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

Welcome back everyone to Needham Tech Week. My name is Matt Dezort, Senior Security Analyst here at Needham. It's my pleasure to welcome next to the stage, the management team from F5. We have with us today COO, Tom Fountain. As a reminder we will be hosting a fireside chat format. We would love to make this as collaborative as possible with you guys. So if you have any questions, please submit them through the queue or you can e-mail me at [email protected], and I will be sure to prioritize those. And with that, welcome, Tom.

Fantastic. Thank you, Matt.

Great to have you here. I guess let's start at a high level. You guys just posted Q4 -- fiscal Q4 results, really strong close to the year. I think accelerating software, better-than-expected systems demand. I guess for you, if you could recap the print from your perspective, maybe what 2 or 3 KPIs really stood out for you in the current Q?

So I guess -- but before I respond, I need to get our safe harbor on record. So let me just read it for a second. 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. So yes, indeed, Matt, we had a really good Q4, delivering a strong close to both the quarter and the fiscal year. Q4 posted a record $747 million in revenue. That's a 6% increase year-over-year and surpassing the high end of our guidance range. The Q4 growth was really driven by a 19% increase in software revenue, which I think really illustrates the successful shift in our business toward software and subscription-based offerings. When you look at the full year, F5's transformation from a hardware-centric company to a leader in security and software for hybrid and multi-cloud environments, I think it's really unprecedented. In FY '24, software revenue grew 11% compared to FY '23. Subscriptions are now 85% of software revenue, which is a significant increase from just 20% in FY '17. With this, we've significantly diversified our revenue streams. We've got a lot more visibility into the future revenue and earnings growth as a result of the recurring nature of our business. And we delivered a non-GAAP EPS growth of 14% year-over-year, which I think really highlights both the top line growth and the improved operating margins that are coming from our strong operational discipline in FY '24. So when I look to FY '25, the combination of our strong software renewals, the growing and improving software demand trends and growing pipeline. We've guided to a 4% to 5% revenue growth for FY '25. This outlook is really based on strong visibility that we have to our software subscription renewals. And we think those will make up 2/3 of FY '25's software revenue base. And then looking past FY '25, I think we're really well aligned to take advantage of a number of meaningful industry trends, whether that's the ubiquity of hybrid multi-cloud environments, the increased distribution of apps and APIs, the role of AI and of course, the exponential growth of applications.

Yes, definitely a lot to chew on there, and I want to get to a lot of those points you made on some of the drivers. But to go back to the renewal visibility that you guys have, I guess, you talked about that accelerating subscription growth next year with a weighting towards second half driven by the visibility you have from renewals, I think your assumptions around new growth are pretty modest. I guess, what drives that visibility and confidence? What sort of telemetry do you have on customer usage that sort of gives you that confidence heading into fiscal '25?

Yes. So we've guided this 4% to 5% revenue growth for FY '25 back-end weighted toward the second half. And I think a lot like FY '24, we've got really good visibility into the growing renewal base. I think that's in part because of the cycle of our multiyear renewals. So we really started selling software subscriptions in FY '18 and that consumption model really gained momentum in the second half of FY '19, in particular. The majority of these software revenues are really 3-year term subscriptions. And so the FY '19 cohort, of course, then comes up for renewal in FY '22 and then will be coming up again in FY '25. And so the layering of these really gives us a lot of confidence. We also saw through the challenging period of FY '23 that despite sort of the macro-related cautions on new spend, the renewals continued to perform largely to plan. And then we also have really good telemetry data from our customers. So these multiyear renewals all have a component of them called a true forward where the usage from 1 year determines the baseline price for the remaining years. And so through that, we have really good visibility into the telemetry around how our customers are actually using our products. And so when you put all of those together, we've got a lot of confidence in our FY '25 outlook.

Got it. Yes, I guess to follow up on something you mentioned, sort of the stacking of the 2019 and 2022 cohorts coming up here at '25. How are you feeling about your capacity to service and win those renewals? And how do we think about the maturity and retention of those cohorts throughout time?

Yes. So we saw some of this start in FY '24, of course, with the FY '18 and then FY '21. As we head into FY '25, we've got the significant growth that we saw in FY '20 and then the significant growth in FY '22. And so when you see the sort of stack, we've seen really good renewals on the second term renewals from FY '18. So we expect FY '19 second term renewals to perform very well. And similarly, the FY '22 renewals are coming up for their first renewal term. And again, we've seen really good success on those renewal rates. So when we put those together, we feel really good about the capacity that we have to be able to meet and capture the renewals that are coming up in FY '25.

Got it. I guess shifting gears to some of the exciting drivers you listed earlier, AI being the one I want to talk about first. What are you seeing in your customer base regarding widespread AI deployments planned for 2025? And maybe double click for those less familiar on some of the wins that you guys have already talked about over the past couple of quarters that are AI-driven.

Yes. So let me start -- we serve some of the largest enterprise service providers and governments. And I'd say, for the most part, our customers are generally in the phase of experimenting with AI right now. And that's ahead of sort of wider scale AI implementations. Having said that, we've got some really exciting AI wins from some of the leading franchises that are early in adopting AI. And our AI opportunities really center on 3 principal use cases. So the first one is around AI data ingestion. And this one is all about high-performance traffic management around getting data in for either training purposes or retrieval augmented generation, or RAG, purposes. This requires really advanced traffic management to optimize that data ingestion and no one does that better than F5. We have a number of deployments already. We talked about one of them in our Q3 earnings call that was an automotive manufacturer that was really leveraging BIG-IP to rapidly secure and transfer the data to the storage system into their large scale clusters and that significantly accelerated their model training. The second use case then is really focused on the AI factory and load balancing for the AI factory. And here, again, it's about optimizing the performance and scalability of these AI factories using traffic management to do that. And a lot like the first case, this too really is an ADC opportunity, and that's certainly a market segment where we've been a leader for the last couple of decades now. And then the third AI use case that we're seeing a lot of success around really applying Web Application and API Protection or what people call WAAP technologies to secure AI inferencing. And this solution really requires an integrated offering that brings together the web application firewall, DDoS, anti-bot, API security, all into 1 converged solution. And again, we have a very differentiated WAAP solution and a number of customers that are early in applying that technology to securing AI inference workloads.

Got it. Yes, lots of exciting opportunities there for F5. It seems multiple facets. I guess staying on AI last quarter, I think you guys announced an exciting partnership with NVIDIA, where I think you're going to be placing your ADC software onto their infrastructure. You also talked about BIG-IP Next for Kubernetes now being compatible with their DPUs, seems like a really exciting partnership. I guess, what are the details of the partnership? And how should we think about this as an AI opportunity for you guys near term?

Yes. No, thank you, Matt, we're very excited about the potential for both of these. And as you noted, there are really sort of 2 different solutions here. The first is our BIG-IP Next. It uses Kubernetes and it runs in a Kubernetes containerized environment. Enterprises and service providers who are building AI factories and have AI workloads, these almost always are built using Kubernetes technologies. And so BIG-IP Next for Kubernetes really brings the market-leading networking traffic management, security capabilities that we're known for into this sort of AI workload environment. The second is really the partnership with NVIDIA. And here, this is really about making BIG-IP Next for Kubernetes, work seamlessly with NVIDIA's BlueField-3 DPUs or their data processing units. And when you combine BIG-IP Next for Kubernetes together with these DPUs, you effectively sort of create this AI accelerator and that increases the performance and the security of the training and inference were closed. This solution, I think, is pretty early to really size its potential, and there are a number of dimensions around the commercial model and terms that we're still working through. But we have been talking with customers about the solution, and I think that feedback has been very encouraging around sort of the ability to accelerate AI workloads by running BIG-IP Next directly on DPUs.

Got it. I guess Shifting gears to your partner program. I think you've announced some rehauls there. Any changes as you enter fiscal '25 and especially how are you thinking about incentivizing the more productive set of partners that you're focused on now as you roll out DCS and you just launched NGINX One. Talk to us about some of the partner changes that you're making with your go-to-market.

Yes. So we've worked, I think, very successfully to evolve our partner program and our partner mix over the last several years, largely as our product portfolio has expanded pretty significantly. I think today, we feel like we've got a very strong partner base that provides us access both to the customers and the specific projects for which we are really well suited. And so while we make adjustments every year to the partner program, we didn't make any significant adjustments for FY '25, but we did make some minor tweaks. As it relates to our distributed cloud SaaS platform, we already are seeing a really meaningful part of that business coming from partners, about 2/3 or so of it. And our focus in FY '25 is really in 2 areas. One is really around building out more and more customer reference stories together with our partners. And then the second is that we increased the incentives for our partners around closing business with some of our largest customers. In terms of NGINX One and going after modern application solutions, the focus with partners in FY '25 is really about expanding the number of NGINX certifications that are out there. We think this will increase the number of experts that are available to customers to be able to roll out and deploy the solution. So a lot of the partner activity this year is centered there.

Got it. I guess -- want to ask a question about cross-sell sort of between BIG-IP and NGINX. I think earlier this year, you guys called it out really strong. I think somewhere 50% of NGINX customers have become BIG-IP customers. Any update on that metric and plans to sort of accelerate that cross-sell vector that you guys have between BIG-IP and NGINX?

Yes, Matt. So I don't have an update for you on that specific metric, but our land and expand motion is very strong. I think our greatest growth opportunity is about expanding our footprint and our wallet share in our installed base of about 20,000 customers. And as I said, they're really the largest of enterprises, service providers and governments. And I think doing that, we really have 3 principal levers that are available to us. The first is that we generally grow as an apps utilization grows over time. So it naturally grows. The second is that we have an opportunity to expand to additional apps within an organization. And as the number of apps expands within companies, we see growth. And then the third is that we really grow by expanding the number of services that F5 is able to provide. And so for example, that may be about adding more and new security capabilities on top of some of the traffic management capabilities. And so I think this expansion motion, you see in action in a number of different places in our business. And I'll use F5 distributed cloud as an example. We launched that platform in February of 2022. And as of Q4, we're up to over 800 customers now on that platform. And as I mentioned earlier, 2/3 of those are existing F5 customers. And so seeing a very significant expand motion with these new offerings into our installed base.

Got it. I guess shifting gears sort of towards product revenue growth. I think you guys guided to higher than mid-single digits in Fiscal '25, is like what you said. What sort of expectations for systems and refresh specifically are embedded in that growth and what sort of trends have you seen with refresh activity heading into fiscal '25?

Yes. So if I start at the very top, we expect, as I said, FY '25 revenue of kind of 4% to 5% back-end weighted towards the second half. And I think this outlook assumes continued macro stability. So no significant improvement to the macro environment. It also doesn't assume substantial growth in our customers' IT budgets. We've said before that customers have better clarity on their calendar year '24 budgets, but early to see sort of calendar year '25. And within that, sort of what we really are expecting is upper single-digit software growth and low single-digit systems growth. The software outlook, I think as we talked about before, was really the visibility that we see in the sizable renewal base that's coming up over the course of the next year, coupled with the very consistent strong renewal performance that we'd had. And I also think that the systems view is really informed by the uptick that we're seeing in refresh activity. We started to see that here over this year, and we think that, that will continue to drive some of the systems growth in FY '25. Upside from here could come from a variety of different places. So that could be around new subscriptions that are more than we expected; larger expansions, we're seeing a really good expansion activity at the time of renewal. It could be around stronger refresh activity that certainly had been building here in FY '24 and then stronger IT budgets overall, which we said we're currently assuming to be the same, but certainly, that may change.

Got it. Yes. I appreciate all that color. I guess staying on products within the system specifically. I think last quarter, you guys announced a price increase, I believe. Any sort of details you can give us around the magnitude of that increase? Why now? How do we think about balancing that versus sort of the mid -- persistent mid-single-digit unit decline growth that has characterized the ADC market?

Yes. So we talked a little bit on our earnings call that we announced a modest single-digit percentage price increase across the entire portfolio, both systems and software, that will take effect January of '25. Most of our sales cycles are 6 to 12-month sort of engagements, and we're honoring any of the pricing that is out there already. And so we don't expect a meaningful impact to have an effect on FY '25. And then in terms of sort of thinking about price increases, we regularly monitor both the competitive environment and think a lot about the price performance value that we want to be able to deliver to customers. And so our price adjustments really reflect the combination of those factors.

Got it. I guess shifting over to Services now. I think you talked about lapping price increases from fiscal '22 and fiscal '23. How are you thinking about the puts and takes for services growth from here. I think you talked about low single-digit growth in that sort of segment down from where it was last year when you benefited from the price increases. What are the puts and takes for services growth? What would it take for services to exceed these modest expectations as you lap the price increases?

Yes. So thank you. I'm proud of the services results in FY '24. I think it really demonstrates the resiliency in our financial model. We expect the Global Services business will grow low single digits in FY '25. And we think that the services business over time really aligns best to our deployable products. And so that's our systems and our BIG-IP and NGINX software that a customer operates. And so we would expect that the services growth rate would, over time, align to those. We think that if the SaaS business accelerates, that mix shift would actually naturally lead to more moderate service revenue growth than what we're expecting. But right now, we think that it's going to be in the low single digits in FY '25 and then moderates accordingly in out years.

Got it. Staying sort of in the financial model, I think last year, you talked about net expansion rates that were world class and software that were 120%, I think, for our term licenses. Any color around where that net retention figure is today? How is gross retention -- gross retention also trending for your SaaS business as that becomes a bigger piece of your overall pie?

Yes. So broadly, we continue to see very strong expansion rates across our software subscriptions. And I think that really comes in 2 ways. One is continued strong utilization against the multiyear subscriptions. And then the second is that we're seeing significant expansion and additional opportunities across the portfolio that are at time of renewal. And that's why we see those opportunities grow pretty significantly in some cases. We've talked a lot about some of the transitions in our SaaS business, and that has a very short-term impact on ARR, NRR, GRR for SaaS. Last year, we noted that we were retiring several of our legacy offerings and in some cases, moving them to F5 distributed cloud. We thought at the time that a lot of that would happen in '24 and '25. And in fact, our SaaS and managed services business, ARR declined from $198 million to $182 million in FY '24 as a result of those transitions. And the vast majority of that decline was really around that planned churn in the discontinued offerings. So the growth in the distributed cloud business within our SaaS portfolio is offsetting some, but not all of these transitions. But that portion of the business is growing quite quickly.

Let's stay around those transitions. I think the silver line unwind, you're converting a subset of your customers from the legacy version to F5 distributed cloud. You've also had some planned churn? I guess how is this migration shaping out versus your guidance expectations so far?

Yes. So it's still somewhat early in this transition. We had expected it to be more weighted to FY '25 than FY '24. I think what we're finding is that it's actually even more back-end weighted than I think we maybe initially expected. And that's really a function of customer readiness. These are pretty substantial technical migrations for customers. And of course, not every customer will ultimately make that transition. But those that have gone through that transition are very pleased with the distributed cloud platform. And we think that having them on distributed cloud platform creates a number of upsell opportunities with those accounts over time.

Definitely. Yes, I definitely see the benefit of getting them over to F5 distributed cloud. I guess shifting gears a little bit to sales and marketing spend. I think it declined again this year, maybe the second straight year that's happened. But you've also said that awareness is the biggest limiting factor for F5, especially as you shift to distributed cloud in your other SaaS products. So how are you thinking about incremental returns on investment, especially in sales and marketing? And what sort of plans do you guys have for quota-carrying headcount expansion into fiscal '25 and beyond?

Yes. So the year-over-year reduction in sales and marketing for FY '24 was actually more a function of realizing the full year impact from the headcount reductions that we've made in April of '23 that were part of our broader cost base adjustment. And so if you look at sort of the second half of '24, sales and marketing spend actually increased roughly 5% year-over-year for the second half period. More generally, though, our software subscription model, I think, is yielding the efficiency in sales and marketing that we had hoped. And with that, a growing percentage of our revenue now is coming from renewals, which, of course, has a lower cost to serve than acquiring new business. And so in terms of building kind of market awareness, we believe we're investing at the appropriate levels. Last year, we launched a global marketing campaign that was really focused on creating awareness around the breadth of the portfolio that we now have. That was an event called AppWorld that we took on the road globally. And we had a lot of success with it. And we felt that the program delivered really good ROI. And so we're expecting a very similar sort of program in FY '25.

Got it. Make sense. I guess, shifting now to like the competitive environment and pricing a little bit. Any changes to the competitive environment today across systems or software for you guys? I know specifically in the recent past, you called out Broadcom and VMware that tie up sort of causing consternation amongst your customers. I mean, is that still impacting demand? Or what sort of shake outs within budgets could that potentially drive benefits for F5? How do we think about the competitive environment?

Yes. So we can and are benefiting from some of our competitors' behaviors here. We've had a very active competitive takeout program, in fact, for the last several years, and that's grown each year for us. Initially, I think we really competed on the fact that we were driving innovation in this product portfolio, whereas the competitors were not. But what our competitors are now deemphasizing support and employing what I think customers feel are pretty unacceptable pricing practices. That makes it even easier for us to win business. And so we are seeing really good results in our continued focus around competitor takeouts.

Got it. I guess moving now to like security, I want to ask about consolidation in WAAP and API. I think you've called out some impressive wins for WAAP as more cyber attacks are now coming through APIs than ever before. Do you have everything from a product perspective that you need to compete there? And what's the appetite in the market today for a consolidated offering around WAF and API security?

Yes. So you're absolutely right. APIs are already one of the greatest threats for organizations. They're often exploited by adversaries and very few organizations actually have a good handle on their API security. And of course, the proliferation of AI apps is only going to make the challenge around APIs even worse. API security requires a greater level of expertise. APIs can't simply be protected with the traditional web application firewall. There's a lot of API-oriented attacks that really go after the application logic. And so the result is that signature-based WAFs are less effective in solving the API needs. Many customers don't yet fully understand this distinction. And in order to truly protect APIs, you need to do several things. You got to be able to discover all your APIs. You must be able to scan and analyze the code for those APIs. You then need runtime protections that are able to monitor the calls against those APIs. And finally, you've got to be able to enforce and block malicious actors in the line real time. And competitors provide point solutions around sort of each of those individual areas. We instead have taken a single holistic best-in-class approach to bringing all of those together into a very comprehensive API security solution. And we feel very good about the completeness of our offering here. No one else is able to deliver this same range what we call shift left and shield right.

What sort of growth do you see coming out of the WAF market? Is it being cannibalized by the new API security solutions? How do you see them jointly surviving going forward?

Yes. So we see customers increasingly looking for WAF vendors that are able to bring all 4 of these technologies together. So web application firewall, anti-bot, distributed denial of service and API security, all into 1 complete offering. We have a very complete offering that's highly differentiated in those areas. And so we feel very good both about the growing customer demand for the subscriptions as well as our competitive position.

I guess staying in product, I think you guys did just announce -- you hired a new [ CPO ], Kunal. I think he was coming over from Imperva. So he's got a really strong background in security and sort of this realm. I guess what's changing with the new Chief Product Officer, if anything, from a philosophy standpoint, do you think he's going to come in and have a different vision around where a WAAP and distributed cloud service as you go? Is it kind of more the same and just accelerating sort of the growth vectors that you see in security working?

Yes. So thank you. We're thrilled to have Kunal on board as our new Chief Innovation Officer. He's taken responsibility for the product org and is really focused on tackling some of the biggest customer priorities. We've talked a lot about this rising complexity to delivering and securing apps what we call our ball-of-fire problem. And we've spoken before about our solution to address that. Kunal and his team are really focused on addressing sort of 3 areas within this. The first is around delivering compelling SaaS services on top of the distributed cloud platform. The second then is around leveraging the F5 distributed cloud platform to really unify and converge the entirety of our product portfolio across both deployable and SaaS offerings. And the third area that is really concentrating a lot of energy around is on ensuring that our customers are AI ready and that we have the solutions to be able to provide ADC capabilities for all of these new emerging AI workloads.

Yes. Now it's really exciting to see you guys bring him on board and best wish just to Kara who was incredible, and I know it's taking on an awesome seat over at HackerOne. Maybe shifting over to the CSP marketplace, the Cloud Service Provider marketplace. Any updates that you can give us on growth in our partnership with AWS. How is that sort of taking off as we see cloud apps sort of reaccelerate, coming out of the period of optimization and now we have AI. Maybe just talk to us about what sort of opportunities do you see with other cloud service providers as well.

Yes. So we have a really strong relationship with each of the major cloud providers. And I think a lot of it, for us -- the CSP marketplace is, for us, just another example, ways that we can provide choice and flexibility for our customers to be able to consume our offerings in whatever commercial model best suits their needs and wherever those applications happen to be running. And so a lot of the focus with the hyperscalers is around their private offers. And we've been very pleased with some of the large transactions that we've been able to close through this model. In terms of new activity with hyperscalers on AWS, we just launched our first pay-go offering to be able to consume and buy our SaaS offerings through their marketplace. And on Azure, we previously launched our NGINX as a service offering. And we're now seeing really good customer adoption around NGINX as a service on top of Azure. And customers tell us that they really value both the simplicity of the offering as well as the comprehensive functionality that it provides and being able to do all of that through a cloud-native environment has been quite compelling for our customers. So we continue to see sort of really good opportunity in partnership with the cloud service providers.

I guess staying on NGINX, how have you seen since you guys acquired that asset. How have you seen the competitive environment change, if at all, are there new entrants into that market? Just what's changing with NGINX and sort of market share and competitive environment?

Yes. So we haven't seen a lot of changes in the competitive dynamic. A lot of our focus over the last year now has been around bringing together the NGINX portfolio. We historically had gone to market with a series of individual offers around NGINX. And what we came to appreciate was that the customers didn't actually want all of that complexity. They wanted to be able to buy 1 SKU that provided them all of the functionality that they needed around NGINX. And so we've been bringing that together in a new combined offering called NGINX One. And then I think what's really compelling, and it's an example of sort of where we're going is that's now available through the distributed cloud console. And so customers are able to get the benefit of some capabilities, be it SaaS, some in a deployable model, all through a single SKU. But I think it's a great example of customers being able to take advantage of distributed cloud to really help unify the portfolio and their experience. And we expect to be able to do more of that across more of the portfolio over the years to come.

Got it. I guess a few minutes left here. I realize -- this is a CFO question. Maybe I know you don't guide to free cash flow, but how should we think about free cash flow conversion in fiscal '25, especially as you have these large renewal cohorts coming up and you're talking about 35% plus operating margins into the future? How do you think about free cash flow conversion going forward?

Yes, you're right. So we don't guide to free cash flow. But we do guide to operating margin. And so we guided FY '25 operating margin to approximately 35%, which is roughly 140 basis points up from FY '24. And I think the way to think about free cash flow is that we expect the free cash flow to begin to more closely track net income going forward. And so we would expect those 2 to start to converge.

From a growth perspective or a margin perspective?

Yes. From [indiscernible]

I guess with a couple of minutes left here, Tom, I want to turn it over to you for any closing thoughts, if any investors are dialed in and you want to walk away with 2 or 3 things to take away from this conversation, what would they be?

Yes. So I think the most important is that F5's business has transformed quite successfully over the last several years. And I think we are ideally positioned to be able to capture the emerging opportunity around hybrid and multi-cloud. Organization and space, just a really acute pain point around being able to secure and deliver their applications in these sorts of environments. And the work that we've done over the last several years really positions us with the portfolio of offerings that customers need in the era that we now find ourselves in. And I think that's a very compelling position for us to be in. We're seeing some of the benefits of that already. And as we've guided, we're excited about the prospects into the future based on the portfolio that we now have available for customers.

Got it. That's great. Perfect synopsis. I think that brings us to time. So I want to thank you, Tom, Suzanne, for joining us from F5 and for all the clients that tuned in. Thank you so much for your attention, and please enjoy the rest of the Needham Tech Conference.

Wonderful. Thank you, Matt.