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

Good afternoon, everyone. I'm Samik Chatterjee, I cover the hardware and networking companies at JPMorgan. I have the pleasure of hosting F5 for the next fireside chat. With me her on the stage are Francois Locoh-Donou, the CEO; and Frank Pelzer, Chief Financial Officer. Thank you both for taking the time to attend the conference.

Francois, I'll start off with you. And I'm asking most of my companies to make this sort of 12-month projection of what they think spending as well as their end markets look like 12 months from now. We all know where we are today with sort of the enterprise spending being a bit more challenged. But just give us how you're thinking about the next 12 months playing out. Where do you think we will be in terms of spending from enterprises? And also, I know the other sort of customer verticals are less relevant, but how do you see them playing out over the next 12 months?

Thank you for having us, Samik. Before I begin, let me just, if you don't mind, quickly read this safe harbor and put that on the 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. Okay. So enterprise spending. So look, if I just compare, you're asking me about 12 months from now, I'm going to start from 12 months ago. 12 months ago, we saw spending obviously decrease significantly. All significant projects were curtailed. There was a lot of surprises in our own customers and sponsors of projects because, at the last minute, they thought a project was approved and a CFO would come and say, "Actually, it's not approved anymore." If I compare it to where we are today, what we see is, I would say, 2 categories of customers today, a category that continues to be very frugal on spending, very cautious on their spend. And for the most part, looking to sweat their assets as much as they can. But we're also seeing a category of customers who have gone through that for the last 18 months and feel that they can no longer wait in their spending. And so they're moving forward with their projects. If you ask me about where we're going to be 12 months from now, I think we will have more customers move in the latter category of we can't wait, we have to spend. We have to extend capacity. We have to modernize our infrastructure, or we have to deal with new security threats. And so I think you will see spending steadily resume and move towards the second category. In the case of F5, we feel that we're going to be very well positioned as spending resume because most enterprises, whether they're in my first or my second category, actually have growing complexity that they need to deal with. And that complexity is coming from their applications being deployed increasingly in hybrid and public cloud environments. And this hybrid multi-cloud environment creates a lot of need to connect apps together to secure these apps together. And doing that today is dauntingly complex, and we've built a portfolio to make that a lot easier.

Got it. Okay. We definitely want to -- as we sort of progress through this discussion, talk AI a bit. But before we get into the demand drivers from customers through AI, I wanted to ask you more in terms of how you think about adopting AI internally in the organization. What are some of the improvements you can think of that it can bring? And what could be more tangible for investors to track on that front as well?

So we are rapidly moving to embed AI in a number of functions at F5. We do think there are potential productivity enhancements to come from AI. I would say the 3 areas where we are most focused today is, one, at the front end of the business with our sales team building propensity models that allow them to identify better which customers are likely to buy the next product, all matters of content development and helping them build more customized content development for customers faster with better productivity. The second area is in our engineering and research and development effort, anything from code development and assistant to building code to automating routine tasks or routine configurations. All of those are sources of potential productivity improvements in our R&D teams. And then third is in support. And so for our customer services organization, helping them deliver content and knowledge articles to our customers way faster, being able to customize their response way faster and also being to -- enabling them to support customers to self-serve a lot better than they have in the past. So all -- in all 3 areas, we see the substantial productivity gains we're early stages, but a number of these cases have now moved into production at scale in the organization.

Got it. Moving to a discussion on the business side. Now you called it out in your Strategy Day earlier this year what we had seen for a few years already, which is a lot of sentiment in relation to all the apps moving to the public cloud, which proved wrong, and you had correctly identified that even in presentations in prior years. But did that really change the opportunity set for F5 in relation to application services like what was as that progressed with the enterprises, and you're seeing enterprises really more invest on a hybrid infrastructure. How is that impacting the TAM that you think of for application services?

Well, it's impacting us positively. If you recall, Samik, and we'll go back to the time that I joined F5 in 2017, was, I was hearing a lot from the industry and from some of our customers that were saying, look, I'm going to move all my infrastructure that's in my data center and all of that is going to move into a single cloud. In that single cloud, I will have everything I need, native cloud services, security, better reliability, et cetera. When I look today at what has happened for 99% of our customers, the reality is very different. We have, today, close to 90% of our customers are in more than 3 cloud environments, and almost 40% of our customers are on in more than 6 infrastructure environments, including multiple public clouds. And so that hybrid multi-cloud reality creates a need for more application services, things like securing APIs that connect these things for ADCs between clouds, things for networking applications together. All of these are new application services, and we have been positioning for that opportunity for the last several years. And so now we have a unique portfolio to be able to solve this challenge. We have given this challenge a name. As you know, we call it the ball of fire, which is all of the complexity that comes from this hybrid multi-cloud environment. And today, with the portfolio that were built, we really are the only company that can secure the liver and optimize every application or every API, regardless of which infrastructure environment it sits in.

Okay. And the next question is going to be a bit more sort of background on what you just mentioned, which is, just run through quickly how you've invested in the portfolio across all these sort of different points that enterprise is now looking to leverage. And how is that positioning F5 to succeed in this landscape, where you're seeing enterprises run across hybrid, but including multiple cloud. Since you joined in 2017, which are those exact sort of areas that you invested in? Where in terms of the portfolio?

So we -- since 2017, we invested in 3 big areas. Number one, our ADC franchise, which, historically, was primarily a hardware franchise. We refactored the franchise, both on technical capabilities and commercial terms, to ensure that it could perform very well in hybrid and multiple cloud environments. That's our big IP franchise, and that was a big part of our transition to software. We then acquired NGINX that allowed us to go into continuative environment and become the de facto networking and security ADC for these Kubernetes-orchestrated environments. And then third, we invested in security because we saw that, increasingly, the challenge for applications was application security. And so we bought several security companies, Shape Security, which is focused on bot detection and bot protection thread stack against a threat for workloads in public clouds; and Volterra that brought the foundation of a SaaS platform for F5. So with these investments in our core franchise in container native environments and in security, we have built this portfolio now, which can basically serve, protect and secure any application in any API in any environment. But we also have built a portfolio that is unique in that it is hardware, software and SaaS. And so all the capabilities of F5 can be delivered in any one of these form factors, which is pretty unique in the industry.

Can you discuss a bit more on the competitive dynamics then? When you run across these different points in your portfolio, who do you see as the primary competitors? And break them out maybe between who is more of a platform solution versus a point product.

Well, I think on -- so it's interesting. If you look at hardware, software and SaaS, in each of these 3 areas, I would say, would generally compete with different providers. Certainly, in hardware, software, there's a set of competitors in one hand and SaaS, there's another set of competitors. Then if you look at our capabilities, whether it's API security or bot or web application firewalls or ADC, in each of these categories, we have different point solution providers, best-of-breed point solution providers in each of these categories. But where we are uniquely positioned and really are unique is in, one, our ability to do all this in hardware, software and SaaS. And for large enterprises, that matters, because large enterprises will have hundreds of thousands of applications. For some of them, they prefer deployable products, hardware or software, so that they can turn the knob of the product on their own. And for others, they would rather have a service and not have to deal with the life cycle management of the service. But whether they use hardware, software or SaaS, ideally, they want consistency of their services, consistency of security policies, consistency of application delivery. And our portfolio allows us to do that, and we're pretty uniquely positioned. The second, other than the consumption factors, which is hardware, software and SaaS, if you go to platform capabilities, we have now built essentially a single platform that our customers can go to, to deliver and secure all of their apps and APIs. And that's also pretty unique in the capabilities that we have consolidated in a single platform, especially in application security and delivery.

Okay. So let's hit the mid-single-digit growth that you've guided to on a medium-term basis. Just break that down. How do you think about what we should expect for growth in virtual solutions, systems? And then how to think about distributed cloud as well contributing to it?

Yes. Samik, why don't I take that one? First of all, let's just talk about the 3 different areas of our total revenue. First, you've got Global Services, which is roughly about 50%. And then you've got our product revenue, the other 50% split between systems and software. So first, on Global Services. We've talked about over a long period of time, we expect that to be flat to low single-digit growth. A lot of those drivers are really just shifts that are happening between perpetual and term and managed service. So it's healthy, but totally as we would expect, and that's what we've talked about for this year. The other 50% coming from our product revenue systems over a longer period of time on a unit basis, we've talked about that being probably mid-single-digit decline. There are some offsets potentially to that on a revenue basis, that could be things we do in pricing, things we do with competitive wins, other factors that will hopefully allow us to be better than that. But on a unit basis, that's always been part of our mindset is that it's in probably the mid-single digit declining basis. Then on the software pieces, a couple of different factors to take into place there. First, you've got perpetual that is roughly $100 million to $120 million, not growing a lot. We've got our term base, which has got a large set of renewals activity. And when we talk about renewals, we also put expansion in that base of revenue. And then finally, we have our SaaS and managed service. And each of those have different growth rates. But overall, what we said is, this year, it's going to be roughly flat to modestly up. So far, in the first half of the year, we've done better than that. We do, given the first half results, we'd be disappointed if we ended up in that range. But we talked about that going to double-digit growth in FY '25, really largely off the back of the renewal base that we see. And so this year, in particular, in the total revenue, we have a headwind of about $180 million coming from the improvement in backlog for deals that were sold in FY '22, recognized in '23. From a bookings standpoint, we're actually growing. We're just not seeing that in revenue this year, but we do expect to get to mid-single-digit growth next year.

Okay. Let's talk about security and how important it is as part of the broader application services provided by F5. How do you think about the opportunity to expand F5's position in the security market with the offering as part of the broader platform? And what are F5's growth expectations from security stand-alone?

Well, we -- security has grown faster than our overall portfolio. And our expectation is that it's going to continue to grow faster than total revenue. Specifically, in security, we've made a choice to be narrow in the sense that we have focused on application security exclusively and have not gone into other security market. We've made that choice to be narrow because we believe that application and API security is going to be a big challenge over the next decade as applications proliferate as APIs continue to proliferate and as more and more applications get distributed. And we think that AI is going to accelerate the distribution of workloads, the distribution of applications and is potentially going to make the use of APIs explode. And so we have focused on application and API security. But within that segment of security, we have gone deep meaning we offer web application firewalls, protection against of attacks, of course, securing APIs, but not just securing them, discovering all APIs, testing APIs, cataloging the vulnerabilities. And of course, we offer bot defense and leveraging our own AI to do that. So when you look at our application security portfolio, it's pretty deep. It's consolidated on a single platform. And we expect that to continue to grow faster than the business across the form factors of software, SaaS and hardware.

Okay, okay. A similar question, but just trying to think about what you're seeing for demand for application services, how tight it is to public cloud growth. How are enterprises leveraging F5 solution as well on the public cloud? If you can just provide us a bit more sort of deep dive into what do you see enterprises doing and how we should think it's tied to the public cloud revenue growth that we see as well.

So if you look at the last several years, when we really started -- customers really started to use F5 in the public cloud, I think, was in the 2017, 2018 time frames. And at the time, it was customers kind of lifting and shifting applications and using the virtual editions of BIG-IP to put applications in a single cloud, or in -- starting in 2019, using NGINX in a single public cloud environment. Increasingly, what we are seeing is more customers are in multi-cloud, hybrid and multi-cloud environments. And they need to secure or deliver applications in multiple cloud environments and on-prem at the same time. And they're now using us increasingly to provide consistency across all these environments. And they can do that with our software, they can do that with our SaaS offering. But that's why we've put so much focus on building this distributed application security and delivery platform, it's to enable customers to secure and deliver all their apps across all these cloud environments. And we think that's going to accelerate with AI because workloads are going to be more distributed.

Okay, okay. You outlined a $34 billion TAM in 2028 comprising deployable products as well as SaaS. I think the individual growth rates that you gave, deployable TAM growing at 10%, SaaS TAM growing at 20%, CAGR, obviously, if you take a blended of that, it would imply a mid-single-digit growth. You're almost implying you underperformed the 2 individual markets. Just flesh that out a bit more, and how do you think about F5's positioning in each of those areas as well.

Yes absolutely, Samik. So look, you're absolutely right. In February, we talked about -- updated our TAM outlook and deployable was $11 billion, growing to $16 billion, 10% CAGR. SaaS was 5%, growing to 18% and 26% CAGR. So you can take a look. And our outlook for '24 has been, on a normalized basis, probably mid-single-digit growth if you take into account the backlog improvement that we had last year. And we're also talking about -- for FY '25. And so you would naturally say, okay, why aren't you in that growth rate for your TAM? Well, in the deployable, which is more where most of our revenue is coming from today, particularly when you're taking services into account. The portion of that market that we -- that the majority of our revenues have come from in the past and still represent today are probably flat to low single-digit growth. And that's in the ADC hardware as well as software space. And so it is why we have been investing in these other models, particularly SaaS and managed service that have got a much higher growth rate associated with that. And I think, over time, you will see that overtake the deployable piece. But it will take time, just given the base of legacy revenue that we've got today.

Okay. So just -- so I understand it then, the way to think about this is you will not outperform the 10% CAGR for deployable product. But you'll outperform this -- you'll hopefully outperform the SaaS market CAGR of 20%.

Over time, even on the deployable side, if more comes from a security piece of the business and then we have the opportunity to. But where we sit today and what we are expecting for FY '25, no, we were -- there's just too much revenue to overcome in terms of the maintenance piece as well as the deployable pieces within our business that's tied to ADC.