rate going forward. And we feel comfortable that when things normalize in terms of the macro, we should return to these kind of levels of growth.

Yes. And just to add to that, and some of this is drawing from our own history and prior economic cycles, even on the hardware side. Our underlying drivers applications and the growth of those mission-critical applications and they don't know that there's a recession -- so what you'll see very often in downturns is that the outset of the downturn, customers have to kind of revisit their budgets. They have to go through a new prioritization cycle, and while they're looking to find footing, they kind of put a pause on a lot of variable expense or new project expense, recast their budgets, revisit the prioritization and then move forward at those highest prioritized opportunities. And we feel very comfortable that we are in a period of time while they're revisiting and recasting, some of these projects can get put on hold. But in prior cycles, what we've seen is as those projects have been put on hold, the underlying demands and pressures on those environments continues to increase with the growth of those applications, the increased security needs. And so that investment does return. Does it happen in 2 quarters, 4 quarters? That's what's harder to predict. But we do have confidence that our prioritization remains as high as it's been within our customers. And as those applications continue to grow, they will -- we'll continue to invest in these new projects to support those applications.

Just going back to the hardware side of the equation for a second. So hardware is kind of a misnomer for it. It's really software running on a specialized server. It's -- yes, it's got hardware in there, but -- last time I looked at a hardware product that didn't carry 80%, 85% gross margins, which is what these systems carry. So what is the scale of the backlog there? And is the backlog then a tailwind through 2023?

Yes. I think that's going to be a function on the hardware -- underlying hardware demand. The last couple of years, it's been strong as we -- Francois kind of outlined. Now in this environment, we'll see how that goes, but it -- it is certainly -- we're going to be delivering on that backlog as quickly as we can. To the extent that demand remains strong, it could be a tailwind. Conversely, if there's a softening in demand near term -- it can be a buffer to our expectations for harder revenue growth. So I think the good news is we have really good line of sight, we feel -- or a much better line of sight on the availability of our supply for this year. And so we have confidence that our hardware business will grow in the year. And then beyond that, it's a function of demand and can we secure additional supply chain beyond what's already contemplated in our guide.

So within that context, the rSeries was launched in the calendar first quarter, I think it was, what, the March time, if I remember correctly? And our rSeries required a lot of work, not on the product but rather on the use cases. As we go into calendar '23, have you finished the process of addressing those use cases so that we can now start to see a more meaningful shift to the rSeries and opening up opportunities with that product?

We are -- we've made a ton of progress on that. Alex, we're not 100%, so we're not yet fully at feature parity between rSeries and iSeries, we will be there by the end of calendar '23. But we have actually made more rapid progress than we have made in any prior transitions of one generation to the next. And so in terms of the ramp that we are seeing in rSeries orders, it has been the fastest ramp that we've ever had in a transition from one appliance generation to the next appliance generation, and we will complete the sort of use case parity inside of the next 9 months, but we're already well underway with that.

Let's shift back to the software side of the equation. So I mean, software kind of started through a series of acquisitions. I think the main ones have been NGINX and Shape. Can you talk a little bit about that progress and that -- those events? It seems to me that NGINX positions you extremely well for the code as infrastructure segment in the marketplace, where I think you guys have a very high market share, something in the order of 60% plus of the virtualized code as infrastructure, ADCs that go inside Kubernetes workloads. Can you talk a little bit about NGINX to start with?

Yes, I can start with NGINX, Alex. But just even before I go there, the evolution -- if you think about it, first of all, there haven't been many hardware companies that have gone from being pure hardware to -- in a period of 5 or 6 years, becoming majority software, which we did just last year. And so if you look at that success in a rapid evolution of the business, A lot of it also comes from the organic work that was done on BIG-IP on the existing core franchise, modernizing that franchise, deploying it in public clouds, deploying it in private clouds, building automation on top of the software, so customers can use it as an API-first platform. And so that has played a big role making it available in subscriptions, changing the licensing model completely, expanding the security capabilities of BIG-IP. That has played a big role in customers embracing BIG-IP as a software in software-first environment. Then, of course, acquisitions have augmented that, and let's start with NGINX. NGINX has emerged essentially for all sort of container environments where Kubernetes is kind of the default orchestration platform. Kubernetes -- those orchestrate containers, but when you want to put these applications in production at scale, there are some networking issues and security issues that become pretty big and are pretty gating. And without NGINX, the way customers would have to solve that is they would have to buy multiple tools for an API gateway for a load balancer, perhaps for a web application firewall to be started in there for a service mesh. All of these things, and it's all different tools they have to manage. NGINX is beautiful because it does all these things in one single, very elegant, lightweight piece of software that fits right into their container-native environment. And so we are basically replicating the BIG-IP playbook with NGINX, which is consolidating all these functionality in one platform that goes into these container-native environments. And that's -- you're right, we have very strong market share in these environments, and that's because of those capabilities. And also because of the strong affinity that developers have for NGINX, starting with NGINX Open Source, which, as you know, is now available in 400 million plus websites around the world. But that translates into big deployment. So some of the biggest collaboration platforms that you know have scaled because of the ability of NGINX to scale 10x or 100x very elegantly. Some of the big media platforms and streaming platforms use NGINX, some of the largest financial services companies around the world now use NGINX for these kinds of deployment. The big hyperscalers also use NGINX. Sometimes they use NGINX Open Source, but the ubiquity of NGINX in all these large-scale environments is part of what has also fueled our software growth over the last few years. Shape has been excellent for...

Before we get off of that, how are you taking NGINX that is bought by the coder, deployed as content inside the container, code as infrastructure, tied into the CI/CD pipelining. And tying it back into the enterprise to actually draw the synergies between the NGINX products inside the container and the BIG-IP and enterprise management tools/policy implementation/on-premise or in private cloud data center environments.

So we are -- it's a great question, Alex. We are -- by the way, NGINX is not bought by the coder, I would say. It is used by -- oftentimes starts being used by a developer -- but the buying center is more of the platform teams who have the responsibility of bringing code into production into this kind of new modern environment. And they are the ones dealing with the scale issues, networking issues and so forth.

But to be fair, those platform teams tend to be coder-centric people, right?

Yes, way more than the network operations.

So the coder/developer teams are making -- still making that purchasing decision more than the gray here, the CIO, CTO, with the Cisco Palo Alto-certified engineer plaques on the wall, right?

Yes. Yes. You're -- in terms of how you're painting the contract, yes, they're -- those platform teams are absolutely closer to the developers in effect.

How do we tie those together?

So increasingly, what we're seeing, Alex, is -- you have a lot of deployment where BIG-IP and NGINX are actually brought together by customers. They'll use, for example, they'll use NGINX in a Kubernetes cluster inside of a Kubernetes cluster, and they will use BIG-IP to front -- potentially front/back cluster. And so these -- that's why I think I shared earlier in 2022 that half of our multiyear subscription agreements included both NGINX and BIG-IP because increasingly, customers are modernizing their applications. I think that the -- there was a fear at some point, I would call it a fallacy that NGINX was a substitution for BIG-IP, and it would be dimes to dollars. We haven't seen that at all. What we see customers do is they have the IP, they absolutely want to keep it and grow it for an application that is already generating revenue, but then they want to add a new component. And that new component to that application maybe a containerized component in a Kubernetes environment, and they will use NGINX for that component of the application and then link with BIG-IP to have an overall environment that is modernized that makes sense. So that's how those two things come together.

So in that context, it's able to establish a policy at the enterprise level and make sure that it's uniformly deployed by tying in both what you're doing inside the data center as well as what's being implemented by the coder/DevOps teams and platform teams, if you will. Now that kind of puts me in an interesting position because now I've got it inside the container over year, maybe in AWS or Azure or wherever. And I've got my data center over here and it's got a lot of BIG-IP, and it's -- but I think it's certainly to get across the WAN, and that brings me to your security products. Is that the bridge between those two and to some extent and the opportunity to provide that cross-WAN capability?

Yes. I mean the -- the bridge between the two is, I would say, more specifically to that example is more around how do we allow customers to, for example, burst -- they may be using BIG-IP on-prem, but they want to burst into a public cloud if an application is dynamic, and we help them do that with automation, being part of their automation tool chains or bringing them our automation tool set. But of course, security is a big part of the consideration here. And what we're doing is bringing our security capabilities and making them available across the entire portfolio, such that a customer can take -- can take a single security policy or even new signatures for application firewall and push them to their entire application portfolio in an automated way. We're not completely there yet, but that's what we are working towards is being able to push these policies across all these environments. And that's the value if you pull up a level, the value of F5 as an infrastructure-agnostic player is that we can provide CIOs with a level of consistency, level of simplicity and level of automation for their security that you cannot provide if you're a vertical platform provider. Vertical platform provider, whether it's cloud players or other platform providers are focused on their vertical garden, and we're focused on the application and really supporting CIOs kind of have the same security posture in front of any application or any component of an application regardless of where it resides. And increasingly, we're going to not just make it possible. Today, we make it possible for CIOs to do that. But increasingly, we're not just going to make it possible. We're going to make it very easy and very automated for them to do that. That's part of the vision of where our platform is going.

So when I look at that security opportunity, and I look at the growth in applications, I think the applications, if I remember correctly, the data is somewhere around 750 million applications globally growing at something like a 30% CLP. And the adoption of Kubernetes within that is at a very high rate. It's going from say, 19%, 20% back in '19. It's up in the mid- to upper 20s now, and it's probably on its way to 50% plus, making that a very high-end market growth rate and the security to secure that cross-WAN traffic is following suit being driven by those same dynamics. Am I in the ballpark on these dynamics in terms of the scale and scope of them?

Generally, I think you are, right, Alex, and I think the penetration of Kubernetes is going to grow over the next few years because it has emerged as the de facto standard and most customers are moving -- I would say we're still even in early stage in having a lot of these application environments fully in production and fully at scale. But I think over the next few years, we're going to see a lot more penetration of this.

So when I think about it from that big picture, it seems like you guys are extremely well positioned because you're the application specialist.

We like to think so, Alex. But I would say, yes, we are well positioned because of the growing Kubernetes penetration and the growing of modern application environments where we insert NGINX and where we can increasingly insert security. But I would say beyond that, the -- what's happening, at least, for large enterprises -- modern applications are not just growing in these environments, completely independently of what's happening in traditional application environments, right? There is -- as I think I shared earlier, there actually is all these components of applications have to talk to one another and it doesn't matter if they're in different locations. And so networking applications together in a secure way is yet another capability that we bring as an infrastructure agnostic player. That's why we made the acquisition of Altera a couple of years ago was precisely to be positioned for this wave of spend that I think will occur around being able to securely network and mesh all these applications or components of applications together. And so that is an opportunity that is ahead of us, and that's why we've been doing all this integration of F5 capabilities onto our distributed cloud platform.

Well, just to put this into context, your stock is now down to 11.7x [ EBITE ] on 23 numbers, which are extremely depressed and 24 numbers here at 10.6x. That's a steep discount to low growth companies in the category that are growing half your pace -- and obviously, it represents enormous value. And if I compare that to the companies that are in the Kubernetes space itself only on EV to sales ratios, you're very inexpensive. Are you at all risk, worried that you might become an M&A target at these price levels? And what are we doing to ensure that, that doesn't happen so that investors actually get the benefit of this growth?

Well, we, of course, are focused on two things. One is continuing to execute on what I shared with you earlier, which is, I think, Alex, if you look at the opportunity for us in being able to secure and deliver every app and API anywhere and how many apps there is going to be, how much security is needed, the opportunity for us is enormous from where we're at. And we're doing all of the work within our product teams and go-to-market teams to execute on that. Whilst we're doing that, of course, the other part of the equation around our valuation and continuing to drive that is ensuring that we have the discipline of executing on this vision whilst driving double-digit earnings growth and maintaining the Rule of 40 that we have committed to as a way to balance profitability and growth as we are executing on that vision. And as we are able to do that, then I think valuations over the right time horizon will take care of themselves.

It's a fair point. You also have an outstanding balance sheet and throw off a tremendous amount of cash flow. So maybe, Cooper, can you talk a little bit about your cash flow generation in a typical year and what you think the long-term model looks like? Can we get back to that 33% to 35% operating margin over time?

Yes. Well, so that's -- we talked about the rule of 40. So it's a balance between investment and top line growth, but -- we do believe that there is an opportunity to improve our operating margin outlook over time. I think in the near term, the gross margin will be the biggest opportunity. We've got some unnatural costs in our COGS right now, just trying to resolve some of the supply chain challenges. As we get on to these reengineered components, we think that some of those pressures will start to dissipate. And as we continue to scale our SaaS business, the margin profile from that business will also begin to improve because it's below the corporate average. So that's the near-term opportunity just on the gross margin side. Beyond that, we continue to operate in a disciplined way on the operating model with our investments being very targeted on where we think the biggest growth opportunities are. And so it will be a balance because if we see good early momentum in a new revenue category, we will continue to invest into that. And that's why we have that guardrail, the Rule of 40 just to make sure that, ultimately, we're translating to a sustainable double-digit EPS model.

So Rule of 40, if you get to 35% operating margin, doesn't ask for a whole lot of growth. So I'm hoping maybe you'll get to a Rule of 50.

We'll say at lease Rule of 40.

Right. So if I think about the competitive landscape, some of the names that come up are companies like Akamai, companies like CloudFlare, how do we think about the competition between you and those type of players?

So the -- I think we have to separate where we compete with them and where we don't. So in the -- I want to say that the traditional application delivery controller market, we don't. Our traditional competitor there has been Citrix. And even in, I would say, security in on-prem implementations, whether it's encryption, decryption or application firewall or DNS security and all of that, we don't compete with those players there. We have more traditional competitors in the data center that we compete with there. And as you've seen from the performance of our business, both hardware and software, we're doing very well there. Where we are an attacker is in the SaaS market, for typically security capabilities that they -- the companies you mentioned, deliver at the edge. And so the -- when we bought Volterra, the idea there was that we wanted to compete in the SaaS security market. And we could marry a great universal edge platform with best-in-class F5 security capabilities and go ahead and compete in that market. And so we started -- we launched this offering in February of 2022 and we have been growing since then, and we're very, very happy with the early customer reception that we have in there. Now the differentiation for us, of course, is we can link these SaaS offerings with what we're doing in other consumption models, and we can go to customers and say, "Look, if you're going to have applications that are supported in hardware or in software, in the cloud or on-prem, and you want SaaS for certain applications, then we can cover all consumption models and actually help you push the same policies across the board. None of the other players can actually do that. And then the second aspect is, we remain infrastructure agnostic. So you don't have to go into our walled garden to be able to consume F5 security technologies. You can do that across all of the environments. And so that's another advantage that we have. Now of course, we are early in this market. These other players have scale and have been in the market for a while. So there's a long way to go. But we see this as a net new opportunity for F5 and we're pretty excited about the sort of early days of that opportunity.

Well, we're pretty much running out of time here with 1 minute left. From our perspective, this is a no-brainer stock at these prices. It's incredible to me to see it down here. I know that there's been a lot of frustration among investors with it. But I think ultimately, coming out of this economic downdraft, you guys are really going to execute well, and I think the value is there. If you want to take 1 minute, 3 key points that you'd want to make in a minute, elevator pitch.

Successful software transformation so far and I think in terms of the team's execution, I am confident we are going to execute on the vision that I've just shared. Very well positioned for hybrid and multi-cloud environment, which is the destination of the enterprise. And in terms of all the software universe -- enterprise software universe that you see, I think F5 is going to be one of these players that continues to be disciplined about driving double-digit earnings growth and staying with the Rule of 40. So that's the profile and the opportunity, and I agree with you, Alex, it's pretty compelling.

Well, with that, we have to call it a wrap. Thank you so much if you are dialed in, in the audience for joining us. And Francois, Cooper, Suzanne, thanks so much for joining us at the Needham conference this year. We certainly hope to have you guys on a regular basis going forward. We really appreciate the quality of the story. So that's a wrap.

Thank you. Appreciate the opportunity.

Thank you, everyone. Thank you, Alex.