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

Great. And could you just give us some color around Distributed Cloud Services, DCS? Like, how does that fit into the broader portfolio? .

Yes. So Cooper already referenced to a bit. We're very pleased with the progress that we've made around Distributed Cloud. So this is a critical part of the portfolio. And I think the numbers tell a very compelling story on that, right? So this is a product offering that we launched 4 years ago now. We've shared that we're over 1,700 customers on it. 33% of our top 1 building customers have now [ noted ] Distributed Cloud, and that's up from 24% a year ago. We really see the SaaS offering as a critical part of the portfolio. It is a key way that customers are able to consume the value that we deliver in a different form/factor and be able to extend those benefits to all of their applications. And so it really is -- a really essential part of our application, delivery and security platform story, what we call our [indiscernible]. And maybe to make it sort of tangible, take a customer that has used BIG-IP in many cases, for a number of years, seeing tremendous value from it, but maybe we're only covering a portion of their applications, probably the ones that are the mission-critical apps in their data center. And many of these organizations, particularly large enterprises, have a large portfolio of applications, some of which are distributed in many locations. And so now they're able to get the same benefits that they had seen from the critical apps in their data center and extend those all the way to their Edge applications wherever they might be running. And because of the application, delivery and security platform story, they're able to get consistent policy, same management interfaces, the same sort of benefits that they're accustomed to from BIG-IP. Of course, that dynamic also works the other way. So there are a number of examples where customers may first experience F5 in a SaaS form factor. And because we're hybrid and multi-cloud, they're unable to extend that back into their on-premise environment. And so we've seen sort of great cross-sell sort of both directions on that. I think one of the really powerful conclusions is that customers that adopt more than 1 modality, so there are 2 or more of these from us, grow 25% faster than others. And so it's, I think, a real testament to the fact that customers that get on to the platform, start to experience the benefits, enjoy of these different modalities, then use it even more thoroughly across their organization.

Great. I wanted to revisit a topic that you mentioned earlier, Tom, which is really about the AI opportunity for F5. And you talked about AI data delivery, AI runtime security, AI factory load balancing. So could you just walk us through where each of those opportunities fit on the customer adoption curve? For F5, which one is contributing revenue today versus which ones have longer-term market expansion potential as you think about genic and physical AI and all those things?

Yes. We're very excited about the investments we're making and the opportunity available in AI. To frame it, though, I do need to step back and remind everybody that we have both the direct and the indirect use cases. The demand for AI is causing organizations to increase their usage of attritional ADCs and those capabilities. And in many cases, for us, those are hard to discern from some of these new use cases because customers just see it as increased capacity. In some cases, they're already seeing it with AI-powered apps that are driving more demand. In others, it's in anticipation of those applications and particularly the agenetic AI world that is now ahead of us that they're planning for that and building that additional capacity. And so we think this indirect use case is actually as big or bigger than the direct use case. The direct use case is the one that we can really sort of put our finger on. And here, there are really 3 different use cases, each of which at a different stage in their maturity. So if I start with the AI data delivery, this one is the most mature. It most typically is a hardware-based use case. So these are customers that want to put performance enhancement capabilities in front of their disk store. That's a net new control point for us, so we didn't traditionally sit that part of the network architecture. And so customers that are building out their AI environments need to be able to get data in and out of their data stores and incredible performance. And we're optimized and tuned really well for that sort of use cases. The second one then is around AI runtime security. And here, organizations need to be able to secure their AI-powered applications. Those look a lot like the sort of capabilities that we've had and that we offer already. But in addition to that, they need to be able to secure the communication between the application and their AI models. And that's a new frontier of AI security functionality. We find that all of that needs to be now AI-powered. So in a world where threat actors are using AI to help find and exploit vulnerabilities in an organization, you have to have AI-powered capabilities to respond to it. So we have made some investments there, a number of investments there, and we're very proud of some of the innovation that we brought to market. And then the third use case is perhaps the most nascent and this is really around AI factory load balancing. That could be across different AI factories or more focused. It's really about load balancing within an AI factory. And so here, we have a partnership with NVIDIA, where we have taken our BIG-IP capabilities and brought those to their DPUs. So this is a data processing unit that runs inside of an AI factory, and that provides a number of performance benefits, a number of security benefits, multi-tenancy. So there's a range [indiscernible] that it brings. That one is by far the most nascent and the earliest in part because DPUs are still getting more broadly deployed. And there are some differences in some of the business models for people that are building out AI factory. But we're very excited about the potential for it.

Great. And then translating that into financials, is there a way to quantify how much of the revenue benefit F5 has seen from AI to date? And then anything that you could share as it relates to which enterprises or verticals are driving most demand?

Yes. So as Tom said, we've kind of got 2 categories of revenue growth. We've talked about the direct use cases, and we've sized that. First half of the year, that was roughly $50 million of bookings, and we continue to see tremendous growth from those use cases. And then of course, we're seeing a lot of the strength on the systems side of the business, is really the some of indirect related demand. We haven't been able to quantify that. But clearly, that's one of the largest drivers of the growth that we're seeing there. In terms of adoption, what we're seeing is data delivery is the largest use case early days. We're seeing customers that are starting to inflect their inference capabilities. We're seeing customers start to evaluate a mix of public models and in hyperscaler environments, and now they're evaluating more open source models that they may be running on their own infrastructure. And that as we see that continue to mature, we think that's going to drive additional data delivery demand. In terms of verticals, one thing that we're seeing is in financial institutions and government agencies, they're AI security is becoming more front and center. And so we're seeing early momentum in some of our AI security use cases within those verticals.

Great. Let's shift gears and talk about the broader F5 security portfolio. What is F5 doing to address some of the enterprise application security issues? And maybe you could talk through what the portfolio looks like today and also touch on the SurePath AI acquisition that you guys just did.

Yes. So maybe the starting point for this really is where we sit. So we sit at the front door, the most mission-critical applications of the largest enterprises, service providers and governments in the world. And as a consequence of that, we see every request, every API call. And as we go forward, sort of every genic call in and through these organizations. Today, we serve 80% of the Fortune 500. And so it puts us in a really prime position to be able to help our customers solve their security challenges. I'd really point to sort of 3 areas of differentiation for us. The first is really around depth. And so here, we have built sort of the highest efficacy set of capabilities around securing applications in the world. That is a set of functionalities that goes very deep into each of the areas that customers need to protect for their enterprise app. The second then really is around the breadth of the portfolio, and this takes a few different forms. So we offer these application security services across a number of different categories. There are several different types of security that are required there. We provide sort of that full range of functionality. We've integrated together into a platform. And so we are the only player that offers a single-integrated platform that allows customers to have policy that runs across these different environments. And then the third is the multiple modalities, the ability to support hybrid and multi-cloud. So the breadth there is quite unique. And then the third, which is sort of where you get to it in the question is really around the role of AI. And here, we built an AI-powered set of AI security capabilities. Our AI-powered WAF, for example, is one of the fastest-growing products in our history. And we're seeing sort of great momentum and traction with that. We are also, as I referenced, building out a number of AI security capabilities. We made an acquisition last year. We combined that with a number of the organic investments that we've been making. I feel very good about the AI security functionality that we have. In Q3, we announced the SurePath acquisition that added to the guardrails and red teaming functionality we have new discovery capabilities, and that really build out a more complete AI security offering. I think we're very pleased with the momentum that we're seeing with customers, particularly in financial services. where we have a number of marquee wins there are continuing to very aggressively grow that business. And so we feel very good about our position in security and [indiscernible] and specifically in AI security.

Great. Cooper, I was wondering if you could just turn to margins and financials. Maybe you can just walk through some of your expectations around gross margins and operating margins over the next couple of years? And then if you could please touch on just what you're seeing in terms of supply chain constraints, kind of operational constraints that may affect the margin outlook over the next couple of years here?

Yes. So gross margins have held up pretty well this year. We've seen a lot of this has to do with some of the dynamics I talked about earlier, customers moving up to higher margin offerings as they're adding capacity. And so we feel pretty good about where gross margins are this year. We've noted that because of some of the [indiscernible] cost pressures that we're seeing, those will start to flow through in the model next year. So we sized at our Analyst Day, the margins would be in the kind of 80% to 82% range for next year. We did see a little bit of stability on the pricing related to memory in Q3 and for Q4. We haven't updated our guidance for gross margin next year. It's kind of cautiously optimistic, I guess, is how we would characterize it because frankly, we're getting some mixed signals where providers are saying that there potentially could be continued cost pressure on memory. But what we've been seeing come through over the last few weeks is signaling more stability. And so we think we'll be in a better position to provide an update on where gross margins look like they're trending in October for FY '27. But longer term, we think the gross margin should stabilize as we start to get a little bit better availability of some of these scarce components. From an operating margin perspective, we think we have an opportunity to continue to improve our operating margins in the long term, notwithstanding the gross margin headwind for next year. as we can grow our OpEx at a slower rate than revenue. We're seeing a lot of efficiency across the business, leveraging automation and AI capabilities we're seeing really strong sales productivity. We've been adding a lot of sales capacity for some of the new growth opportunities that we're seeing. But even as we've added that sales capacity, but the productivity continue to go up. So we feel really good about our ability to continue to scale the business in terms of our OpEx as a percentage of revenue.

Great. And then on capital allocation, F5 has committed to returning at least 50% of its free cash flow to shareholders through buybacks. And you guys have also selectively done some tuck-in acquisitions. So maybe you could just provide an update on capital allocation priorities, how you weigh things like repurchases versus strategic investments in the business.

Yes. So it will be pretty consistent with our approach over the past few years. We will continue to invest both organically and look for inorganic opportunities, but it will be largely kind of the same philosophy as what you've seen with our acquisition approach over the last couple of years. We'll continue to repurchase shares with a target of at least 50% of our free cash flow devoted to share repurchases. And then you see, I think, a little bit of an increase in our CapEx as we continue to build out the distributed cloud part of our business and just building more points of presence around the world to support growth of that business. And then the last item I would note is our inventory position will continue to build as we're sourcing some of these long lead time components, which we feel really good about. That approach, it's provided some stability in terms of our supply that we need to meet demand for FY '27 and beyond. But you'll see some of the actions we've taken to ensure that we can meet that demand showing up on our balance sheet in terms of inventory position.

Great. To close out, I mean, it certainly feels like there's a lot of exciting times ahead. So would you just talk a little bit about key priorities, goals that F5 is focused on over the next 1 to 2 years?

Yes. So the setup for the next 12 to 24 months, I think, is better than I've seen it ever in my time at F5, and I think it's many of the things we were just talking about, right? The incredible demand environment in which we're operating right now, the long-term secular demand for our architectural approach and the way we go about solving things, the platform message is really resonating with customers. And I think the team is executing really well. And so for us, I think that translates into kind of 4 priorities that are immediately in front of us. The first is around capitalizing on this secular shift. The second then is really about capturing the growing demand for ADC. The third is around driving platform adoption across our installed base of customers. And then the fourth is around capturing this new AI opportunity that is available to us.

Well, Tom, Cooper, thank you so much for participating in our conference. It's been a privilege to have you on stage here.

Thank you so much.

Thank you.