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

Hello, everybody. Tim Long here, Barclays' IT hardware com equipment analyst. Thank you for joining us here for F5 Networks. We got Francois and Frank here, CEO and CFO. So happy to have the senior leadership here to talk a little bit of security, ADC, a little bit of everything here. So I think Francois is going to read a little disclosure, and then we'll hop into Q&A.

All right. Thank you, Tim. Hi, everyone. Let me get the -- our safe harbor on record here, Tim, before I respond to your great questions. I need to get our safe harbor on record. Please note that our discussion today may contain forward-looking statements, which involve uncertainties and risks. Our actual results may differ materially from those expressed or implied by these statements. Please see our SEC filings for more information on these risk factors. Thank you.

Excellent. Thank you, Francois. Thanks, guys, for joining.

Maybe, Francois, we'll start with you, just kind of a little bit higher level. You've been there, I think, about 5 years or so. A lot of evolution at the company. Went from a -- basically an ABC company to adding a lot of interesting pieces around security applications. So maybe talk about kind of your priorities as you sit now, looking out the next few years with kind of the assets you have and how you want to kind of better leverage them.

Well, thank you, Tim. Yes, we have had, in fact, quite a bit of change at F5 over the last 5 years. But these changes, and the transformation of the company, have really been driven by what our customers are doing and what's changing in their environment. And the biggest change I would say is if you go back several years ago, applications, F5 is all about securing and delivering applications. And several years ago, applications were typically in private data centers. And the architecture of these applications were typically [ with ] our architectures. What we've seen over the last 7, 8 years is applications are now being distributed in multiple environments. They're in private cloud and traditional data centers, but they're also in public cloud and increasingly, at the edge. And the way these applications are built has also been changing, moving to containers and microservices environment. And so our transformation was really driven by the realization that at the time, we really only supported, meaning secured and delivered applications, large monolithic applications in private data centers, but there was an opportunity for F5 to extend that and to secure and deliver every application anywhere regardless of where that application was and regardless of how that application was built. And so we did a lot of things at F5 to be able to secure and deliver every app and API anywhere in private clouds, public clouds and at the edge. And that's led to a lot of the organic work we've done as well as some of the acquisitions we've made. If you forward to what's next, we're now with the acquisition of NGINX and Shape and Volterra and the work we've done on Big IP, we are now in a position to support any one of these applications on any type of form factor, hardware, software or SaaS. And we're going to continue to do more of that. I mean the priorities over 2023 is continue to integrate our software stack, meaning porting the capabilities from these acquisitions on various parts of the portfolio, such that it's easier and easier for our customers to leverage F5 across all of these environments. And then we intend to bring all of that in our portfolio together in our distributed cloud console, so we can give customers a single pane of glass from which they can look at all of their applications across their entire estate and provide this consistency of security policies, consistency of performance management across all of their application portfolio. And that is really what our customers are looking for is they're in all these environments, but they also want to abstract the complexity of being in all these environments and F5, as an infrastructure agnostic player, has the opportunity to play that role for our customers. And that really is the priority.

Okay. Great. Maybe before we get into some of the line items on the businesses, Frank, maybe we'll go to you. Talk a little bit about -- I mean, obviously, everyone's been dealing with supply chain and logistics and things like that. And I know you guys have absorbed multiple acquisitions. So talk a little bit about how you kind of see the next few years of margin recapture, be it some on the gross line and some kind of leveraging OpEx, kind of your views there.

Absolutely, Tim. So let's start on the gross margin side. And obviously, pre, I think, the acquisitions that we had, we were probably in the mid-85.5-ish percent range on our gross margins and saw that start to fall down really through the acquisition of some of the SaaS businesses that were subscale in their gross margin profile. And so that may have taken us down 150 basis points or so. And then the drop that we've seen since then, that has really been around supply chain constraints and expedite fees along with purchase price variance and other factors where it's been just difficult and more expensive to secure components that are critical for the boxes that we manufacture. And so what we've talked about is that that's a trend that we start to see loosening up a bit, particularly as we get out of FY '23 and in FY '24. And we work through some of the backlog that had some lower-priced boxes before we did our price increases, the new orders that we have coming on that are going to make up for some of those component price increases. So we do see on the gross margin side, the abilities to recapture and get back up sometime in the next 1 to 2 years as we work through some of these supply chain challenges. On the operating margin side, I think we've already shown increased leverage that's come post those acquisitions. We will continue to focus on finding efficiencies and to drive the overall operating margin up, both from that gross margin expansion as well as improvements in operating leverage.

Okay. Great. Great. Maybe, Francois, we'll go back to some of the businesses. Obviously, security has been very important for you guys. I think it was always in your -- the competency of F5, but it's become more of a stand-alone business. So maybe talk about how you view that security TAM, where you play well, where you need to invest more in securities. I think it's 35%, 40% of the business announcements. Pretty meaningful.

Yes, it's a pretty meaningful part of the business. I think we shared on our earnings call in October that we had passed an important milestone with more than $1 billion of revenue in FY '22 coming from security. And when you look at our addressable opportunity in security, it's really, really focused around application security. And so we've always had security capabilities on our big IP platform, on our ADC platform. And most of the consumption from customers there with attaching security to ADC sales. But over the last few years, we have broadened our security footprint. And so we did that organically by adding additional application security capabilities on Big IP, but we also did that through acquisitions with the acquisition of Shape Security that give us significant bot and fraud capabilities. And now we've also added to that the consumption factor into SaaS. So the acquisition of Volterra was quickly followed by a lot of work on integrating all of our security capabilities onto the SaaS platform to be able to release in the market a bundle that includes web application firewall, API security, DDoS and bot protection, which is increasingly how our customers want to consume the technology is a lot of customers are looking to consolidate their application security capabilities into a single bundle. And we're able to address that now in hardware, in software and in a software-as-a-service form factor. And so we estimate that the addressable opportunity in our security portfolio will be around $15 billion in 2023.

Right. Okay. Maybe could you just talk a little bit about -- obviously, there's a lot of security vendors, stand-alone security vendors out there. So talk a little bit about kind of whether it's leverage of installed base of traditional ADC technology or the merits of some of the stand-alone technologies that you have. How are you positioned better than maybe just a stand-alone security company that might not have the installed base and the hooks into some of these networks?

I think there are 2 effects. The first is having that installed base and having that ADC proxy installed in our customers, gives us an easy opportunity to go and upsell a customer that's bought load balancing and other application traffic management capabilities and upsell them with security without them having to go to another vendor. And that's been a motion now that's been really successful for F5 over a number of years. But we also have a significant differentiation now on the specific capabilities on application security because we are -- we've not decided to go broad and do everything in security. We've decided to just focus on application security. But within application security, we have best-in-class capabilities in these areas of application firewall, DDoS, bot protection, and we differentiate by the efficacy of these solutions. So having less false positives than anybody, being able to block more of the sophisticated attacks than any other vendors, including, of course, specialized security vendors, we differentiate on these capabilities. And we differentiate against both security vendors or platform vendors like CDN or cloud players that have a value proposition that's more around integration in their walled garden, if you will, whereas we have a value proposition that is we give our customers best-in-class application security across all of their environment, cloud, private data centers or edge.

Okay. Good. Good. Maybe pivot a little bit to NGINX. Obviously, was a deal that you got -- the first of your deals and obviously, a lot of strength here on containers, Kubernetes, NGINX doing really well there. So could you talk a little bit about how that business has progressed under F5? And then if you could work in kind of how you guys are bundling it more with other solutions, other F5 solutions?

Yes. So NGINX, for refresher, has its roots in an open source project that was perhaps one of the most successful open source project ever. It's a web server that is now installed in over 400 million websites and growing every single day. And NGINX also had the incredible advantage that it could take multiple personalities. It could be a web server, but it could be an API gateway. It could be a load balancer. It could be a web application firewall. It could be a sidecar in a Kubernetes environment or an ingress Kubernetes environment. And so the versatility of NGINX has allowed us to significantly accelerate the monetization of NGINX. So when we made the acquisition, it was very early in the monetization journey for NGINX, namely just a couple of features on top of the open source capabilities. And we have broadened the capabilities of NGINX now significantly. And so for a lot of customers that are deploying more and more of these containerized environments in Kubernetes environment, there is a need. Kubernetes does very well on container orchestration, but there is a need for networking and security capabilities that Kubernetes doesn't provide. And NGINX really has emerged as a perfect complement to Kubernetes to simplify the number of tools that these platform teams would otherwise need to use if they weren't using NGINX. So the big value proposition is rather than having to use 7 or 8 different software tools to secure and manage the traffic of these applications in Kubernetes environment, customers can go to NGINX and do that with a single piece of software. So that's what's gained the traction and the growth we've seen in NGINX. And we are increasingly bundling in commercial agreements with other F5 products, including big IP, largely because customers now often want to modernize existing applications so you can have an application that's running on big IP and a customer wants to add a modern component to it, which typically will be in containerized environments and being able to buy that in a single bundle and deploy that consistently is something that's quite attractive to our customers.

Okay. Great. Great. And then on the acquisitions, you mentioned Shape and Volterra. If you could talk a little bit about that journey and where you are with full integration there and this -- kind of the move to the SaaS alongside it.

So the acquisition of -- let me start with Shape and then come to Volterra. So we acquired Shape -- I think we closed the acquisition in January 2020. So it will be 3 years shortly. And the capabilities that we've seen from shape and the traction we've seen has really been around the best-in-class capabilities in bot and the fraud market. So we have really been positioned at the high end of the bot market with Shape. So really in financial services, e-commerce, where we see the most sophisticated bot attacks and unwanted automation. And Shape has capabilities in AI and ML and the ability to connect -- to collect a large number of client signals that allow us to block a lot of bot attacks and automation that other players cannot block. And that's really been the differentiation at the high end of the market for Shape. We have now introduced a -- just recently in the market, an offering for a lower end of the market that is cheaper, in part by doing integration of Shape in other capabilities. So we have now integrated Shape with Big IP. You may have seen we just announced a partnership with AWS Cloudfront, where AWS Cloudfront will be able to leverage Shape technology without having to install a new proxy. And we also have other connection and integration with other cloud players that are accelerating the addressable opportunity for Shape. So that's Shape stand-alone with these connectors, allow us to adjust the high end of the bot market and now increasingly also more of the lower end of the bot market. Volterra actually is quite complementary to Shape and to the rest of the portfolio. We made the acquisition of Volterra largely because we wanted to have a SaaS form factors. A number of our customers were saying, we love your capabilities, but we want to consume them in a SaaS form factor, and we can't do that for F5. And SaaS, for a number of our customers, is the quickest way for them to overcome some staff shortages or skill shortages. And so we bought Volterra to have the SaaS platform and also to be able to insert our security at the edge closer to end users. And so with the integration we've now done with Volterra and the rest of our portfolio, we are able to offer all of our security capabilities as a service. And we're also able to offer capabilities at the far edge. So for customers that want to have applications in thousands of locations for IoT use cases, as an example, Volterra is able to serve these needs and provide application delivery and security in these environments. And that is a pretty significant increase in the addressable opportunity for F5.

Okay. Great. Great. Frank, maybe we'll come back to you and talk a little bit kind of software. Obviously, it's a little complicated because you've got multiple revenue models, perpetual, SaaS, term true forwards, all the stuff. So maybe talk a little bit about kind of how you see -- it had been lumpy, it's starting to be a little bit more predictable. So maybe talk about how you see the evolution of the software business kind of from a financial standpoint. And then the follow-up would be, obviously, there was a little downtick kind of macro driven on the last quarter. As we were saying, a lot of companies are -- more companies are seeing and saying this now. So just curious, a little bit more detail on kind of what drove that.

Absolutely, Tim. So look, as you mentioned, we've got 3 different consumption models that people can choose from and each have their own revenue recognition. So you've got the perpetual side of the business that's been fairly constant as a percent of our software revenue, then you've got term and then you've got our SaaS components. Now when we look out and we say, okay, how are we going to model this and how do we think about the future, we always start with the base of revenue that's much more likely and then what is the go get that you have to do for new business activities. And increasingly, that's been getting better and better as you look at the subscription model and the renewals that come from that. Now in FY '23 and what we were trying to highlight when we talked about 15% to 20% revenue growth versus what some of the model expectations were at the time, which were much higher than that, we said that it is an increasing portion, but the numbers are getting quite large, and we're only in the forefront of renewing some of these multiyear subscription agreements. And so it's not going to be as much of a benefit as it will in the coming years. But in FY '23, in particular, that base of SaaS revenue, the base of renewals, the base of true forwards that we expected, were still less than 50% of the revenue guide, and we still had over 50% that you needed to go get. Now that go-get number has been growing very nicely in the past 2 to 3 years. But with the macro headwinds that we were seeing and experienced in Q4, where especially for some of those flexible consumption programs, the large transformational efforts, people are putting a pause on that. And we expected that, that pause was going to continue and it was going to be broader than just the international markets, it was going to start happening in North America as well. And so we expected that to be relatively flat in terms of growth in our guidance and that -- getting that to the 15% to 20% software growth rate that we anticipated. And so that's how we got there. And that's what we were experiencing in Q4.

And then if you -- I mean, if you look at that software guidance, the 15% to 20%, that was based -- I think Frank touched on what we saw in Q4 was significant change in the customer buying patterns, specifically in Europe and Asia around -- and I think you've heard more of that from other companies since then around deal delays, deals being pushed, extra scrutiny being put on deals of any size. And we saw that in Europe very acutely in part because of the uncertainty there and the crisis we saw it in Asia. And we said we -- in our guidance that we expected to see that in America in our fiscal year. And effectively, that's what we've been seeing since in America.

Okay. Yes, I was -- Francios, I'd love your perspective. It gets confusing. Hardware, virtual and it seems like this quarter is where your customers want more hardware and then some where they want more virtual and perpetual licenses spike all of a sudden. So maybe talk -- like how do you guys look at the different hardware versus software consumption models for the traditional products here? Why is it like so volatile, and it's not you, it's -- that's what the customer wants. What do you think that means?

Well, I think for us -- first of all, the way we look at the business is F5's mission is to secure and deliver and optimize every application and API anywhere. The more applications that we are in front of, the happier we are, okay? And so that, at a macro level, is what our mission is. Now which applications want to consume Layer 4 to Layer 7 services in hardware versus in software, that is a customer-driven decision. And we have not architected our business to push customers to go to software unnaturally. We advise them and we share what's the best environment for us. But what we have architected the business to do is to be able to serve the customers in whichever form factor they feel they need to go for their application. By the way, their considerations around what's the right form factor are not just F5. There are other vendors involved. It has to -- it involves their own skill sets, where they are in data centers versus software-defined data centers, automation versus nonautomation, et cetera. There's always considerations that come into the decision of this application is going to sit on hardware environment. And so we feel that for the long term and the benefit of both our customers and the shareholders, the best thing we can do is be able to support all these form factors and have as many applications as possible on F5, number one. And then number two, make it easier for customers to be able to deploy across all these environments with the same consistency and the same simplicity. Now that's kind of the macro what we're trying to do. If you take it down a level, of course, as a part of our business that is pure software now, NGINX, Shape, our distributed cloud, et cetera. The part where there is sometimes a tussle of hardware and software is, of course, our big IP, which is offered in hardware form factors and in software form factors. And what we have seen over the last -- I would say, over the last couple of years is a lot of customers -- if I go back 4 years ago, a lot of customers that have said, in 2 years, I will be 100% software. In 3 years, I'll be 100% software because I want the automation, I want the flexibility to port my licenses between on-prem and the cloud, have not been able to do that. And so we see that some have done nothing at all. Others have augmented their hardware environment with software capabilities, but not all of them have been able to move to software 100%. And I think that's a combination of just the operational reality of sometimes aspirations are not the same as the ability to get things done. Remember that most of our customers are large enterprises with big environments and updating and changing these environments is a big lift. I think it also has to do with the, we have continued to innovate, both in software and in hardware so some of the inconvenience of hardware, we have made them better over time. And I think that's why, in general, the trend has been more of our customers will move to software over time. But the speed with which we've seen this movement on big IP is less than I would have expected 3 or 4 years ago because of the operational reality of what it takes to do it for our customers. Frankly, in our case, whether it's hardware or software doesn't make a difference to our business model. Our move to software was more to be able to secure more applications. Our gross margins, as you know, in hardware once we recover from our supply chain issues, our gross margins in hardware are great. And when you look at the gross profit dollars we get from a software deal versus a hardware deal, they're about equivalent. So we have even no financial incentive per se to unnaturally push our customers to do one or the other. So the most important is that we support more applications. And frankly, today, the benefit for F5, and I think the incredible position we're in is that we're the only player in our industry. We're the only player in application security and delivery that can secure and deliver apps across hardware, software, SaaS in all these environments. And that's a pretty unique position with large enterprises.

Okay. Great. Great. Frank, maybe back to you. Talk a little bit about -- I mean, people don't talk a ton about half your business is services and it's been pretty stable. So -- and given that there's been more demand the last few years, I imagine that that's up that business fairly well as more systems get shipped. So talk a little bit about kind of view for that service business, understanding is more SaaS you do probably takes away from it a little bit, but what's the outlook there?

Yes, Tim. So it hasn't changed dramatically from what we talked about at our Analyst and Investor Day in November of 2020. We -- over a longer period of time, we do expect that to be flat to low single-digit growth. Nothing to do with the strength of that business, which has been great, but more on the allocation of revenue when you're taking a look at SaaS being 100% to product. And on the term-based subscriptions, 37% of that over that 3-year period goes to services ratably over that period of time. The resiliency of the hardware business that Francois has been talking about actually gives that business a bit more growth. And then frankly, when you're in a recessionary environment and people are sweating their assets longer, a lot of times they will depend on those maintenance agreements longer than what they may -- we would have otherwise modeled. And so overall, we think the service business is quite healthy. We will see that deteriorate in terms of growth percentages as we get further out into the software growth of the business. But it's nothing that we're overly worried about, and it's just going to show up in product revenue as opposed to services revenue. But we really are really happy with the overall performance of the services business.

Okay. Good. Maybe, Francois, just kind of wrapping it up here in the last few minutes. The business has become very complicated for investors, so you guys have spent a lot of time trying to break it down for people better. What do you think are the key metrics and guideposts that investors should look at for you guys' performance over the next few years across the business?

Well, so I'm reacting a little bit to the comment about the business being complicated. It is a broader portfolio than it was several years ago.

Well, it's complicated for me.

No. I mean it is -- in essence, though, Tim, it is about securing and delivering and optimizing applications and being able to do that for more applications. And so yes, it is hardware. It is software. It is SaaS. It is traditional and modern environment. But that breadth is also what makes F5 a very well-positioned strategic partner for large enterprises because we address a bigger portion of the problem that a CIO has and we can give them consistency across all their apps. And that really is a huge strength. Now in terms of the metrics over the next couple of years. Look, I think at a macro level, the biggest metric is we said we wanted to drive double-digit earnings growth. We made that commitment in our Investor Day in 2020, and we're really committed to that. And doing the things that we need to do to be able to drive that earnings growth is a huge driver for Frank and I. Now underneath that, there are a number of things around continuing to drive software growth because we think software is going to be a growth engine for F5 going forward. We look at the resilience of our hardware business and continuing to ensure that it is highly competitive in the market where our hardware competes, which is in ADC hardware, where we believe we have been gaining share, and we'll continue to do that as well as in security, hardware, especially in service providers. We're going to continue to be competitive and drive resilience in the hardware business. So those are 2 of the underlying metrics and continuing to be disciplined on our operating expenses to be able to drive the rule of 40 and drive double-digit earnings growth.

Okay. Great. Thank you, everybody, for joining. Thanks, guys.

Thanks so much, Tim. Appreciate it.

Thank you, Tim.