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

Thank you, everybody. Welcome to F5 fireside chat at the Goldman Sachs Communacopia and Technology Conference. I have the privilege of hosting and introducing Francois Locoh-Donou, who is the President and CEO of F5; and Cooper Werner, who is the CFO of F5. My name is Mike Ng, and I cover F5 and IT Hardware and Networking here at Goldman Sachs. We have about 35 minutes for today's presentation, inclusive of a couple of minutes for investor Q&A. So first, I wanted to thank you both for being here with us. It's been an incredible privilege to have you here at the conference and on stage with us.

Thank you for having us, Michael.

Thank you.

Michael, maybe before I respond, you mind if I read safe harbor.

Please, yes.

So I need to get our safe harbor on record. 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. To start things off, maybe just a bigger picture question. F5 is a leader in the ADC and security market. The company's talks about this intensifying complexity that customers face in a hybrid multi-cloud environment. Could you elaborate on some of the challenges here and why F5 is uniquely situated to address some of the complexities that customers face?

Yes, of course. So the complexity that customers face today comes from a couple of what we consider to be secular trends. The first one is that most large enterprises now have embraced hybrid and multi-cloud architectures. They need the flexibility of being in multiple infrastructure environments to deploy their apps in the most efficient way and different apps need different kinds of environment. But of course, with that flexibility of being in multiplying cloud environments comes a complexity of securing and delivering apps across these environments. So that's first source of complexity. The second source of complexity is that the number of application services that are required to secure and deliver applications have increased substantially over the last 7 years because applications have evolved substantially. So it used to be things like just load balancing and maybe web application firewall. Now you need API security. You need securing against bot attacks, as an example. We'll talk about AI in a moment, but those are net new services. So there are more application services required by customers. And thirdly, AI, the rapid proliferation of AI applications is also going to exacerbate this complexity because it requires new services like AI security, which we will talk about. So for these reasons and largely because customers have responded to these complexities by adding a lot of point solutions in their environment, they have ended up with very complex application infrastructure environments. We at F5 call this the ball of fire. The reason we're very well positioned to address that is because we made a strategic choice several years ago to remain entirely focused on application and API delivery and security. But within that category, to invest across hardware, software and Software as a Service, such that we could secure and deliver all these apps and APIs across all these infrastructure environments. And increasingly, we have been bringing all products, all of these form factors in our portfolio into a single platform to make it even easier for customers to operate across multi-cloud environments.

Great. Maybe just going back to some of the basics. I was wondering, if you could just talk about the role of an ADC in a modern data center. I think there's a perception that, hey, this is a piece of hardware that is probably more of a legacy piece of hardware, but the demand and the growth in the category has been very strong, right? And you guys have been leading the charge there. So maybe you could just take a moment and clear up any potential misperceptions beyond ADC just being a legacy device and why the features that are made available through ADC are still critically important to workloads today?

Well, maybe at the most fundamental level, yes, an ADC sits in the network in enterprise infrastructure, but it's very different than a traditional data center switch. A data center switch is typically Layer 3 to Layer 4 technology, whereas an ADC is Layer 7 technology. The simplest analogy here to describe the difference at the fundamental between the two is, a data center switch, if you think about it in a postal environment, a data center switch is going to look at a letter you're sending. It will look at the address of this letter and route it accordingly, whereas an ADC is going to read the entire letter that's inside and pretty much read every word and make decisions to let the traffic go or route it based on that. So this very deep granular inspection of traffic is what makes ADCs a very unique category. And essentially, is why ADCs have been placed by customers right next to their application, and we control 100% of the traffic that is going into our customers' mission-critical applications. Now why is the category growing? The category is growing because, first of all, the number of applications continue to grow. Applications are deployed in more and more complex environments, and so it also requires ADCs in different form factors in hardware, in software, in Software as a Service. As applications -- application architecture changes and application attacks continues, there are more services, more functions than an ADC needs to do. It's always from the perspective of having very granular inspection of traffic but that is the thing that originally allowed us to do maybe just performance and uptime and now allow us to do a lot more in security. And so the application delivery and security today have converged. You can't separate the two. And so the role of ADCs for applications has increased significantly. So that's why you -- the category is very different than typical switches, and it's evolving very quickly because there are more applications, they require more application services, and they are deployed in more diverse environments, requiring multiple form factors of ADCs.

And maybe we can just double-click on what's happening in the ADC category, talk about ADC market share. I mean some of the market research data that we've seen is that F5 has gained 16 percentage points of market share over the last 5 years within the ADC market. So put simply, like what's going on? And why are you gaining so much market share? I think this is a very intriguing story in terms of why there's so many opportunities for you here.

The choice that we have made, and I think it's a choice that now dates back to a few years ago, is, if I go back a few years ago, at the time, there was this perception that you mentioned that ADCs were hardware, it was legacy, that everything was going to the public cloud, and therefore, there was not going to be a lot of growth opportunity in the ADC market. We took an approach that was to say actually we think application delivery and security are converging. We think ADC are going to be playing a huge role in that convergence. And they're going to be deployed in multiple form factors. So we're going to double down in this category of application delivery and security and we will invest in hardware, software, SaaS, all the form factors. Some of our competitors did not make that choice stopped -- either stopped investing or they were in one category of it and decided to stay in hardware or in pure software or in pure SaaS. No other competitor made the choice to invest in application delivery and security across all form factors. The reason we're gaining share today is, I mean we're reaping the rewards of those strategic choices, meaning we have all of the delivery and security services now in a single software stack, and we can deploy it in any form factor that a customer may want and also in any commercial model that a customer may want, be it perpetual license, software subscription or Software as a Service. That gives us an enormous advantage of that in that market. And the result of that is, we're seeing share gains in a couple of different flavors. One is simply displacing competitors as a substitution. Going in and a customer had this competitor, and they replace it by F5 because there's a stronger road map, there's more features, there's a better commercial model. The -- and then the second flavor is consolidating spend on F5. So there are customers that may be doing one application delivery and security service with a competitor, another one with a second competitor and a third with F5. And now that we have this portfolio with all form factors in all commercial models, it's easy for customers to say, "I will just consolidate the spend on F5." And we are accelerating that phenomenon by bringing all of our products into the single application delivery and security platform, which not only makes it easy commercially for customers to consolidate on F5, but makes it easier for customers operationally to do that because we give them a single pane of glass, a single software stack and a single place to put policy and orchestration of our solutions.

Yes. And how would you describe why your competitors in the ADC market aren't investing like the way you are? And I guess my understanding was your primary competitors have either been acquired and kind of run for cash, and that includes being really aggressive with price increases. I don't know, if that's a fair description of how you view the competitive market, but would just love to hear your thoughts there.

I think it's a fair description of what -- how I view the -- our competitors in the traditional ADC market. But we have competitors in Software as a Service. We have competitors that come more from a cloud offering in security, in particular. We have competitors in each of these categories. But where we are unique is in our ability to bring all of that under a single platform that can be delivered in multiple form factors, but it's a single platform. And that's where we don't really have competition today. And when you look at the complexity that customers are facing what I call the ball of fire earlier, having a single platform that you can go to and say, "I'm going to have a single place from which I can see how I'm securing all of my applications across all clouds and securing all of my APIs across all cloud environments," it's a pretty powerful proposition. And beyond the share, okay, these are the technology assets we have on the table. I think our customers also see us as a company that is invested in the space, that is innovating, and that is trusted, and that is an important part of how we differentiate.

Right. So you've got market share gains, but I think there's also very interesting refresh story as well, where you have this large installed base of users. And I think you have said more than 50% of the installed base is on older generation VIPRION or i-Series. And I think there's an emphasis on well over 50%. I don't think you guys have quantified exactly where that number is. But with end of software support for some of these legacy products coming in the next 12 to 24 months, maybe you could just update us on the pace and timing of refresh and how that gives you visibility into, I'll call them, upgrades, right, over the next couple of years?

Yes. And I'll take that. So in the last refresh cycle, we saw customers that were refreshing at a slower pace than we normally would have seen. We think a lot of that was they were still kind of grappling with the architectural choice of where ultimately are their applications are going to live, there's aspirations to move everything to the public cloud. And so they were kind of reinvesting in that refresh motion kind of at a bare minimum cadence. And then as we progressed through that refresh cycle. You saw a lot of customers for macro reasons, budget impacts, they were kind of sweating their infrastructure. And so there's a little bit of a lag on what would normally be the cadence that they would refresh their equipment. What we're seeing now is a more orderly approach to that refresh with customers. As you said, we're still very early in that refresh cycle, but we're seeing really a pickup as customers have maybe recognized some of the challenges that were brought from a prior approach to that refresh. We're also seeing the growth in the form of capacity expansion at that time of refresh. So customers are recognizing some kind of new dynamics around things like data sovereignty and compliance considerations where they recognize that the data center is an area, where they need to be invested for the long term. We're also seeing what we call indirect demand related to AI, where customers are recognizing that the growth in application workloads may be accelerated based on their AI journey. And so at that time of refresh, they are expanding at a higher rate than what they may have otherwise expanded out. And one of the things that we're seeing is a lot of customers at the time of refresh are moving up in the stack. So we have an appliance family that runs from the low end to the high end. And typically, in a refresh cycle that mix would stay pretty consistent. What we're seeing is that a subset of our customers are moving up in that stack from either the low end to the mid-end or mid-end to the high end. And we see that, that's additional capacity that they're investing in ahead of some of the growth they could be seen from AI.

Great. Yes. And I think on the -- I think it was last earnings call, you guys talked about 1/3 of the systems revenue coming from what was described as, I think, non-refresh demand, right? And some of that was AI, I guess some of that is new use cases, modernization, capacity expansion. Maybe you can just talk a little bit about the key drivers of those non-refresh demand drivers and whether these are related to mostly existing customers? Or are you actually getting net new customers who are interested in some of the things like supporting AI application delivery and security that helps you get new customers as well.

So I would say there are 3 drivers of this non-refresh -- non-tech refresh motion that we're seeing. And I think those are more secular -- refresh, of course, is a cyclical phenomenon. These other drivers are more secular trends that we're seeing. The first is hybrid multi-cloud architectures. We're seeing customers who, in the past, were -- had been maybe hesitant to add data center capacity because they thought, ultimately, they would all go in the cloud. Who are now embracing that they're going to be a hybrid multi-cloud environment that their data center assets are actually strategic assets for them, and therefore, are much more comfortable investing in hardware in data centers and sometimes hardware and software, but that's Trend #1. Trend #2, we already talked about, which is competitive takeouts. So that's not a refresh per se, but it's taking wallet share or taking footprint from competitors, and we can see you see opportunity there for multiple years. And then I would say the third driver is really related to AI, and it's in two flavors, one is customers getting their data center ready for AI. So investing in more capacity, potentially doing some data repatriation or application repatriation and generally expecting that AI traffic is going to be important and making sure their infrastructure is ready for that. And the second flavor of AI is those are direct use cases where we know customers are putting F5 hardware in front of data stores in a data delivery use case, meaning they are trying to connect AI models to data store or AI applications to data store. They do need in front of these data stores, high-performance traffic management and security, and they're introducing F5 for that. So those are net new use cases that are not related to refresh that we are starting to see. It's a small number of our customers that do that today. It's a tiny portion. We said on our earnings call in July that it was single-digit millions of dollars per quarter, but we expect that to be steady growth going forward.

That's great. Shifting gears and maybe just talking about software growth and software renewals. I think you have a revenue growth outlook for fiscal '26 of mid-single-digit growth in software. And software is a lot of different components, perpetual, SaaS and term. Could you just talk a little bit about some of the dynamics that impacts software revenue growth? What is the fiscal '23 cohort look like for term? And how does that inform how you think about fiscal '26?

Yes. So you're right. There's -- we have a number of flavors of software. So we've got perpetual software, which is fairly steady state. It's one of the benefits that Francois alluded to, where we provide customer choice. We're very intentional about that, and it's a good contributor to our software revenue. And then we have our SaaS and managed service business, which is largely our distributed cloud platform and then some legacy offerings that we are transitioning on to that platform. And then the biggest part of the business is the term license subscription business that you're referencing. And so that's kind of the -- where we're looking ahead to next year and providing -- it's not an outlook yet, but it's just kind of a starting point on how to think about next year. And so what we've said is that the majority of our term license subscription business is sold on these multiyear subscriptions. We call it the flexible consumption program. It's been probably the most successful commercial model that we've had over the course of our history at F5. It really facilitates a glide path for customers to expand how they're consuming F5. It takes a lot of the friction of the process. And so that motion because it's a 3-year motion, that renewal, when you look at what that opportunity could look like, you want to look back 3 years ago. So FY '23, that was where we had some challenges related to the macro. The software business was flattish year-over-year. Within that subscription cohort, there was modest growth. And so you think about, as you look ahead 3 years later, that base that's what we're growing against a base that had modest growth in it. And so then what's the expansion opportunity off of that base. In this year, we've had strong expansion rates, right? And so next year, we've got a base that setting the expansion to the side, that base has modest growth in it. We also expect then to see healthy expansion in next year. We've talked a lot about our strategy around the platform, the ADSP platform and really that's something that we think is going to help drive a faster rate of expansion for customers. And so that's the opportunity to drive a higher rate of growth. But just as a starting point, when you look at the base, that's kind of where -- what we outlined as the dynamic behind that mid-single-digit early few. Now what you want to do when you're considering that, if look ahead into the following year because if that's a math headwind on FY '26 reported revenue growth opportunity, that flips in FY '27, right, where you had a stronger growth of software in FY '24 that will be coming up and make that next base. And then the last dynamic is on the SaaS piece of our business, where we've been sunsetting some legacy offerings and transitioning some offerings onto the new platform. We think a lot -- the majority of that work will be behind us as of the end of this year. And so the underlying growth that you're seeing on the platform will start to matriculate in terms of ARR growth and then revenue growth in FY '27.

That's great. Sorry, if I could just jump back on the competitive takeouts for a moment. What is the process for a competitive takeout? Like said differently, as for instance, if F5 was replacing Citrix, like how long would that process take? And I know you guys generate an incredible amount of your revenue from services. And maybe you could also just touch upon the services component and the complexity of the systems that require healthy services.

Well, the ADCs in general are very sticky. And that's because they are so close to applications. And so making a move, changing ADC vendors is actually quite a complex undertaking. Now we have a number of folks in our services organization that are very, very good at handholding customers and helping them make a transition. But customers don't do that overnight. Typically, they would introduce F5 in their estate, ensure that for a portion of their estate always going well and that transition is going well and over time, roll out more F5 into their entire estate. And that is also why we are -- we continue to be excited at this opportunity that even though we have won a number of estates from competitors, in a lot of cases, it was the initial entry into these estates. And so even within the estates that we have won, we see a lot of runway to go and get more wallet share over time in addition to a lot of the new estates that we think we're going to win in the next couple of years. So the process takes time. It can take multiple years for F5 to basically win over the full estate of a customer, if the customer has decided to go single source with F5 over time. But it's also a multiyear opportunity in terms of revenue services associated with it. And what we're seeing, Michael, is, a lot of customers come to us because they have a single pain point around a certain vendor, and they want to replace that vendor. But then when we come into the estate, they then discover the breadth of F5's portfolio and they discover F5 distributed cloud, they discover our API security solution, they discover what we've done with NGINX around security. And so we see a significant cross-sell opportunities into the estate to bring the breadth of the application delivery and security platform from F5 to these customers.

So your entree into a potential competitive displacement might be that person didn't like the price increases they got from your competitor, and then, yes, with...

Yes. So we come in with a single. So it's a single product for single function, but that's the initial entree. And after that, there's a ton of opportunity to cross-sell and upsell the rest of the platform, if you will.

Great. Could we just talk a little bit about security. I mean the company has, I think, increasingly been incorporating and investing in security capabilities across its entire portfolio. And I think, last year, security represented about 41% of revenue. Why is F5 well positioned to address application security when you think about security as an umbrella, like which facets of security does F5 compete in most aggressively?

So the -- I'm going to go back to what I said earlier, that we -- ADCs control 100% of the traffic going into mission-critical applications. Originally, our customers use that -- the ADC capability, this very granular inspection of application traffic. They use it primarily to keep the applications performing and to keep them available. But over time, customers have realized that, that place of inspection was an ideal place to also secure applications, protect them before attacks reach the applications or the database behind the application. And so F5 has been in security now for over a decade, primarily from this place of inspecting traffic very granularly and securing applications. Today, application delivery and security have converged. You cannot really separate performance of an application from the application being secure. And that makes F5 absolutely critical to all application security. Now where we do that today is in three places. First is, we secure the front end of all applications in APIs with our -- what we call our WAAP portfolio, which is web application API protection. So we secure the front end of applications with those solutions in also in hardware, software or SaaS. Two is, we also secure users in the workforce by securing their access with our Zero Trust Access solution, securing their access to applications. And increasingly, we're bringing our capabilities to securing the new AI stack. And so we -- these -- if you should think about it in AI, securing AI basically requires securing every token. And that is more of a Layer 7 capability, and that's where F5 shines. So we are bringing this capability. We've built -- introduced a product called an AI Gateway that secures the connections between AI applications and AI models, provide delivery and security for these connections. That's very specific to AI traffic and AI protocols. And we're going to augment the capabilities of this solution going forward because we think AI security as a market is one where F5 has an important role to play.

Great. Cooper, I was wondering if I could ask you about financial guidance. The company has performed incredibly well this year. You guys are guiding to 9% revenue growth at the midpoint, which is up from the initial outlook of 4% to 5%. What drove the outperformance this year? And how are things pacing kind of post last quarter?

Yes. So we saw -- we've been seeing outperformance across both software and systems. So our initial outlook on software was for upper single-digit growth. And on the strength of some of the expansion outperformance, we updated our guidance to at or around 10%. And then on the system side, we don't specifically guide, but the growth that we've seen, it's in the upper 20s year-to-date. And a lot of that is on some of the factors that we've already discussed, but we've seen real strength in the refresh motion and then the expansion at that time of refresh, which is kind of a new phenomenon. And then growth in the nonrefresh side, which has been effectively at the same levels of growth as on the refresh, and that is very new. So if you look back 2 years ago, that wasn't an area where we anticipated seeing a lot of growth, but some of these new dynamics that customers are grappling with are driving them to increase their capacity and ready for AI. And so that's really what's been behind the strength of the year. We discussed on our April call that we were seeing really strong results. Our pipeline suggested we could have a strong back half of the year, but there was a lot of macro uncertainty related to tariffs, et cetera. And so we took what we think is a prudent posture around our guide for the second half of the year, while at the same time, acknowledging that we're not actually seeing this impact to our business. And so if we don't see a deterioration in the macro, we would expect to outperform to the rest of the year. So at that time, we had taken our guidance up to 6% to 7%, and then we've increased it through the year to the 9% guide that we're at right now.

Great. And then on the margin side of the equation, what's been helping there? And do you see further opportunities for continued margin accretion and expansion?

Yes. So the margins have been improving. We're targeting 35% for the year, and this is kind of a multiyear improvement we've been driving in our operating margins. We're very disciplined about how we manage the business. We go through our planning process, and we have a real focus on where we can drive efficiencies in the model to facilitate continued investment in the business. So the OpEx is growing slower than the headline revenue growth rate, but our level of investment into new use cases, into AI, et cetera, is at a higher rate than what you would see in the underlying OpEx growth, and that will continue to be our model as we look ahead. Our gross margins have also been improving and that's -- a lot of it is driven on the strength of the software as well as customers that are moving up the stack on the appliance lineup that carries a higher margin profile.

Francois, in closing, I was just wondering if you could tie it all together for us and talk about the next 12 to 24 months key priorities, things you're most excited about. It seems like between ADC refresh, nonrefreshed demand wins, AI, the term renewal seeing good expansion rates, it seems like there's a lot of things going in your favor right now, but perhaps you can pull it all together for us.

Yes. Our focus over the next 12, 24 months, #1 is our application delivery and security platform. So bringing our product families together under a single platform that really makes things way easier for -- it has a benefit of making things way easier for our customers in terms of securing and delivering all their apps across all their environments, but doing that with essentially a single way of provisioning policies, orchestrating their environment, visualizing their environment. And so that application delivery and security platform and making that real for our customers is kind of the #1 priority. And then second is AI. And in AI, we see opportunity in AI data delivery that I mentioned, which we think is largely an opportunity in hardware for BIG-IP. And we see opportunities in AI security that are nascent and also inside of AI factories. So really, these are very early opportunities. It's a space that is nascent that we understand less well because there's less of a history and a track record. And it's very difficult to extrapolate numbers from this because it's very early days. But we see the opportunity. And so we are focused on the work to bring these opportunities to life.

So great place to wrap it up, Francois, Cooper. Thank you so much for coming out here to the conference and being on stage here with us. It's been an incredible privilege to be able to host you guys. So thank you.

Thank you so much. Thank you.

Thank you.