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

Okay. Hello, everybody. Thank you for joining. Tim Long here at Barclays, IT hardware analyst. Thank you for coming by to see F5. I almost said F5 Networks, I've still got the old company name in there. Happy to have Francois and Frank here to walk us through the story. I've already got a bunch of questions here, so I think you're going to do a little safe harbor first.

Thank you, Tim. Appreciate it. So before I respond, 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. Great. Thank you. So maybe, Francois, I'll start with you kind of higher level. There's been a lot of change at the company over the last few years, so maybe walk us into, as we're walking into next year, kind of top strategic priorities for you for the business.

Well, thank you, Tim. And yes, indeed, there has been a lot of change. If you go back several years ago, we were primarily a hardware company. And the view of the market at the time was that pretty much all applications would move to a single cloud. That has not happened. And most large enterprises today, in fact, 90% of our customers operate now in multi-cloud environment, both on-prem, traditional data centers, private cloud environments as well as multiple public clouds. And their biggest issue today is how to deploy and secure applications in this hybrid cloud environment. And doing that is actually dauntingly complex. And we feel that with the investments we've made in our portfolio, both organically in the development of our BIG-IP technologies as well as through the acquisitions of NGINX and Shape and Volterra, we now have a full portfolio to address this hybrid cloud environment, and we're uniquely positioned to drive that. And so with that, the priorities looking at the next 12 months is: number one, evangelizing our multi-cloud vision and helping our customers deploy secure applications in this multi-cloud environment; number two, the continued adoption and development of our Distributed Cloud Services platform, which is our SaaS platform that actually will help all these environments; and number three, continuing to ensure that we meet and exceed our commitment to double-digit earnings per share growth this year.

Okay, great. That's a good place to start. Maybe let's start hitting some of the software pieces. Frank, if you want to go first here. Last quarter was the end of the fiscal year, so you gave us a little bit more clarity on the businesses. But maybe just take a few minutes to walk us through kind of the software model and visibility. And obviously, you have SaaS, you have perpetual, you have term, that's a little more complicated than most companies. So just kind of walk us through how you look at it, how investors should look to those businesses going forward.

Sure, absolutely. So Tim, the way we think about our business is we have deployable models and we've got models that we provide as a service. And in those deployable models specifically within software, we have perpetual software, and then we have term-based software. Within the services that we provide, we have a pure SaaS business and we have managed services. And for the first time at the end of October, we sort of split out the revenue components of all 3 of those. Prior to that, we had always talked about the perpetual business and the subscription business, so combined those two. And we were trying to give people insights to is that we've got different dynamics that happen with each. So on the perpetual side in FY '23, that actually declined by 25%, but that was really more from the fact that '22 was unusually strong as opposed to anything about that business. We generally think of that business as sort of a flat business. It's a way that some of our customers, particularly service providers and some larger financial institutions really still want to own their software or their hardware on-premise, and so we offer that as a flexible option for them. And over a longer period of time, we think that, that's going to be a flattish business. When we take a look at our term business, we've talked about that in relation to what is new and there's new opportunities that are adding into that revenue base every year. And then the pieces that are coming up for renewal are actually true forwarding through that. And up until probably the beginning of FY '23, we had seen the new business growing rather quickly. And then the recurring side of that business was growing but it hadn't really come up for renewal yet. So we saw a lot of great activities that were happening with the growth of that business with our true forwards, but only in the end of '22 did we start to actually see some renewals come through. And that's a part of the business that really probably affected our overall growth rate in '23 from the expectations that we had at the beginning of the year versus where we ended up. So we expect it to be 15% to 20% growth within our software business. As of FY '23, we were actually flat for that business. And the way we modeled that is that we thought the recurring revenue was going to do a certain thing, which it ended up doing. And the new business that had been growing 25% to 35%, we thought that was going to be flat and that actually was down double digits. And so that led us to be up 9% in that business as a whole, but it was obviously different than our expectations going into the year. And then within the SaaS and managed service, we've talked about there's some different dynamics going on there. We've got a strongly growing Distributed Cloud business but off of a relatively low base. And we've got about $65 million of the $200 million of SaaS and managed service that we do expect to moderate out of the revenue stream over the next couple of years. And that piece of the business, obviously, we wanted to split out so people understood those dynamics. And that we do see Distributed Cloud growing, we don't think from a revenue side, it's going to be able to make up for some of that loss over the next couple of years, but bookings, we expect to continue to grow relative -- very nicely in that regard.

Okay, great, great. And then maybe just -- you did talk a little bit about net dollar retention, and just talk to us about where you are. I know it's very complicated and a lot on the back end, but where is F5 with more regular disclosure around some of these...

Yes. So what we talked about is in terms of net dollar retention, we had two different dynamics going on. It's not easy for us to convert the 606 revenue back into a subscription revenue just due to systems limitations and other factors. But it's safe to say that, that piece of the business is probably world-class above 120%. And the SaaS and managed service piece was not. It was below that. And so that combination sort of left us in a good place for us to meet the commitments that we thought we were going to do within that recurring piece, but it was coming from two different spots. We will continue to look at that, and we have committed to talking about those numbers on an annual basis. We will see if we get to a place where we start to talk about those on a quarterly basis.

Okay. Great. You mentioned the $65 million. In my discussions, a lot of investors were kind of happy to see the streamlining of that business. So maybe talk to us a little bit about when you -- Francois, you're looking holistically at the software businesses. What was it about these that made sense to kind of walk away from the business? And how is this going to make the model maybe more consistent going forward?

Well, we're excited about our SaaS and managed services business because we see a number of our customers who are consuming our hardware or our software who also want to consume for some of their application estates. They want to actually serve these applications through a SaaS or managed services offering, and we're now in a position to capture all of their -- or a large majority of their wallet share because of the different consumption models. But on the SaaS and managed services, there were two dynamics that led us to making that rationalization. The first is we have a platform called Silverline that we've had for many, many years, which was offering a limited set of managed services. And we knew that we wanted to retire this platform and over time, migrate all customers to Distributed Cloud. Distributed Cloud is the more modern platform. It is offering already today and will in the future offer more services. So it's a better way to serve these customers. There were around $35 million of managed services revenue that we are therefore -- that are on Silverline today, that would over time, we would expect to migrate a number of customers to Distributed Cloud. We don't think it's going to be 100%, but all of them will go to Distributed Cloud, but we're hoping the majority of them will. And then there's another -- the other half or so of that $65 million is a number offerings, these are managed services offering that we had launched in the market and for which we didn't feel the ROI was what we expected or legacy offerings from companies we had acquired that we didn't feel we had the right ROI. And we made a decision to rationalize these services out and focus on the ones that are being really successful. And that's why we're retiring about $65 million of revenue stream in SaaS and managed services. But the other part of that $200 million, which is about $135 million or so, we feel very good about and we think over time is going to grow.

Okay. Great, great. Frank, you mentioned like new deal activity was weak last year. And obviously, investors hear a lot of enterprise companies have had the same thing happening. So where do you think we are now with macro impacts deal activity? Is this something that you think will work through in the next few quarters? Or is there potentially more of a hangover here?

Tim, the exact timing of it, I wish I had a really clear crystal ball that would tell me. But I will say that we have some pipeline activity increase, which is great. But we'll see what the close rates look like on that. We'll have more to talk about that next -- in January. As a whole, when we looked at the model and what we talked about for FY '24, we weren't expecting a tremendous rebound in new activity. The exception of that is probably in our hardware business, in our systems business. We do expect our bookings rate to be higher than what we saw in FY '23. And we think that there's a combination of factors, including just how long can you sweat assets, competitive dynamics going on in that marketplace as well as other certifications that we have in foreign jurisdictions that are now allowing us the ability to sell those through our channels. And so we do expect an increase in activity in bookings. It's not going to make up for the $180 million of backlog headwind that we've got going into that business. So you're not going to see revenue grow, but we will see bookings internally grow from the levels that we saw in FY '23.

Okay, great. Francois, you mentioned Distributed Cloud, it's still kind of early days, but what are you hearing from customers on that? How is that impacting your ability to take share and really be a more important partner with a lot of the enterprise you deal with?

Well, we are -- customers are excited. We serve large enterprises customers, Tim, as you know, across technology, financial services, telcos and then health care, manufacturing, a number of verticals. And the platform actually is playing across all verticals. And the big benefits that customers are seeing is, a, the ability to secure a full application security stack, including API security, protection against DDoS, application firewall and also bots, which are increasingly a problem. So it's a full application security stack. The ease of implementation of the platform is a real big benefit because customers can get to value very quickly. And the ability to run this platform in any compute environment that customers need is a big benefit relative to alternatives in the market. And then we've brought to the platform the high efficacy that F5 known for. So the very high efficacy against the facts that we have had on-premise in our hardware, in our software, we're bringing that to the world of SaaS, and that is a differentiation relative to the alternatives that have been there. And then on -- so that's on the security side. And then in terms of the problems that customers are having around having applications across multiple cloud, we are an early player into this multi-cloud networking market. And so those capabilities are pretty unique. The ability to combine cloud networking and security in the same platform is actually unique to F5, and we're seeing customers pretty excited about that. So we think the combination -- and both of those are growth markets. So we think the combination of these capabilities and future capabilities that will come on the platform actually are going to be an important differentiator for F5. And then the last thing is for large enterprises that have applications that they want to keep supported by hardware on-prem or software on-prem and other applications for which they just want a service as opposed to owning the package hardware or software, having one vendor that can provide all of that with the same security engine and the same application delivery engine is actually a pretty compelling proposition. So that's the other piece of feedback we're hearing from customers, it's a big simplification in their environment.

Okay. And where are you now with -- it's been a while for the acquisitions that you mentioned. Is everything fully integrated across the company? And obviously, you streamline, you've taken some things out, NGINX, cross-sell, maybe talk a little bit about having the different aspects of it.

So in the world of packaged software and packaged hardware, this is where BIG-IP plays and NGINX play. And they -- generally, they can play stand-alone but they also play increasingly together for a number of customers who are having modern applications and traditional applications in their environment. Those integrations are largely completed, both from a technical perspective, porting capabilities from BIG-IP on NGINX, porting security on NGINX and from a commercial perspective, offering our partners and our customers single commercial vehicles to deploy these technologies. And where we're seeing the benefit of that is in what we call our Flexible Consumption Programs -- we used to call them ELAs, but Flexible Consumption Programs today. In the world of SaaS and managed services, we are still doing some integration and the product rationalization that I talked about is part of that. But essentially, we want all of our customers to be on the Distributed Cloud platform, which is a modern platform that gives them better experiences. And we're still completing -- I think over the next 12 to 24 months, we will complete the majority of the integration work we wanted to do there.

Okay. Great. You talked a little bit about security. Maybe just level-set for us, I know you break that out kind of once a year. So it's been increasingly a higher piece of the revenues, both stand-alone and integrated with BIG-IP. Talk a little bit about F5 differentiation there. And is that an area that you continue to see outgrowing the rest of the business?

Yes. Over time, we expect it to continue to outgrow the rest of the business. We did share, Tim, as you know, last year that we had crossed the $1 billion in security revenues. I think this past year in 2023, it was a little over $1.1 billion. And the differentiation for F5 is, of course, number one, we have always been known for high-efficacy security solution. So not just good-enough security but best-in-class security. And that continues to be a differentiation in the enterprise market. Number two is we have a very complete application security stack. We've made a decision to be focused in the space of security around securing applications. But in the area of securing applications, we have a full application security stack. And it's the same stack in SaaS, in software and hardware. And that is actually very unique. We essentially are the only player that could offer all of that across the spectrum. And then the third thing that is playing -- we're seeing a big differentiation is the ability to run the stack in any environment for our customers, which means that we can essentially secure any application or API anywhere for customers. And that is a unique proposition at a time where customers are looking to decomplexify their environment, potentially reduce the amount of vendors, the ability to do that in all consumption factors and do it across any environment is unique to F5, and it's a big help to customers in simplifying what they're doing.

Okay. Great, great. Maybe I just wanted to touch on services for one. I know Tom is here, but when you guys can take this -- it's been a good business, and I think it adds up with what you're saying, sweating assets, and it looks like it's been outperforming. What's the outlook there? And it feels like a very good and stable business that maybe doesn't get the credit it deserves. So I don't know if there's a question in there, but talk to the importance of it and kind of how we should look at that as a kind of stable, high-margin growth business for you guys.

Absolutely, Tim. So our services business has got several components into it. The smallest is actually professional services side of the business. And the bigger, meatier chunk of that's very high margin for our services business is what's been associated with the hardware deployment that we've had for decades as well as an allocation of our Flexible Consumption Programs that come into the services revenue stream a bit at a slightly lower level than some of our perpetual revenues that come into that stream. So those are the components of the service business. In FY '23, that actually grew 7%. That was unusual. It was a factor of a couple of things. The primary factor is the services is generally a derivative of the product pricing. And so when we raised prices in July of '22, because of the supply chain issues, that then had the benefit to our services revenue stream in FY '23. But that's a -- that's as they came up for renewal. It's not something that we expect to be a trend going forward. The other component of it was the sweating the assets. And so people who we would have expected to migrate over to a new platform or software or SaaS solutions stayed on their traditional hardware solutions for longer than what we otherwise would have modeled. And both of those factors are what led to that 7% increase. Over time, we've talked about flat to low single-digit growth, and that's healthy in that business. We'll just see more of it come through the product revenue stream in our growth rates with SaaS. It has 0 allocation to the services stream.

Okay. Great. Maybe to hardware, I think you touched on kind of the order headwind that you're going to face. But it's been a crazy 2, 3 years where, I guess, we expected there'd be a lot more hardware to software, but then some companies still wanted hardware and then they didn't want hardware. So what are you seeing from the customer base on the consumption model, whether it's a virtual or a hardware-based product? And what is that trend going to look like going forward?

Well, I think in general, we're seeing more customers want to move to software-first consumption models. Customers move there in part for flexibility of being able to put the software in different -- I mentioned multi-cloud earlier. It's the flexibility, if you're not sure where all your apps are going to be, to have software appliances, you can deploy them in a private cloud on-prem, potentially move your licenses to the public cloud. That's important. Sometimes, it's for economic model. I prefer to move to a subscription or an OpEx model rather than a CapEx model. And also to sometimes accelerate automation initiatives in organizations. So generally, the trend is going to be towards more software. What it means for the hardware business is this and what we've seen over the last 6 years, despite the gyrations of supply chain and macro and all of this is the hardware business is very durable. And we have a number of customers who have use cases that will be hardware and will be hardware for many years across all of our verticals. So the hardware business is going to be durable. We do expect that the unit demand in hardware over time is probably a low single-digit decline, demand in hardware units, because of the general aspiration for software, even though the durability will come from all of these use cases that are hardware based, including sometimes repatriation of workloads, including new use cases that require hardware acceleration, a lot of customers that require big throughput. So all of that is providing durability in the hardware, but over -- when you aggregate all these dynamics, we think the demand -- the unit demand for it is kind of low single-digit decline over time.

Okay.

And Tim, we generally don't think of our business as a from-to, we think of it as an and-and. And so it's hardware and software and SaaS and managed service. And we want to provide, as Francois said earlier, a consistency across that. So when customers really think about the management of their application infrastructure, they have sort of one pane of glass or one management dashboard to look at that will go across all of their different deployment environments.

Okay. Great. I did want to touch on the telco end market. It's been a challenge for a lot of companies. Just curious what you're seeing on your side being a little bit different angle into these networks than some of the more traditional com equipment players. So what are you kind of seeing there? And do you think that's an area that when we finally get 5G applications and moving, that it could be a better end market for F5?

Well, we think it will be. I think as other companies, what we've seen in the telco market is, in general, service providers sweating assets and curtailing spending. And in general, the transition to 5G has been delayed, I think, at least a couple of years relative to what expectations would have been 3 years ago. There are exceptions to that. And so we're seeing one or two large service providers who have launched 5G offerings are seeing substantial increase in demand and traffic on their network. And we will benefit for that -- from that in the near term. And we will see it in both software when these 5G architectures are in place and in hardware for those customers that are augmenting 4G and just adding capacity in their 4G infrastructure to deal with initial 5G traffic. So generally, some delay, but we're starting to see green shoots of a couple of service providers resuming spending driven by 5G offerings.

Okay. That's great. Maybe, Frank, talk margins a little bit. I know you guys obviously went through a little headcount reduction there -- not little, a headcount reduction. Very nice margin improvement with that. Talk a little bit about how you see operating margins project looking forward the next few years. Obviously, you have a very high, great gross margin to start with, which helps. So maybe give us a little sense on how that will look in the model.

Sure. So you're absolutely right, Tim, we do have a high gross margin, but it had been higher, and we had impacts from the supply chain. And largely, the crazy component pricing that we are paying in '22 and portions of '23 have largely worked their way out of the inventory. And so we are seeing improvements in the gross margin that obviously helps the operating margin as well. We have three initiatives in AI that will also improve both the gross margin and the operating margin side. We are specifically using like many other companies, AI technology to help in our services in case deflection, helping in our product development in terms of co-piloting with developers to streamline some of those efforts and then also in our sales and marketing areas. And over time, also the benefits of a subscription model within sales and marketing will reduce that expense-to-bookings ratio that we continue to be focused on. So we've talked specifically about gross margins in '24 and '25 in that 33% to 34% range and then growing 100 basis points from there, likely to 35% plus. And so we see that as a natural way we continue to look for efficiencies in the business. We've got specific programs that are going out and looking for that. We've seen improvements in our discount rates and other factors in the overall business. And so all of these are things that we continue to expand on to get double-digit EPS growth on a compounded annual growth basis going forward. We do -- we had to talk about this year as being possibly below that because we don't know exactly what's going to go on with tax. But looking at a pretax basis, we expect to get there this year as well.

Okay. Great. And then maybe just on capital allocation, update us there. And Francois, if you can talk a little bit about M&A. I mean we've -- there was a lot of activity and then a pause in integration. So where is your head at now on that dynamic?

Well, we've got a lot of focus on -- I mentioned earlier, some of these integrations and the organic growth in the portfolio. We've made big investments in our core franchise, BIG-IP, and we're now releasing next-generation hardware and software. We think that's going to allow us to continue to gain share in the ADC market. We're making substantial investment in NGINX and Distributed Cloud because we see the opportunity there in these growth markets, modern apps and SaaS. And we still have a lot of organic work to do there. So that, of course, remains the priority. In terms of potential inorganic activities, we will continue to be disciplined about that. And when we're looking at potential adjacent services, continue our build versus buy analysis. Where we would see the potential opportunities there is Distributed Cloud and accelerate potential other services that could come on the platform, maybe inorganically in the future. If you think back of what we did with BIG-IP over the last 15 years, BIG-IP really initially started as purely application delivery, but it was at a point in application infrastructure where it was convenient for our customers to consolidate other services. And so we added other services, including security, some through organic development, some through acquisition. We got in the WAF market, for example, by acquisition. It's -- we will probably have a similar opportunity on the SaaS space with Distributed Cloud, and this is where we might look at acquisitions in the future. Inside the framework that we've laid out where we've committed that more than at least 50% of our free cash flow would be used for share repurchase and the other 50% for other activities, if you look at our track record over the last couple of years, it's been way more than 50% on share repurchases.

Okay. Great. Look at that, we finished exactly on time. So thank you very much, both of you guys.

Thanks so much.

Thank you, Tim.

Appreciate it.