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

The disclosure. For important disclosures, please see the Morgan Stanley Research disclosure website at morganstanley.com/researchdisclosures. If you have any questions, please reach out to your Morgan Stanley sales representative. Tom, if you want to read your disclosure first, then we can really get into the conversation.

Thank you, Meta. I should start by just saying that some of our statements may contain forward-looking statements. We'd ask that you please listen to these in the context of our SEC filings, and that actual results may differ from those that are discussed or implied.

All right. Perfect. So welcome, everybody. I'm Meta Marshall. I head up Networking here at Morgan Stanley. We're delighted to have F5 Networks here with us today. We have Frank Pelzer, EVP and CFO; and Tom Fountain, EVP of Global Services and CSO.

So a couple of weeks ago, you guys held a strategy session that I thought was super helpful, and it outlined your market opportunity had grown from $11 billion to $16 billion today and with certain product expansions you've made over the past couple of years and was growing to $34 billion by 2028. Just what are some of the changes that the portfolio has undergone, that have helped grow the addressable market so meaningfully.

Yes. So if you go back 5 or 10 years ago, most organizations had spent a tremendous amount of time collecting all of their applications and putting them in data centers. And we had a model where you connected directly to those apps in a singular data center. The rise of public cloud sort of promised that all we needed to do is to take those applications and move them from the data center into the public cloud, and you'd keep them in one public cloud and enjoy sort of all of the cloud benefits that would follow. The reality for most organizations is that, that isn't the world that they live in, that instead, most of their applications today are distributed across a wide range of different environments. Some of them are the traditional data centers, some of them are colo, sometimes it's the public cloud. Increasingly, now it's even the edge. And so those apps are quite distributed. Seeing sort of this transition in the market, we have really pivoted F5's portfolio to address sort of this growing what we call crisis that is the "ball of fire" that customers are facing in managing these multi-cloud environments. And so we've done that across sort of all 3 of our major platforms. So our BIG-IP franchise we've really innovated there for the next decade and have brought a lot of the cloud benefits to the deployable products in BIG-IP with our NGINX business, we are able to address modern applications, and we brought a lot of security functionality to be able to protect those applications and then through a combination of acquisitions and a lot of organic execution, we've built our distributed cloud platform that is our platform for SaaS and managed services. And that platform is able to address a number of both traditional and modern application use cases. And so we believe that we are the first and only vendor to provide sort of this application security and delivery across hybrid and multi-cloud environments. And the result is a much larger market opportunity that's now available to us.

Okay. So as you're solving for customers kind of ball of fire and the complexity that these environments have created and expanded out that portfolio. At the strategy session, you rolled out some attach rates that were impressive just as that portfolio has grown. Can you just outline those for the audience? And just why you think you've seen traction with kind of the larger customers first?

Sure. So let me take that one. We did talk about our land and expand motion at our strategy and product session, and let me give a little bit of context. So our customers are generally the largest of large enterprises, governments and service providers and we've got about 20,000 of them. When you take a look at some of the specifics, we kind of talked about 4 key metrics in our portfolio of BIG-IP, NGINX and distributed cloud or SaaS and managed services. Within I think from FY '20 to FY '23, we have doubled the number of customers that have both BIG-IP and NGINX. We did the same thing actually for BIG-IP and SaaS and managed services. By the end of FY '23, over 50% of the NGINX customer base were also BIG-IP customers. And I think over that same -- that same period of time, 63% of the SaaS and managed service also we're BIG-IP customers. So there has been great, great attach. The other 2 metrics that we sort of pointed to is taking a look at just the subset of that 20,000 customers, our top 1,000 customers from '17 to '23, we went from 3% having multiple solution families to 44% over that same period of time. In the total customer base, it went from 1% to 7%. So within that, the largest of large, that is where we've seen most of the traction, but we still have plenty of ocean to serve as Chad likes to say, our head of sales, for all of our customers in terms of attach rates. I think it's really made a couple of things. One, the largest of our large customers probably have the most complex environments and need really a centralized tool in which to manage all of that. And that's really what the distributed cloud platform gives as well as they are modernizing their portfolio, which is what NGINX provides. And so I think just from a sort of dollars that they have to invest and the complexity that they need to manage, -- they're the first starting point of that. I would also say that those are probably the bigger opportunities, and we have a sales force that's coin operated. And so they can -- they're going to probably spend their time on some of those larger opportunities.

And so I mean, a point that we've had kind of in discussions is don't take the attach rates to mean that those customers are fully penetrated and so -- both in terms of how do you increase that penetration with the customers you've already made traction on? And then what are the initiatives to kind of bring those attach rates kind of further down market where maybe less dollars, but still tons of opportunity?

So I think, again, our focus probably still going to be on the largest of large in the near term. But over time, particularly as the use cases for our centralized console or better understood, which should be the cloud, as our channel partners are better educated on the entirety of the portfolio, we will start to see more penetration down market. We are never going to really be an SMB provider, but we do obviously have a huge amount of opportunity with enterprises that maybe aren't the largest in the world. So I think over time, we will be able to dedicate more resources to the lower end of the market. But right now, we're still focused on the top end.

Okay. Okay. So increasing penetration of those attach rates or kind of those accounts.

Absolutely.

You're dominant in the ADC market. So just how do you translate some of that competitive positioning, both in terms of kind of channel education but customer education about some of these platform extensions that you guys have made?

Yes. So the largest of the organizations that Frank was speaking to, I think, have tremendous trust in F5 and that gives us a really powerful position to start with our land but then really expand in a variety of different ways. Maybe to add a sharper point to kind of some of those levers, I think one of them is certainly as the number of applications in these environments grows, we are able to grow with the demand around any one of those applications. The second is that we can expand to new applications within the environment. I think our NGINX business, as an example, allows us to address modern applications. And so a lot of our work has been -- about being able to expand to every app and every API in an organization. And then the third lever really is around bringing new functionality into each of those applications. And we've done a lot of work around continuing to expand our security portfolio, in particular, but we've got a very broad set of security, delivery and application optimization functionality. And so each of those 3 levers are able to give us a significant opportunity to expand with an account, and that's what Frank was speaking to with some of the statistics and some of the great results that we're seeing.

Okay. So I mean as you expand that platform and you've traditionally sold to a chief network operator. Increasingly, you're also selling to the security teams or kind of some of the more modern development teams. Just how does that change maybe the channel partner that would have traditionally kind of sold into that environment and efforts to kind of expand the channel that you're selling?

Yes. So we've done quite a lot of work over a number of years around cultivating the right channel partners. We have really evolved our selling motion over the last 5 or 6 years. If you go back 5 or 6 years ago, we were fairly transactional and really around repeat buyers and selling them sort of refreshes. Over the last 5 or 6 years really as we built out our software and subscription capabilities, we really changed it to a continuous selling motion. And along that path, we have continued to work with partners that are capable and able to do that, that are able to bring us into the right opportunities. We are deeply committed to making sure that our partners are successful in these engagements. And so we're seeing really good success with the partner ecosystem that we have today. Maybe just as an example of that, in the last 3 months, we've trained 1,000 partners on our newest offerings on distributed cloud. And with some of the market dynamics and the competitive dynamics right now, we're seeing actually increased interest from partners and doing even more with us. And we think and expect that by the end of this quarter, we'll have 1,500 partners trained on our distributed cloud platform. So quite excited.

And so just where do you feel -- that rounds out kind of the channel education process that you guys have gone through. Do you feel like your customers are -- how much of that has translated to customer awareness of how much the portfolio has expanded?

Yes. I think some of it has, but there is an opportunity to do more. Just this last month, so in February, we held our big customer event, we call it AppWorld. And this is the first time of getting our customers together in 5 years now. And we were able to share with them sort of the entirety of the portfolio and really the vision that we're pursuing. And I think we had resounding sort of support from the customers that were there. We're now taking that show on the road. And so we've got a series of regional AppWorlds that are planned globally through the next couple of quarters to get that message out there. And so we've got a lot of activity there that's trying to get to more customers. Maybe the other piece that I'll add to it is we think that part of the equation here is also about making it easier for customers and partners to do business with us. And some of that is around the product and being able to integrate and deliver sort of this cohesive portfolio of solutions that promotes and encourages or use across all these different environments, but it's also about the contracting and commercial vehicles. And so we put in place the commercial model that makes it easy for customers to start with one product and then be able to expand across the portfolio as they consume more from that. And so we think that the combination of all of these will help educate the customers on sort of the opportunity to use us in different ways across their environment.

Okay. So TMT 2024, we'd be remiss not to talk about AI. So just how much do you see as AI as being a catalyst for the organization? And just looking at your applications more organizations and customers looking at their application environments more holistically. And what kind of opportunity does that create for you as they kind of look at these environments?

Yes. So I think -- I don't know that AI will be a catalyst for them to think holistically necessarily. But it absolutely is going to be a huge catalyst for this ball of fire problem that we described. And I think there are 2 defining characteristics to AI apps. And I think effectively, all apps in the future are going to be AI-powered in some way, shape or form. And the 2 characteristics that really make these AI-powered apps unique is, one, they tend to be very dependent upon application programming interfaces or APIs. And the second is that the data and the app, particularly on the inference side, are highly distributed. And so both of those are going to put even more pressure on the fall of fire problem, the multi-cloud and hybrid reality that our customers face. And so we think that those are accelerants for the things that we're able to solve. F5 really is an AI enabler. And so we think that these forces are going to create more apps in the world. They're going to create more APIs. They're going to distribute them into more places. And then, of course, they do all about security is going to become an even bigger problem. And we think that the vendor that understands how applications and security all come together is going to be best positioned to be able to help them solve these problems. And I think we are definitively the experts in doing that.

How do you think of -- I mean the question of the day is when does AI actually act as a trigger for kind of some of this investment? Just what are you kind of hearing from customers? Because I'm sure you're not seeing demonstrable orders today, but just how are they thinking.

Yes. So we are seeing some early -- both -- everything from startups to large tech companies that are starting to build AI models and AI-powered applications. But the vast majority of enterprises are really in an experimental phase right now. They're testing sort of different applications, they're testing how AI is going to work for them. And we really think that sort of over the next 1 to 2 years is really when they'll start to build AI-powered apps in a much more significant way and start to build out both the infrastructure and then ultimately, the delivery capabilities to bring those apps to users.

Okay. So another tailwind for you guys has just been kind of the disruption, the competitive environment. Just how are you taking advantage of some of that disruption and particularly just as -- some of your competitors are just under new management altogether.

Yes. So I think we are taking share across a number of different segments, but ADC, the application delivery controller space in particular. First, we made a series of deliberate decisions over the last several years to invest in innovation in both our hardware and our software and today, we have a superior set of capabilities around performance, a lot of functionality, particularly around cloud-like capabilities and overall, a TCO advantage as a result of those investments that we've made that our competitors chose not to. We're also seeing a bunch of sort of immediate actions that our competitive set is taking that is also giving us a significant opportunity. A lot of our value proposition or a portion of our value proposition is really around the choice and flexibility that we provide customers, being able to operate in all these different environments to be able to consume it in a variety of different models, perpetual, subscription, consumption. And again, our competitors are significantly narrowing that set of which deployment models they're going to make available and under which license models they're going to make available. And the effect of that is that we're able to gain share because customers don't like to be boxed in that much. I'll use maybe just as an example. We talked about it on the most recent earnings call but a Fortune 100 customer that had been a longtime customer of one of our direct competitors, deeply embedded in their organization. They -- that customer has gotten quite frustrated with the lack of innovation. They are -- we're dissatisfied with having only a single model that was available to them for how they had to consume the technology. And then frankly, the straw that broke the camel's back with a significant price increase on the services. And they've now come to F5 and they are making a wholesale change to F5 across the entirety of their estate. And I think it's a good example of the sort of pattern we're seeing as a result of some of these market forces.

Okay. Perfect. Maybe turning to the current environment. We just talked about a lot of the tailwinds for your business in the coming years. But you've noted seeing stabilization in fiscal Q1, better than almost every networking vendor who kind of saw enterprise deterioration. Just what do you think explains some of that discrepancy and -- is it tied to being -- tied to more multi-cloud investment or just having larger customers? Just how did you kind of take your results as we went throughout earnings season.

I wish I had a -- I wish I had a clear answer for you, Meta, on exactly what we're saying that others are not. And I can't really speak to their businesses. But I will say that we obviously -- when we talked about our '23 outlook, gosh, back in October of '22, we talked about our renewal business and our new business and the renewal business largely did what we expected to do and the new business has really hit last year and we saw for the last couple of quarters some stabilization, which was nice for us to see it's sort of what we baked into our expectations for the year as well as our quarterly outlook at the time. And that's what we've been -- what we've been seeing. If we take a look back at the history of F5, there's when we've had these recessionary moments and demand really comes down, it only goes for so long before people really have to make that next level of investment as applications and infrastructure just require it. And so that's what we're seeing in our business, I can't speak to everybody else's.

Okay. I mean after we've gone through the couple of once-in-a-lifetime events over the past couple of years, either in terms of COVID or supply chain challenges, inventory digestion, just -- how are you gaining comfort in what the baseline level of business really is across systems, software and services portion of the business given and there's multiple different purchasing models.

So more and more. Over 70% of our business is now really on a renewal cycle, whether or not that's software subscriptions, whether it's maintenance within our services base, but a large majority of our revenue is coming from renewable sources. And so we're just not as dependent on new opportunities as others might be. The system side is still the hardest to "predict" and we have talked -- I just mentioned that, that 4 to 6 quarters of refresh cycle, we're hopefully getting to the end of that. We talked about in the last earnings call that the pipeline was increasing for the back half of the year, particularly on the system side. We actually have to convert that into bookings and more to come as we get through the year. But those are the opportunities that we see. In the software side, this year, more than 60% is going to come from that renewal base. We talked about double-digit growth into '25, based off of that renewal base. And so it's not all ratable, but there is more visibility that we see based off of the different consumption models that we offer our customers.

Okay. I mean -- and just do you feel like you have started to gain a better view on what election tendencies are. Part of the advantage that you guys have is choice, but that can also be a headache for you on a forecasting basis. Now that we're getting back to more of a baseline, do you have a better sense of how that's tracking?

We do, and we've got better metrics out there that we do track internally. The last thing that I probably failed to mention is when we take a look at our customer base and what we are understanding of budgets going into FY '24 the early read that we got in calendar Q4 is that they were going to be relatively flat to last year. Now last year was obviously down dramatically from where they had been in the past 5 years before. But at least they were going down again. And so that gives us also some comfort in the outlook. Now you may say, okay, well, systems, you expect to do better bookings on flat budget? Well, I think that's probably an allocation of what you can sweat for only how long and maybe our time is coming for some of that refresh to happen where our services have really benefited by having a elongation of customer sweating assets. But at some point, that converts over to systems bookings, which we would expect in the back half of the year.

Okay. And maybe you can just outline for investors just some of the puts and takes on the software or line item. I know there's a number of headwinds that you guys are kind of working through. But just how to think about the software growth?

Sure. So I think about that in the 3 different consumption buckets. So perpetual has generally been about $100 million to $120 million in any given year. Some years it's more, some years it's on the lower end of that. But that's generally the range, and we don't expect that to change dramatically. On the perpetual side, that's where we've got our split between the renewal business and the new business, and we had lower expectations this year on the new business than we did last. And so we don't expect a ton of growth out of that this year. But on the renewal side, we just have a bigger base than we've had in the past. Next year, we'll have even bigger bases, some of the contracts are entering their third term of renewal. So that's on that piece. On the SaaS and managed services side, that's what we split out for the first time at the end of FY '23. And it's what we talked about from a revenue side would be relatively flat for the next couple of years with some gives and takes. Now the give is that our distributed cloud business is growing rapidly off a very low base, but it's nice to see. And that is giving us benefit in terms of bookings growth on a ratable basis. On the take side though, when we evaluated the managed services business that we had and some of the SaaS business that we had, there was probably $30 million out of that $200 million that we said that's not growing at the right rate, it's not got the right margin profile. We're going to make the decisions to sort of in those businesses as those contracts come up over the next couple of years. And so we talked about that $30 million coming out of the base. And then there was another $35 million associated with our Silverline Managed Services business that we are migrating over to our distributed cloud platform. That will take a couple of years to build future parity particularly for some of the larger revenue. And so it's going to be a little bit more back-end loaded into FY '25, but we're going to end of life the Silverline product at the end of '25 and try to migrate over as much of that $35 million is possible to distributed cloud TBD on how that plays out.

Okay. Obviously, most people think of you as kind of a large enterprise customer base. But you do have a decent amount of service provider customers, it's been thematic over the vast majority of this conference. Just what are you seeing from service provider customers, just in terms of kind of investment cycles? Or when do you expect some of that demand to return?

So as a vertical, that's probably been one of the more challenged in terms of sweating assets and really holding on to those dollars tight. We did talk about in Q1 that -- in our software business, particularly perpetual benefited from a couple of those service providers, making some fairly large architectural decisions that had good revenue for us in the quarter. But it was more a one-off for that those particular service providers that we're making some of those, I would say, futuristic 5G type investments. But that wasn't necessarily a broad trend across the industry, and we tried to highlight that this may be one by one as opposed to the floodgates open for all service providers. I do think that they probably sweated assets as hard as anyone else. And so that refresh cycle will come. I can't tell you whether it's in the back half of the year or sometime in '25, but I think there's only so long you can go.

Okay. You've laid out targets not only for fiscal '24, but fiscal '25 in terms of mid-single-digit revenue growth and 10% plus of EPS growth. Just what parts of the portfolio gave you confidence to kind of lay out those targets, particularly just with so much macro uncertainty?

Absolutely. Absolutely. So largely, it was the renewal base on our software term that we saw coming due. And that third term of commitment where we have largely performed to the expectations that we've set in any given year or any given quarter for what that renewal base is going to be. It's not beyond us to screw up our relationship, but we hope we don't. And we just have much more of that business to come in '25, which should lead to double-digit software growth and allow us to achieve that mid-single total revenue growth with services holding in there and not necessarily expecting a ton out of new business for our systems side.

Okay. Perfect. You've talked a lot about utilizing AI for internal purposes, perhaps more than many other companies, I cover, helping to improve OpEx and helping get back to kind of mid-30s operating margins. Just what have been early success signs here? And just what are kind of the time lines you're looking at for some of that?

Sure. So I think, as Tom mentioned, we are like other enterprises in the early exploration phases of what AI can do for productivity. We've rolled it out to 3 core areas. Tom Services' team is beginning to utilize it as a start of case deflection and much better knowledge management of all of the knowledge that sits across F5 for decades of servicing our client base. We are using it in sales and marketing in some areas on content development, and we are using it as a copiloting tool within our product development group and starting to see some early benefits of that, but it is really too early to say when that's going to help margins dramatically, but it is something that we are employing and getting better and better as each day passes.

Okay. Are there any questions from the audience before I move on? Okay. Perfect. Frank, sticking with you, just kind of M&A has been something that you've been pretty active in over the past couple of years. And now we're at the point where people can kind of see it. But for a little bit, investors were maybe questioning kind of the M&A strategy. Just -- how do you see M&A as having a role in the ongoing portfolio development?

Sure. So we did 3 large acquisitions over a relative short period of time between the middle of 2019 and the beginning of 2021. And when I came into the business in 2018, there was a lot of skepticism around the long-term outlook for F5 because we had this huge base of private hardware on-premise that was effectively going away as everybody thought every application was going to move to the cloud. And it was just how quickly is that revenue line going to go to 0 was the question. And from our perspective, we hadn't necessarily made the same level of investments in the late 2000s, early 2010s that we probably could have and should have to catch the wave of cloud applications and the growth that it could become. I think since then, there has been a broader recognition across the market that we live in a hybrid world, particularly for the largest enterprises, and not every application is going to move over. And what we really need is a centralized console of management that I can use both for my on-prem as well as cloud as well as edge applications such that I've got a common security framework and management to provide the best possible application performance and experience for the end user. And so that's the reality of where we are today. In terms of M&A. We feel like we plug those gaps with those 3 major acquisitions. And we've probably done 4 or 5 smaller tuck-in acquisitions most of which we've talked about publicly, some that we have not, but they've all been sub $100 million. And they provided additional security and other service capabilities for a distributed cloud platform. That's been the core focus and will continue to be the core focus. Not to say that we couldn't do anything major transformational in the future, but our core focus is really with the portfolio that we've got today and increasing its competitiveness through organic development.

Okay. So I mean you've talked a lot about you need to kind of roll out a lot to the channel, you need to roll out a lot of just education to customers, you're continuing to kind of evolve the platform. Yes, you're showing operating leverage. And so is all of this just AI helps offset that? Or where are your kind of investment priorities next couple of years?

Yes. So we are very fortunate to have a legacy business that allows us to make types of investments in the next generation. And most of our -- most of that investment has gone into modern applications as well as distributed cloud services. And that will continue to be the case. AI will continue to benefit us in terms of raising our operating margin profile and yet still continuing to invest in those businesses to achieve the growth rates on the overall revenue base that we expect and hope to achieve. But that's -- we continue to look for efficiencies across the portfolio. We're making large investments in another part of Tom's organization with our IT systems that we're highly tuned to processing hardware orders through our channel and now need to encompass many more consumption models with different revenue recognition. And so we will get better and better at that with all of our internal systems as well as that will drive efficiency, but those are the key areas of focus that allows to make these investments and still drive operating margin performance.

And then just capital allocation. You've made some changes over the years to be a little bit more shareholder friendly. Just how are you thinking about capital allocation today?

So it really hasn't changed. I know we were fairly consistent of $150 million of share repurchase a quarter until we acquired NGINX, and we knew we had some other acquisitions. And so we had to put a halt to that program. Once we finalized the Volterra acquisition, which has become distributed cloud, we said we are going to resume our share repurchase program. We're going to do $500 million over the next couple of years and then 50% of free cash flow. And that's exactly what we did and have done. And so in '23, I think we returned 58%, 59% of free cash flow, in this last quarter it was almost 100% of free cash flow. And so we continue to be committed to returning capital at least 50% of free cash flow in the form of share repurchases to our shareholder base. That will not change. That has been something that we have said is one of our North Star drivers to getting to double-digit EPS growth on a compounded annual growth basis for the future.

And maybe just to finish up, Frank, you have a lot of investor conversations. Just what do you feel like is the most misunderstood part when you talk with investors?

Yes, it's a great question. I think more of the story is now understood, and we are in that execution mode. So we've had a couple of years of missed expectations as we gotten into Q2. The first year was really from supply chain issues and last year was more of a demand environment type issue. And so -- this year, I feel like we've set out the plan. We're on track to perform to that plan. We actually took up our EPS expectations at the end of Q1 based off a very strong Q1 EPS performance. And I think right now, especially after our strategy and product session in early February, more and more of the community understands the investments we made where the product is going, our strategic outlook but we're being encouraged by everybody, okay, execute against that plan.

All right. Perfect. Well, Frank, Tom, thanks so much for being here today.

Absolutely. Thank you so much.