F5 Inc (FFIV) — Q3 2023 Earnings Call Transcript

Hello, and welcome. I am Suzanne DuLong, F5's Vice President of Investor Relations. Francois Locoh-Donou, F5's President and CEO; and Frank Pelzer, F5's Executive Vice President and CFO, will be making prepared remarks on today's call. Other members of the F5 executive team are also on hand to answer questions during the Q&A session. A copy of today's press release is available on our website at f5.com, where an archived version of today's audio will be available through October 24, 2023. The slide deck accompanying today's discussion is viewable on the webcast and will be posted to our IR site at the conclusion of our call. To access the replay of today's webcast by phone, dial 877-660-6853 or 201-612-7415 and use meeting ID 13739739. The telephonic replay will be available through midnight Pacific Time, July 25, 2023. For additional information or follow-up questions, please reach out to me directly at s.dulong@f5.com. Our discussion today will contain forward-looking statements, which include words such as believe, anticipate, expect, and target. These forward-looking statements involve uncertainties and risks that may cause our actual results to differ materially from those expressed or implied by these statements. We have summarized factors that may affect our results in the press release announcing our financial results and in detail in our SEC filings. In addition, we will reference non-GAAP metrics during today's discussion. Please see our full GAAP to non-GAAP reconciliation in today's press release and in the appendix of our earnings slide deck. Please note that F5 has no duty to update any information presented in this call. With that, I will turn the call over to Francois.

Thank you, Suzanne, and hello, everyone. Thank you for joining us today. In my remarks today, I will speak to the quarter's results and the current customer spending environment. I will then highlight some notable customer wins from the quarter, including some emerging areas where we are seeing good early traction. Overall, customer caution persists, with customers continuing to sweat assets amidst tight budgets and lingering macroeconomic uncertainty. Despite the tough environment, our team is executing well and we delivered third quarter revenue at the midpoint of our guidance range, with earnings per share well above the high-end of our range. From a demand perspective, we are seeing some early signs of stabilization. Q3 demand played out slightly above our beginning of quarter forecast, which was up from Q1 and Q2 this year, though still off from FY '22 levels. Our global services team delivered strong 8% growth, driven by a continuation of customer trends from the first half of the year, including strong maintenance renewals and price realization. With customers sweating existing assets, we also continue to see higher maintenance attach rates on all the deployments. Our product revenue grew 1%, with systems revenue growing 5% and software revenue declining 3% year-over-year. While systems revenue is benefiting from supply chain normalization and our efforts to substantially work down backlog, systems demand remains constrained. In contrast, we are seeing some positive signs in software demand. Total software revenue was down 3% year-over-year, against a strong Q3 2022 comparison. However, total software grew 32% sequentially. And within software, our subscription software revenue grew 4% year-over-year to a record high of $152 million. This reflects strong growth in our software renewals and interim expansions or true forwards, as well as some stabilization in new term subscriptions from the first half. Moving from revenue to our operating results. We are also demonstrating operating discipline and driving operating leverage. Our Q3 non-GAAP gross margins of 82.5% improved more than 200 basis points from Q2. This was slightly ahead of our guidance and reflects the combination of expected supply chain easing and price realization, as well as some of the ancillary supply chain costs like broker and expedite fees. Finally, working their way out of our inventory as planned. In addition, our Q3 non-GAAP operating margins of 33.2% improved 600 basis points from Q2 and more than 400 basis points from Q3 FY '22. As a result of these improvements as well as some tax favorability, we significantly overachieved our non-GAAP EPS expectations in the quarter and now expect to deliver double-digit non-GAAP earnings per share growth for FY 2023. We believe our growth opportunity is fundamentally linked to the continued growth of applications and APIs and the need to secure, deliver, and optimize those apps and APIs. As part of our efforts to capture that growth, we continue to drive innovation, advances, and integration across our product families, including F5 BIG-IP, F5 NGINX, and F5 Distributed Cloud Services. I will call out some customer highlights from each product family from the quarter. Our BIG-IP family, which serves traditional applications either on-premises, collocated, or in-cloud environments, continues to take share from competitors who have failed to invest in innovation. From a hardware perspective, the value proposition with our next-generation platforms is resonating with customers with our rSeries and VELOS platforms representing more than 70% of Q3 systems bookings. On the software side, BIG-IP's data point performance, automation capabilities, and lower total cost of ownership continue to differentiate our offering and drove multiple wins in the quarter, including wins at a major American airline, a multinational automobile manufacturer, and a major UK retail and commercial bank. We also saw strong demand for F5 NGINX in the quarter. NGINX serves modern, container-native and microservices-based applications and APIs. We continue to see large enterprises adopt NGINX for their cloud and Kubernetes workloads. We have repeatedly demonstrated that when applications are built with NGINX from the ground-up, and those apps grow, we grow with them. We saw this in several NGINX growth opportunities in the quarter, including a multi-million dollar term-based subscription renewal that grew by an extraordinary 10x from initial inception. The customer, which provides a large collaboration platform, is streamlining deployments in both public and private clouds using F5 NGINX as their single platform for load balancing, caching, and telemetry. Over the last several years, we have invested both organically and inorganically to build a portfolio of SaaS and managed services called F5 Distributed Cloud Services. Since launching distributed cloud in February of '22, we have been expanding our offerings and building momentum for multiple security use cases. A good example of this is a win with a global financial services industry application provider that wanted to standardize its web application firewall and API protection or WAP policies and deployments in APAC and EMEA to reduce time to delivery. Their existing application security and complex policy tuning were a challenge, as was managing apps and APIs across distributed environments with a small team. Today, F5 Distributed Cloud Services is protecting their apps and APIs with WAP and multi-cloud networking, reducing their time to delivery from months to minutes. It is early days still, but we are also seeing encouraging signs that our distributed cloud services are intercepting the markets, specifically in two emerging categories, API security and multi-cloud networking. On API security, with the growth of modern applications using containers and composed of distributed microservices, the number of API endpoints is exploding. CISOs tell us they struggle to know-how many APIs they have, where they all are, who is connecting to them, and to what extent they are secured. Doing so requires robust API discovery and protection capabilities like those we offer in our distributed cloud API security service. When a North American service provider experienced a serious cybersecurity incident, which caused them to lose their entire virtualization infrastructure at multiple data centers, they turned to us for urgent help. F5 Distributed Cloud Services, superior features, functionality, and value beat a competitive offering, and we worked with the customer to emergency onboard the platform, including advanced WAP both defense and API security. Once deployed, the customer immediately started migrating sites to restore their services. We are also seeing strong early traction in our distributed cloud multi-cloud networking offerings launched just this past March. 85% of respondents cited in our 2023 State of Application Strategy Report said they are already managing multi-cloud environments; securely connecting applications between on-premises, multi-cloud, and edge environments at scale is a tough task for any organization. Our secure multi-cloud networking solutions change the game. Our ability to package networking, security, and distribution of applications and APIs is unique. Until now, customers have been forced to manage and secure these layers in isolation, often leading to operational complexity, network latency, and weak security. Our multi-cloud networking solutions reduce operational complexity for our customers and make it possible for them to securely connect distributed networks and applications across public clouds, on-premises data centers, and edge locations. Customers are beginning to understand the power of our secure multi-cloud networks, ability to provide end-to-end visibility, control, and security across all of their applications. This empowers them to move workloads to the cloud between clouds and even through the edge while maintaining end-to-end visibility and consistent security policy. F5 Distributed Cloud uniquely unifies the visibility, control, and security for every application and API so that applications can be delivered without constraint and with the security today's threat environment demands. Early traction for our secure multi-cloud networking offerings includes a win with one of the world's largest independent providers of insurance claims management systems. F5's multi-cloud networking now enables their global SaaS offerings. The customer first deployed our Distributed Cloud WAP in February of 2022 to protect a business-critical public cloud workload. In early '23, the customer was abruptly asked to leave a data center, forcing them to lift and shift workloads to the public cloud in just two weeks. They used F5 Distributed Cloud for this emergency lift and shift. In fact, the project went so smoothly that they opted to expedite moving their global data centers to public clouds. Now, the customer has standardized on F5 Distributed Cloud for their secure multi-cloud networking needs, spanning across multiple clouds and protecting external and internal applications and APIs. These are just some of the customer challenges we help tackle in Q3. While we are not in a position to predict with precision when customer spending patterns will return to more normal levels, F5 is well-placed to benefit when they do. We are encouraged both by the early signs of stability in Q3 and with the resonance our application and API-focused approach is having with customers. We are making it possible for our customers to secure, deliver, and optimize their applications and APIs with a consistent approach, no matter what environment they're deployed in, data center, collocated, private cloud, or public cloud. And this is a critical capability and differentiator in today's hybrid multi-cloud network world. Now, I will turn the call to Frank.

Thank you, Francois, and good afternoon, everyone. I will review our Q3 results before I discuss our fourth quarter outlook. We delivered Q3 revenue of $703 million, reflecting 4% growth year-over-year. Our revenue remained roughly split between global services and product, with global services representing 53% of total revenue. Global services revenue of $374 million grew a strong 8%, due to continued high maintenance renewals as well as the impacts of the price increases introduced last year. Product revenue totaled $328 million, representing growth of 1% year-over-year. Systems revenue of $155 million grew 5% year-over-year. Software revenue totaled $174 million, down 3% from a tough comparison in the year-ago period. Our software revenue is comprised of both subscriptions and perpetual license sales. Subscription base revenue hit a new high in Q3 in both dollars and as a percentage of software revenue. Our subscription revenue totaled $152 million, or 87% of Q3's total software revenue and, as Francois mentioned, grew 4% year-over-year. Perpetual license sales of $22 million represented 13% of Q3 software revenue. Revenue from recurring sources contributed 75% of Q3's revenue, which is a new all-time high as a result of the strong subscription contribution. Recurring revenue includes subscription-based revenue as well as the maintenance portion of our services revenue. On a regional basis, revenue from Americas grew 3% year-over-year, representing 57% of total revenue; EMEA grew 16%, representing 26% of revenue; and APAC declined 6%, representing 18% of revenue. Looking at our major verticals, during Q3, enterprise customers represented 66% of product bookings, service providers represented 13%, and government customers represented 21%, including 8% from U.S. Federal. Our Q3 operating results were strong, reflecting our previously announced cost reductions and overall operating discipline. GAAP gross margin was 79.8%. Non-GAAP gross margin was 82.5%, an improvement of more than 200 basis points sequentially. GAAP operating expenses were $457 million, non-GAAP operating expenses were $346 million, slightly lower than our guided range and reflecting a partial quarter benefit from the cost reductions we announced in April. Our GAAP operating margin was 14.7%. Our non-GAAP operating margin was 33.2%, representing a sequential improvement of more than 600 basis points. Our GAAP effective tax rate for the quarter was 16.4%. Our non-GAAP effective tax rate was 18.1%. This is below our target range for the year, largely driven by a non-recurring benefit associated with the filing of our annual federal income tax return during the quarter. Our GAAP net income for the quarter was $89 million, or $1.48 per share. Our non-GAAP net income was very strong at $194 million or $3.21 per share, well above the top end of our guided range of $2.78 per share to $2.90 per share. This reflects the combined impact of our gross margin improvements and operating expense discipline as well as a Q3 tax benefit. I will now turn to cash flow and the balance sheet, which also remains very strong. We generated $165 million in cash flow from operations in Q3, driven by our improved profitability and strong cash collections. Capital expenditures for the quarter were $15 million. DSO for the quarter was 56 days, down from 62 in Q2 and closer to our historic range as a result of earlier invoicing related to improved shipping linearity as our supply chain continued to stabilize. Cash and investments totaled approximately $696 million at quarter end. Deferred revenue increased 9% year-over-year to $1.79 billion, driven by the high service maintenance attach rates we've seen throughout the year and continued growth in subscription as a percent of our software mix. As we committed to on our last call, we repurchased $250 million worth of shares in Q3. Finally, we ended the quarter with approximately 6,500 employees, which reflects the headcount reductions we announced in April. I will now share our outlook for Q4. We expect Q4 revenue in the range of $690 million to $710 million with gross margins of approximately 83%. Unless otherwise stated, my guidance comments reference non-GAAP operating metrics with the full quarter benefit from the cost reductions announced in April. We estimate Q4 operating expenses of $338 million to $350 million. Incorporating our year-to-date results, we have now narrowed our estimates for FY '23 effective tax rate to approximately 20% for the year. As a result, we are targeting Q4 non-GAAP earnings in the range of $3.15 to $3.27 per share. We expect Q4 share-based compensation expense of approximately $55 million to $57 million. Year-to-date, we have used 68% of our free cash flow towards repurchases. We remain committed to returning cash to shareholders and continue to expect to use at least 50% of our annual free cash flow towards share repurchases. I will now turn the call back over to Francois.

Thank you, Frank. Customers made F5 the standard for securing, delivering, and optimizing traditional applications. Now, with compelling and differentiated solutions for modern applications and APIs as well as those mission-critical traditional apps, we are being architected into new areas and use cases across our portfolio. Our holistic application and API focused approach enables newfound consistency across environments and across hardware, software and SaaS deployment models, which reduces risk, lowers operating costs, and delivers better digital experiences. In closing, I ask that you take away three things from this call. Number one, we are seeing some early and encouraging signs of demand stabilizing. Number two, we are seeing demonstrable proof points that the differentiated solutions portfolio we are creating through a combination of organic and inorganic innovation and technology integration is well-aligned with how application architectures are evolving. And number three, we are delivering on the operating discipline we committed to, and expect to produce additional leverage in FY 2024. Operator, please open the call to questions.

Great. Thanks for taking the questions. Maybe first for Frank. How did the true forward portion of renewals perform this quarter relative to the last and assuming it has improved, which it seems like it has, do you think we're at the tipping point where customers simply need to add capacity, which will continue to drive relative strength and renewals going forward, or is it too early to tell whether or not that's bottomed?

Hi, Ray. Thank you so much for the question. So the true forwards, when we set out our plan at the beginning of the year, we had higher expectations than what we've seen throughout the course of this year. That having been said, it was a strong quarter in our renewals, and included in that would be our true forward number. It's early to indicate that we've seen an absolute bottom and things are going to grow from here. What I was incredibly encouraged by was the expansion that we saw in some of our second terms, as Francois mentioned, were quite high on a few large deals. And we are seeing a stabilization right now in the demand environment, which is better than what I can say for the last couple of quarters. So again, early signs, but not yet ready to call it a trend.

That makes sense. And maybe if I could follow up for Francois. You mentioned you're obviously seeing signs of macro stabilization here? Can you unpack that a little bit more? I mean, how broad-based is the stabilization maybe from a vertical perspective? And from a product perspective, are you seeing each vertical kind of stabilize, or is there kind of give-and-take between where the spending is kind of more firm than others?

Hi, Ray. I think it's helpful to contrast what we experienced this quarter with the first two quarters of the year. One thing that remains consistent is that customers are still carefully evaluating their spending. We continue to observe delays in deals, with some being postponed. Across all sectors, customers are aiming to minimize their spending and maximize the value of their existing assets. These patterns have persisted. Consequently, while we experienced stronger demand in Q3 compared to the first half of the year, it still fell short of the levels we saw in 2022. However, one positive change is that we did not see conditions worsen this quarter relative to the first half of the year, indicating we may have reached a stable point. In March, there was significant uncertainty, particularly in the financial services sector following the bank failures, as well as ongoing concerns about interest rates and the U.S. debt ceiling. Spending in financial services almost completely stalled during that time, but that sense of volatility has diminished. While there are still deal delays and cautiousness, deals are being approved even with scrutiny. This shift is particularly noticeable in the financial services vertical. Additionally, we've observed that some of the delayed projects have proceeded, especially in financial services and a few other enterprise sectors. Service providers are still trying to optimize their assets, and this trend is evident across the board.

Great. Thanks for the color. I appreciate it.

Hi, thanks for taking my question. Francois, I’d like to revisit your comments about the stabilization of demand and explore that further. You mentioned stabilization in a quarter when systems revenue significantly declined, as you've outlined with the backlog. Should we interpret your remarks regarding both hardware and software as indicating a more normalized mix based on the current macro environment? As we consider fiscal '24, does this suggest that you're viewing a $700 million or $2.8 billion annualized figure as a base level, assuming the macro situation stays the same? Is that the correct interpretation of your demand stabilization comment?

Hi, Samik. Let me break that down for you. There was a lot to cover. When I mentioned demand stabilization, I meant that the situation had been deteriorating from January to March, but by the end of June, we didn't feel that things had worsened further. Specifically regarding hardware, demand has been weak throughout the year due to the macro environment and customers managing their resources. Additionally, customers had orders from last year that they still needed to receive, install, and deploy. As a result, we have significantly reduced our backlog, which is reflected in the Q3 hardware results. Looking ahead to Q4, I anticipate hardware demand may decline even further compared to Q3. As for 2024, it's too early to confirm specifics, but historically, similar cycles have lasted four to six quarters, and we are currently three quarters into this one. We expect demand to return in 2024, although we cannot predict the exact timeline. We do anticipate hardware demand to be higher next year than this year, but keep in mind that due to the significant backlog we were able to ship, we mentioned last quarter that there would be a headwind of six to eight points on total revenue growth next year because of how we've managed the backlog this year. So, it's important to consider that when thinking about revenue for next year.

Got it. And Francois, a question that I'm getting a lot from investors really is about AI and the investors are expecting inflection again in terms of application growth because of AI use cases. It's really more about your application security capabilities. How do you think they are positioned to navigate sort of that inflection and application growth and how do you think about the challenges in managing that growth as well at the same time?

In the AI space, we are focused on enhancing our productivity by leveraging new capabilities. We are committed to achieving double-digit earnings growth this year, and we aim to drive productivity improvements over time, using tools to support this effort. Additionally, we have already integrated AI into our security products, particularly through the Shape Security acquisition, which has brought valuable AI capabilities and expertise. This allows us to analyze application traffic in great detail, providing us with powerful insights. Moving forward, we plan to enhance these capabilities with new machine learning models, especially in security, where we believe AI will be crucial in addressing challenges. With access to a significant amount of data, given our presence with 40% of the world's websites and over 300 million sites, we are well-positioned to leverage this information for our models. We also anticipate new opportunities in emerging AI-related workloads, which, while still in early stages and somewhat undefined, possess two intriguing attributes for us. Firstly, these are next-generation workloads designed with an API-first approach, leading to an increase in API connections and calls, which will drive the need for robust API security and orchestration—areas where we excel. Secondly, these workloads will often require access to distributed data, which supports the adoption of multi-cloud architectures, another opportunity we are well-equipped to address. Overall, we believe these characteristics of AI-related workloads will present significant opportunities for us in the future.

Got it. Great. Thank you. Thanks for taking my questions.

Thanks for taking the question. I was looking at really where the systems revenue had been prior to the pandemic. And wondering how you would think about the idea that a normal revenue run rate might be in that sort of $170 million and $180 million a quarter. Clearly, a lot has changed. Gilbert, since I guess late-2019. Could you maybe help us think about sort of the puts and takes to even if we don't know the timing to sort of get a better sense of what should be the sort of base run rate for hardware?

I don't think we can specify what the base run rate for hardware should be. However, I can share that we believe the trajectory for hardware units should decline in the mid-single digit percentage range. It might be slightly more or less, but it's generally in that area. If you examine the overall normalized trend of our hardware units over the last few years, you would notice this decline. While revenue has faced significant disruptions due to the pandemic, supply chain issues, and macroeconomic factors, if we focus on the long-term trend of hardware units in the field, that decline in the mid-single digits is what we expect. I would also emphasize that a key strength of the F5 model is our ability to provide solutions in hardware, software, and Software as a Service. Customers appreciate the flexibility offered by our model since applications may reside in diverse environments. They value having applications supported by hardware in private data centers and others by software or SaaS. Within large enterprises, we see multiple deployment models being utilized. What is important to customers is the consistent delivery of policies and security across these different consumption models. We will continue to offer this flexibility as it is essential for driving earnings growth in our business.

That's helpful. And just maybe as a follow-up, in terms of the software trajectory, what sort of signals might you suggest we look for in terms of sort of things getting better and things getting back to normal apart from just sort of the macro? What kind of advice would you give to the analysts?

In terms of specific metrics, more information will be provided later. Regarding the delivery strategy that Francois described, one reason we have moved away from giving exact guidance on the mix is our desire to provide customers with flexibility. We allow them to decide what they believe is the best approach. This will lead to some fluctuations and volatility between software and hardware. I anticipate that as the SaaS business, particularly in Distributed Cloud, grows significantly over the next few years, this volatility will lessen as more of that business comes to us in a predictable manner. As this segment continues to expand, we will provide more metrics that will offer insights into where software revenue is expected to come from.

Thank you very much.

Hey, guys. Following up on a few of the questions asked here already. But what are you seeing demand-wise or demand stabilization between the product side, meaning on the ADC side versus security? And really asking also, what percentage of your customers are actually using products from both as we're trying to understand what penetration opportunity you guys have left?

Hey, Jim. Let me provide an overview of the demand we're observing by product. As mentioned, hardware demand has been weak, particularly in the ADC area, where customers are looking to postpone purchase orders and make the most of their existing assets. Stand-alone security has been more stable than ADC, but security linked to ADC is similarly impacted. However, we have witnessed strong demand for NGINX, especially for modern application deployments, along with renewals and expansions from current clients. We're also experiencing notable growth in our distributed cloud opportunity, focused on application security offered as a service for various applications. We're increasingly finding opportunities in API security, which is an emerging but promising market, and in securing multi-cloud networking to connect applications securely across different clouds. These are growing quickly, although from a small base, and this reflects a different trend in demand. Overall, this is the landscape of demand levels across our portfolio.

Makes sense. And Frank, maybe for you. You guys keep mentioning expansion opportunities and expansion rates being pretty strong. I know you're not quantitatively giving them, but can you qualitatively kind of give us some color around what you saw versus the first half of the year with net retention rates, be it on recurring revenue or just the recurring software piece? And also trying to understand how much of growth is being constrained by the transition to recurring sources, particularly the SaaS side of things, as you collect more revenue over time but less upfront. Thanks, guys.

Sure. So yes, that dynamic, I will be excited to see, Jim, but we have not yet seen that, where the SaaS piece has overtaken the term-based subscription side of the business. That still is the majority of our software revenue. In terms of net retention rates, it was strong in the quarter. That part is part of our renewal base of revenue, which has been, frankly, much closer to plan than new business. New business activity was challenged in the quarter in relation to what we expected to do at the beginning of the year, but much better than what we had seen in the first half of the year. So in total, again, the net retention that we have seen in our recurring base of revenue and the renewal base of revenue has been growing and strong. But the new business opportunities that we see, those are the ones that are still challenged in relation to what we expected to do at the beginning of the year. But they were largely in line, slightly better than the revised expectations that we set last quarter.

Thanks, Frank.

Thanks for taking my question. Was there any difference in the mix you observed this quarter compared to your expectations? The backlog appears to be depleted, but the systems number was somewhat lower than anticipated. Are more customers choosing virtual editions as they shift towards hybrid cloud solutions? Also, could you elaborate on the share gain opportunities you mentioned? What has been the most effective approach or sales program to identify and target those customers? Thank you.

Thank you. Your questions are interconnected as they relate to the flexibility of our model that includes hardware, software, and SaaS. Regarding your first question about the mix of hardware and software, we were pleased to see that some of the larger software deals we anticipated actually came through without delays. This positively impacted our software performance for the quarter and reflects a stabilization in our customer base. Although we have not yet returned to the project levels of 2022, we are still seeing essential projects move forward. On the hardware front, we expected to ship our backlog throughout the year, and we are glad to report that we have achieved this. Our lead times have returned to nearly normal at two weeks, which is crucial for our customers to access the equipment they need. We believe this will drive future demand as they implement these projects. In terms of market share, specifically in the traditional ADC market, we believe we are gaining traction due to our investments in next-generation platforms and software. This quarter, we rolled out the rSeries and VELOS platforms, with over 70% of our hardware shipments coming from the new rSeries platform. The adoption of this platform has been remarkable, and we view it as the quickest adoption we've experienced in any transition. This underscores the capabilities of our new platforms and software, which deliver cloud-like benefits in on-prem environments. Moreover, our CapEx and OpEx models, along with our various subscription offerings, are compelling. Compared to our competitors in the ADC space, we are capturing market share, including customers from those who have not kept up with investments. We are also actively pursuing the WAF market, which includes services for API security, DDoS, and bot protection. As a new player in the Distributed Cloud space, we are quickly acquiring customers and challenging established players. We have distinct advantages in API security and bot defense, particularly in networking applications between clouds, as secure multi-cloud networking emerges as a vital opportunity. We feel confident in our ability to continue gaining market share in the upcoming quarters.

Great. Thank you.

Great. Thanks. So last year, you had a pretty steep decline in your systems business. You cited the supply chain, and now you're up low-single digits and you're suggesting that your backlog has already been resolved, that really doesn't imply a particularly strong headwind as we go forward of 6% to 8%. So can you reconcile why that headwind of 6% to 8% would be there given you haven't really produced meaningful strong top line growth in that business? And then conversely, you're citing a 6% to 8% headwind going forward. Your comps on the software side were extremely difficult over the last year but now have gotten quite easy with declines in the September quarter last year and are setting up for pretty easy comps over the next year. So if I look at the software side of it, is it reasonable to think that we're going to now see a meaningful shift to software growth, and therefore, it's still possible to produce revenue growth on the product side as we go into 2024? I know you don't want to give guidance, but you have given guidance on 6% to 8% headwind. What should we be thinking about as the offset to that and these easy software comps?

It's Frank. I'll begin and see if Francois wants to add anything. In short, the 6% to 8% relates specifically to the systems business based on the backlog we had going into fiscal year '23, which has enhanced our recognized revenue compared to the demand for that year. For fiscal year '24, that 6% to 8% is primarily linked to the hardware business. We've faced challenges on the demand side in both areas, although the situation improved in Q3 compared to the first half of the year, stabilizing at a lower level than in fiscal year '22. We do anticipate changes, especially in the systems area, with a significant shift compared to fiscal year '23 in terms of demand. However, we're uncertain about when in fiscal year '24 we will see that change in systems. On the software side, we have experienced good traction, particularly in renewals, but there have been challenges regarding new business. This is expected to improve, likely in the form of SaaS revenue, though it may not be recognized at the same rate as our term-based agreements in fiscal year '24. It's too early to determine how this will unfold, and we'll provide more updates in the next call, but these are our initial indications and the context to help clarify some of our previous comments.

Thank you, Frank. I would just add so that it's absolutely clear. When we talk about, Alex, the 6 to 8 point headwind, it's not demand headwind. We, in fact, expect demand next year in hardware to be higher than this year. But it is a shipment headwind that's impacting recognized revenue. So wanted to be clear about that.

So just to clarify, it sounds like you don't expect your software revenue to recover enough to offset the headwind on hardware. And it sounds like your hardware expectations for demand are less than the headwind as well. Are we thinking that the outlook should be fairly flat or even down on revenues? Because that's the implication you're giving us on these commentary relative to the product side of the equation.

We are not ready to provide guidance for 2024. The 6 to 8 point headwind on total revenue remains unchanged from last quarter. We want to clarify that this year, as we fulfill our backlog, we are shipping more revenue than the demand we've experienced for hardware, which creates a challenge for growth next year. However, we are committed to achieving double-digit earnings growth, and we took several actions to drive that growth this year. We anticipated addressing supply chain challenges from 2022, and we expected to begin seeing improvements in the latter half of 2023. This quarter, we saw a significant improvement in gross margin as we managed high-cost components, and we have maintained disciplined pricing strategies. Operating margins also increased substantially, and we plan to continue this operating leverage next year, focusing on driving earnings growth.

Hey. Good afternoon. I just have two questions. The first is on this trended software. It's clear you had strength in renewals and true-forwards. I think last quarter, there was some weakness in new deals. I was just wondering if you were seeing some improvements there and whether you think software revenue can grow in the September quarter? And then I just have a quick follow-up.

Sure, Michael. Thanks for the question. Yes, we did see an improvement in the new business activity, though it was still down from where we were a year ago. It was a positive sign to see, again, as Francois mentioned earlier, some of the irrationality come out of the buying behavior. There were still many more deal approval levels than what we would have seen a year ago, but the deals were actually getting approved. So we're really happy to see that come through. We're obviously not guiding to a mix on software versus hardware sequentially. But we do have a lot of faith in the software business. Obviously, last quarter was a challenging quarter. This quarter came back closer to the expectations that we have for the business. We'll talk more about the actual outcome next quarter.

Great. And I just wanted to circle back on some of the double-digit earnings growth commentary. I think in the past, you guys have said you expect double-digit earnings growth for fiscal '24 as well, more so on cost cuts, recognizing the uncertainty on the top line. Is that still the case? And do you still expect at least 300 basis points of margin expansion next year? Thank you.

Absolutely. So yeah, Michael, when we made those comments, obviously, we had had an outlook of 7% to 11%. We're higher now on EPS for where we're going to be in FY '23. We're really happy about that. Some of that is coming from the tax benefit. When we take a look at our pretax income for FY '24, it's certainly our aspiration to be double-digit. How the things like tax and share repurchase and stock price as those share repurchases come into play, it's just too early to give any specific guidance further than that on FY '24. We are really, really happy with the progress that we made, the leverage that we're seeing, particularly in our gross margins and operating margins. It's exactly what we thought was going to happen, and more to come on FY '24.

If I go on the second part of the question around operating margins, look, we said we expected operating margins in 2024 to be around 33%, and we still feel that that opportunity is there and we intend to drive to that.

Hi. Thanks for squeezing me in, guys. Can you maybe just talk a little bit about how competition for F5 has changed, particularly as you enter some of these new markets like API security, multi-cloud networking? And then maybe expand a little bit on some of the key points of differentiation as you look to take share a few comments here.

Yes. Can you repeat the first part of the question?

Yeah. Just maybe could you talk a little bit about how competition has changed as you entered some of these new markets around API security, multi-cloud networking, etc.?

Thank you. In API security, we see a developing market with a few startups involved. API security presents significant challenges as it involves managing large volumes of API calls, and identifying threat patterns often requires sophisticated methods to pinpoint issues amidst substantial data. To succeed in API security, capabilities in AI and machine learning, along with effective attack mitigation strategies, are essential. F5 stands out with our ability to discover and protect APIs and combat potential attacks. Competitors lacking these dual capabilities are at a disadvantage. We're also seeing rapid progress in the Distributed Cloud market. Multi-cloud networking is emerging and expected to grow as most of our customers utilize multiple cloud services. Our latest report indicates that nearly 90% of our clients have adopted multi-cloud solutions, leading to a rising demand for secure connections between applications across these environments. While some competitors can manage Layer 3 networking, enterprises increasingly require security capabilities up to Layer 7 for secure application integration. F5 has made significant strides through organic innovation and strategic acquisitions, positioning us as the only company that can ensure security and connectivity for applications and APIs across clouds. We are excited about the opportunities in this space moving forward.

Great. Thank you. That's very helpful.