F5 Inc (FFIV) — Q4 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 A copy of today’s press release is available on our website at f5.com, where an archived version of today’s audio will be available through January 28, 2024. 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 13741762. The telephonic replay will be available through midnight Pacific Time, October 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. In my remarks today, I will speak to our Q4 and FY ‘23 highlights, as well as our expectations for FY ‘24. Frank will then review the details of our Q4 and FY ‘23 results and provide some additional color about our outlook. We delivered a solid Q4 in an environment that showed some additional signs of stabilization. We saw strength from our enterprise vertical, including technology and financial services customers, offset by softness from service providers. The result was Q4 revenue near the high end of our guidance range. Our continued operating discipline helped us deliver earnings per share well above the high end of our range. Our global services team delivered robust 9% revenue growth, driven by strong maintenance renewals and reflecting the benefit of price increases announced last year. In addition, software revenue grew 11%, aided by 27% growth in subscription software. Software revenue from renewals, which performed well all year, ticked up in Q4 over Q3. And while new subscriptions remain down year-over-year, we saw some improvement compared to the first half. Strength in global services and software offset a systems decline of 25%, which reflects a lower level of backlog related shipments than we had for the first three quarters of the year. Stepping back and looking at fiscal year 2023, we adjusted to the environmental challenges we faced, resolving supply chain pressures and largely returning to normalized delivery times. We took decisive actions to adjust our operating model to the realities of the demand environment, driving meaningful improvement to our operating margins and delivering 15% EPS growth. We also returned 58% of our annual free cash flow to shareholders through our share repurchases. Highlights from FY ‘23 include: first, subscription renewals performed largely to plan for the year. In today’s tough IT spend environment, this is a strong signal that customers are getting the value and return they expect from our software solutions. Second, F5 Distributed Cloud Services SaaS offerings are gaining traction with both new and existing customers. In fact, 29% of Distributed Cloud SaaS customers are new to F5. In total, we now have more than 500 customers for our SaaS services on Distributed Cloud, an increase of more than 200% since Q4 of last year. Third, we are having very good success displacing a traditional ADC competitor in both software and hardware form factors. And finally, we delivered meaningful operating improvements, driving our non-GAAP operating margin up 130 basis points from FY ‘22. As we look ahead, we enter FY ‘24 in an environment that seems to be stabilizing. In fact, from a demand perspective, we saw encouraging early signs with enterprise customers in Q4, but it is too soon to say if what we are seeing is a durable trend. As we contemplate our outlook for FY ‘24, we consider a number of factors. At the macro level, we expect continued application and API growth, fueled by automation efforts and new use cases, including Generative AI. We also expect customer spending caution to persist into FY ‘24, but it’s stable. And finally, we believe the tension between application and API growth and customers’ ability to sweat assets will reach a tipping point, causing them to reinvest in their application infrastructure, likely beginning sometime in FY ‘24. At the F5 level we also consider: first, we have an approximately $180 million revenue headwind from FY ‘23’s backlog fulfillment primarily in systems. Second, we expect flat to modest total software revenue growth in FY ‘24, as a result of a number of dynamics, including continued subscription renewal strength and steady Distributed Cloud SaaS revenue growth. These positive trends will be offset by a series of transitions we are executing in our SaaS and managed services offerings. And third, we expect our global services revenue will return to low-single-digit growth as we lap price increases. As a result of these factors, we expect our FY ‘24 revenue to be flat to down low-single-digits from FY ‘23, inclusive of the 6% headwind related to FY ‘23 backlog shipments. We also expect to return to mid-single-digit revenue growth in FY ‘25. Whether we achieve the lower or high end of our revenue range, we are committed to driving continued strong profitability, and we will continue to manage our operating model with discipline. We expect to deliver FY ‘24 non-GAAP operating margin in a range of 33% to 34%. We are also targeting FY ‘24 non-GAAP EPS growth of 5% to 7%, reflecting growth of at least 10% on a tax-neutral basis compared to FY ‘23. 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. F5 is the only company that can deliver, secure, and optimize any app and API anywhere. Our security and delivery solutions offer a custom fit for each app and API. Modern apps and APIs require different solutions than legacy apps. We have the right solutions for both. In addition, to delivering the right tools for the right app or API, our combination of deployable software and hardware, and SaaS and managed service offerings mean we are the only vendor that can serve every app and API across all environments in a datacenter, public cloud, and at the edge. We are the only company who can do this today. And going forward, further integration and convergence of our solutions will make it much easier for our customers to secure and deliver their apps across all infrastructure environments. The power of our converged portfolio is resonating with customers who are able to deploy the solutions they need today, with the knowledge that F5 will be with them on every step of their multi-cloud journey. Before I pass the call to Frank, I will speak to some customer highlights from each of our product families. Our F5 BIG-IP family serves traditional applications, either on-premises, co-located or in cloud environments. BIG-IP’s data plane performance, automation capabilities, and seamless integration into public cloud environments continues to differentiate the platform, and we continue to win against competitors. 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 80% of Q4 systems bookings. In one example of a BIG-IP win from Q4, we displaced a competitor for a North American healthcare customer. The opportunity arose as a result of the incumbent provider’s inability to handle a mission-critical upgrade to the customer’s physician portal. The customer selected F5 BIG-IP based on its advanced application delivery capabilities, secure access management, our partnership with their healthcare records platform, and confidence in our roadmap. In addition to providing the mission-critical functionality that the customer needed urgently, we replaced all of the competitor’s use cases with the customer, simplifying their application environment and future-proofing their datacenters. F5 NGINX delivered a very strong Q4. 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, and as those applications scale, we are seeing our NGINX opportunity scale as well. In addition, customers are also leveraging NGINX for app layer security for containers. As an example, in Q4 when the e-commerce division of a global technology customer needed to comply with new data security standards, they selected NGINX App Protect to implement app layer security for the containers processing consumer’s credit card data. We have invested both organically and inorganically to build our F5 Distributed Cloud Services, a portfolio of SaaS and managed services. Apart from the offering transitions I mentioned, we are really excited about the future for Distributed Cloud. We are intercepting two exciting emerging growth categories, web app and API protection or WAAP and secure multi-cloud networking or secure MCN, that will drive future growth for Distributed Cloud Services. In one WAAP win for the quarter, we are helping an EMEA-based banking customer evolve from its traditional WAAP security posture to a more comprehensive WAAP solution that encompasses web application firewall, as well as API protection, bot defense, and Layer 7 DDoS Protection. This customer approached us when they came under attack by a malicious foreign actor that their existing WAF could not handle. Against multiple competitors, we successfully demonstrated the superiority of our WAF offering, including our ability to protect major payment companies' APIs. Early traction for our secure multi-cloud networking offerings includes a Q4 win with a large retailer in Latin America, that also offers a range of financial services to its customers. As part of its digital transformation efforts, the customer needed a solution to enable them to grow and manage their expanding body of cloud-native applications. They also planned to migrate their large existing footprint of virtual machines and on-premises appliances to the cloud. After a thorough proof-of-concept, the customer selected our secure multi-cloud networking solution because of our ability to use the customer edge to make the move 100% transparent to both internal users and consumers. We are also seeing cross-portfolio traction with customers who are operating in hybrid environments, choosing to deploy F5 across multiple form factors. In a win that highlights the synergies of our product families, during Q4 we secured a win with an APAC-based financial services provider. The customer launched a multifaceted modernization project designed to add and consolidate applications and enable scalability to handle exponential traffic growth. They also needed help stopping a barrage of constant automated attacks. In a competitive bid, our combination of BIG-IP and F5 Distributed Cloud Bot Defense won out. The combination enables the customer to manage unpredictable traffic growth, customize services for each application, and enhance their security posture with our ML-based AI engine. These real-life use cases offer a view to how we are enabling customers to secure, deliver, optimize, and manage their applications and APIs and how we simplify the challenges of operating in a complex hybrid multi-cloud world. Now, I will turn the call to Frank.

Thank you, Francois, and good afternoon, everyone. I will review our Q4 and FY ‘23 results before I elaborate on the outlook Francois shared. We delivered Q4 revenue of $707 million, reflecting 1% growth year-over-year, with a mix of 54% global services and 46% product revenue. Global services revenue of $382 million grew a strong 9% due to continued high maintenance renewals as well as the price increases we introduced last year. Product revenue totaled $325 million, down 7% year-on-year. Systems revenue of $134 million declined 25% year-over-year, reflecting a lower level of backlog related shipments that we had in prior quarters and demand that showed some signs of stabilization, albeit at lower levels than we have seen historically. In contrast, software revenue grew 11% over the year-ago period to a new high of $191 million. Subscription-based revenue grew 27% year-over-year to $166 million, another record-high, representing 87% of Q4 total software revenue. Perpetuals and software license sales of $25 million represented 13% of Q4 software revenue. Revenue from recurring sources contributed 76% of Q4’s revenue, another all-time high. Recurring revenue includes subscription-based revenue as well as the maintenance portion of our services revenue. On a regional basis, revenue from the Americas was down 6% year-over-year, representing 57% of total revenue. EMEA grew 16%, representing 26% of revenue, and APAC grew 4%, representing 17% of revenue. Looking at our major verticals, during Q4 enterprise customers represented 72% of product bookings. Service providers represent 9% and government customers represented 19%, including 7% from U.S. Federal. Our Q4 operating results were strong, reflecting operating discipline and a full quarter benefit from the cost reductions announced in April. GAAP gross margin was 80.1%, non-GAAP gross margin was 82.7%, an improvement of 125 basis points from Q4 of FY ‘22. GAAP operating expenses were $394 million, non-GAAP operating expenses were $345 million. Q4 non-GAAP operating expenses as a percent of revenue was below 49%, resuming pre-2019 acquisition levels. Our GAAP operating margin was 24.3%, our non-GAAP operating margin was 33.9%, representing an improvement of more than 600 basis points from Q4 of FY ‘22. Our GAAP effective tax rate for the quarter was 13%, and our non-GAAP effective tax rate was 14%, below our initial expectations for the year, as a result of IRS guidance issued during the quarter relating to foreign tax credits. Our GAAP net income for the quarter was $152 million or $2.55 per share. Our non-GAAP net income was $209 million or $3.50 per share, well above the top-end of our guidance range of $3.15 to $3.27 per share. This reflects the combined impact of our gross margin improvements and operating expense discipline, as well as the Q4 tax benefit. I will now turn to cash flow and the balance sheet, which also remain very strong. We generated $190 million in cash flow from operations in Q4, driven by our improved profitability. Capital expenditures for the quarter were $15 million. DSO for the quarter was 58 days. Cash and investments totaled approximately $808 million at quarter end. Deferred revenue increased by 5% year-over-year to $1.78 billion. We repurchased $60 million worth of shares in Q4. For the year, we used 58% of our approximately $600 million of free cash flow for share repurchases. I note that in each of the past three years, we have met or exceeded our share repurchase commitments. Finally, we ended the quarter with approximately 6,500 employees. I will now recap our FY ‘23 results. For the year, revenue grew 4% to $2.8 billion. Global services revenue grew 7% to $1.5 billion, representing 53% of total revenue for the year. Product revenue grew 1% to $1.3 billion, representing 47% of total revenue. For the second year in a row, software represented roughly 50% of product revenue. Software revenue was flat compared to last year at $664 million. This was down from our initial expectation of 15% to 20% growth as a result of customers delaying large transformational projects. As Francois noted, software renewals performed largely as planned. We delivered $671 million in systems revenue during the year, representing 3% growth. I would now like to provide some additional information regarding software revenue. We said we intended to provide additional software revenue details as the SaaS business scales. As we said last October, we had several SaaS and managed service transitions planned. We started these transitions in FY ’23 and they will continue through FY ’24 and FY ’25, leading to some short-term revenue variability that is not necessarily indicative of potential future performance. We believe that providing visibility to our SaaS and managed service revenue and to the transitions that are underway, provides greater clarity on both our FY ’24 revenue expectations and our expectation of returning to mid-single-digit revenue growth in FY ’25. Today, I will speak to three components of our FY ’23 software revenue. The first, term subscriptions, the second, SaaS and managed services, and the third, perpetual licenses. We intend to continue to report the SaaS and managed service portion of our revenue on an annual basis going forward. In FY ’23, revenue from term-based subscriptions made up BIG-IP and NGINX subscriptions, contributed $353 million to software revenue, up 9% year-over-year. Under ASC 606, sales of term-based subscriptions are recognized largely upfront as software revenue. The remainder is deferred and recognized as service revenue over the term of the subscription. The majority of our term-based subscriptions are contracted for three years. Term subscriptions included both new, renewal, and true forward or expansion revenue for both annual and multi-year subscriptions of deployable software. New revenue includes new customers, as well as new use cases or offerings sold to existing customers. In FY ’23 renewal and true forward or expansion revenue experienced healthy year-over-year growth, offsetting the weakness in new term subscription software projects. Renewals performing largely to plan in FY ’23 is encouraging for several reasons. First, given the current levels of customer spending scrutiny, strong renewals are a signal that customers are getting the value they demand. Second, our renewals motion is still relatively new and it is great to see confirmation that it is working as intended. The second component of our software revenue, SaaS and managed services contributed $203 million in revenue in FY ’23, up 2% year-over-year. SaaS and managed service comprise our F5 Distributed Cloud SaaS offerings. Revenue from managed services, including our legacy F5 Silverline offering in our anti-bot and anti-fraud offerings as well as revenue from legacy SaaS offerings. SaaS and managed service sales are recognized ratably as product revenue over the term of the subscription. At the end of FY ’23, our SaaS and managed services ARR was $198 million, down approximately 2% year-over-year. There were four primary contributors to this performance. First, we are seeing solid early momentum from our F5 Distributed Cloud Service SaaS offerings. Second, in FY ’23, our most advanced anti-bot and anti-fraud managed service solutions underperformed relative to our plan, as a result of customer spending caution and budget scrutiny. Third, in FY ’23, we began migrating customers from our legacy Silverline managed service offerings to our F5 Distributed Cloud SaaS offering. And fourth, we began executing the planned retirement of legacy SaaS offerings from companies we acquired. Both the Silverline customer migrations and the retirement of legacy SaaS offerings resulted in planned revenue churn. The third component of our software revenue is perpetual licenses, which contributed $108 million in software revenue, down year-over-year after unusually strong FY ’22. In FY ’23, 71% of our revenue was recurring, up from 69% in FY ’22. Several years ago, we began breaking out our security-related revenue annually. This year our total security revenue, which includes standalone security, attach security, and security related to maintenance revenue, was approximately $1.1 billion or 40% of total revenue. Our standalone security product revenue grew 5% to approximately $475 million. We are seeing good traction with the lower-end anti-bot offering delivered through Distributed Cloud services as well as from security on NGINX. Our FY ’23 security revenue growth was affected by customer spending caution, including stalled transformational projects and underperformance of advanced anti-bot anti-fraud solution as I mentioned previously. During the year, we overcame supply chain challenges and successfully returned our lead times to normal levels. As a result, our FY ’23 product backlog returned to pre-supply chain challenge levels and we closed the year with approximately $53 million in product backlog. I will now turn to our FY ’23 operating performance. GAAP gross margin in FY ’23 was 78.9%. Non-GAAP gross margin was 81.5%, down 110 basis points from FY ’22 as a result of higher supply chain costs in FY ’23. Our GAAP operating margin for FY ’23 was 16.8% and our non-GAAP operating margin was 30.2%, up 130 basis points from FY ’22 as a result of our previously announced cost reductions. Our GAAP effective tax rate for the year was 18.7%. Our non-GAAP effective tax rate for the year was 18.3%. Our FY ’23 annual tax rate was lower than expected, primarily due to IRS guidance issued during the fourth quarter related to foreign tax credits. GAAP net income for FY ’23 was $395 million or $6.55 per share. Non-GAAP net income was $705 million or $11.70 per share, representing growth of 14.8% over FY ’22. Francois outlined our annual and longer-term outlook at the start of the call; I’ll recap that with some additional color. I will also provide our outlook for Q1. With the exception of revenue, my guidance comments reference non-GAAP metrics. In our FY ’24 outlook, we’ve made the following assumptions. We expect customer spending caution will continue into FY ’24, but we also expect customers will begin to reinvest at some point in the year. We expect our global services revenue will return to low-single-digit growth as we lap price increases. We have approximately $180 million total revenue headwind in systems from FY ’23’s backlog fulfillment. We expect to continue to take share in the traditional ADC space with BIG-IP in both hardware and software form factors. Within our software revenue, we expect continued strength from our term subscription renewals and continued growth from our F5 Distributed Cloud SaaS offerings. As I’ve discussed previously, we will have some planned revenue churn as we work through the SaaS and managed service transitions I discussed. We expect these transitions will be largely complete in FY ’25. In FY ’23, ARR associated with the transitions is approximately $65 million, a little more than half of which is associated with offerings we intend to transition onto Distributed Cloud over the next two years. The net of these assumptions, combined with the current demand levels leads us to expect FY ’24 revenue in the range of flat to down low-single-digits from FY ’23. Excluding the $180 million or 6% headwind from our FY ’23 backlog reduction, our guidance range would reflect low to mid-single-digit revenue growth in FY ’24. Whether we achieve the bottom or top end of this range largely depends on when customers resume more normal levels of spending. We expect some continued quarter-to-quarter variability, as a result of upfront revenue recognition related to our term subscription offerings. Regardless of our revenue performance, we remain committed to driving strong profitability. From an operating perspective, we expect gross margin to improve in fiscal year ’24 to the range of 82% to 83%, primarily as the result of supply chain-related cost pressures working out of our model. We expect our continued operating expense discipline will result in FY ’24 non-GAAP operating margin in the range of 33% to 34% for the year. On a percent of revenue basis, this would put our operating expenses roughly in line with 2018 levels, at roughly 49% of revenue. We expect our FY ’24 effective tax rate will be 21% to 23%. In FY ’24, we expect to deliver 5% to 7% non-GAAP earnings growth, which translates to at least 10% year-over-year growth on a tax-neutral basis. Finally, we expect to use at least 50% of our annual free cash flow for share repurchases, consistent with the approach we have discussed previously. As of the end of FY ’23, we had $922 million remaining on our previously announced authorized share repurchase program. We also want to take the opportunity to speak to our expectations beyond FY ’24, as we believe it will help signal how we intend to run the business longer term. As Francois noted, we expect mid-single-digit revenue growth in FY ’25. We expect to drive additional gross margin improvements, and to deliver gross margins between 83% and 84%. We expect to grow our operating expenses slower than revenue, resulting in an operating margin of at least 35%. We will continue to prioritize profitability, adjusting our operating model if needed to enable us to deliver at least 10% compounded annual non-GAAP EPS growth. Finally, we intend to continue to use at least 50% of our annual free cash flow towards share repurchases. I’ll conclude with our expectations for Q1 of FY ’24. We expect Q1 revenue in the range of $675 million to $695 million. We expect gross margins in the range of 82% to 83%. We estimate Q1 operating expenses of $332 million to $344 million. We are targeting Q1 non-GAAP EPS in the range of $2.97 to $3.09 per share. We expect Q1 share-based compensation expense of approximately $58 million to $60 million. I will now turn the call back over to Francois.

Thank you, Frank. Before we open the call to questions, I want to address our view on F5’s AI opportunity. At the highest level, we believe customer use of AI will accelerate the growth of applications and APIs and the corresponding need to deploy, manage, and secure them, which is what we do best. We also believe AI inference, the process of using a trained model to make predictions on unseen data, will become increasingly distributed. Organizations will need to support it anywhere from datacenters to manufacturing floors to public clouds. We believe every application and API will soon require inference just as they require security and traffic management. With our rich history of delivering innovative ML-based security solutions, including bot defense, protection against denial of service attacks, and anti-fraud, coupled with our role in the flow of application traffic, we are uniquely positioned to secure AI workloads, wherever they reside and to empower our customers to run AI wherever they need it. In conclusion, we are leveraging our incumbency and our position in the flow of 40% of the world’s Internet traffic to deliver hybrid, multi-cloud solutions that dramatically simplify application and API deployment, security, and management for our customers. We are also significantly reducing our customers' total cost of ownership. We are uniting and automating all of our customers' apps and APIs across their datacenters, cloud, and edge environment. We are encouraged both by the early signs of stability we saw in the second half of ‘23 and with the resonance our converging portfolio is having with customers. We have an install base of 20,000 customers, all of whom have an acute and significant multi-cloud challenge. Other than F5, there is no one company that can address this challenge. With F5 Distributed Cloud services, we have created a platform to drive SaaS growth in the future. In closing, I’ll reiterate the three pillars of our long-term operating model, which will enable us to drive double-digit earnings on a compound annual growth rate. Number one, delivering sustained mid-single-digit revenue growth, supported by our differentiated positioning in attractive end markets, along with our durable high-margin global services business. Number two, driving non-GAAP operating margin expansion, which we will achieve through gross margin improvement and operating discipline. And number three, returning cash to shareholders, via share repurchases, using at least 50% of our annual free cash flow. Operator, please open the call to questions.

Yep. Good afternoon. Thanks for taking my question. You know, I guess, Francois maybe to start with, you talked about software growth being flat to have been up modestly, but that included some of the headwinds around the business transition taking place on the managed services side. I didn’t appreciate this, but is the headwind from this transition $65 million or is it half that number? And maybe just flush out how much that is and what are the transitions that you’re doing?

Hi, Amit. So in total, we talked about roughly $200 million in SaaS and managed services. In that $200 million, there is about $65 million of revenue stream that essentially are going to go away. Now, but that’s more than half of that is revenue streams coming from our legacy managed services platform Silverline that we are retiring. But we intend to migrate the customers over to Distributed Cloud. So we would expect, you know, a portion, if not a significant portion of that, you know, of that revenue stream to go onto Distributed Cloud over time. The other, a little less than half of that $65 million are offerings that we are retiring completely that, you know, when we looked at our portfolio and looked at the offerings we wanted to rationalize, we felt were underperforming. We decided to retire these offerings completely to focus on the products that are going forward and successfully rationalized our cost and improve our efficiency.

Got it, that's really helpful to understand the split on the $65 million. Francois, in your comments you mentioned seeing encouraging signs from enterprise customers in the September quarter. Could you elaborate on what those signs are? Is it just that the assets are operating at high utilization and cannot be further stretched? Also, is there any particular geographical sector where you've noticed these initial positive signs of customer demand?

Amit, I wouldn’t say there is a specific region where things are notably different from others. North America has been more solid and stable compared to our Asia and European markets. In terms of verticals where we’re seeing stabilization, the enterprise market shows more stability. The service provider market has been soft due to several factors: service providers are optimizing their assets and being very selective in their priorities. The transition from 4G to 5G is slower than expected, leading to a softer market for service providers, which we anticipate will continue. However, we were encouraged in the second half of the year, particularly in Q4, when some enterprise customers who had been optimizing their assets reached the end of that cycle and began to demand hardware again. We observed a rebound in hardware orders during the fourth fiscal quarter, influenced by customers who had pushed their assets to the limit and by the fact that it took a long time to ship equipment to several of our customers in 2023. In Q4, we saw these customers finally receive their hardware and start ordering again. We are optimistic about these trends.

Got it. Thank you very much.

Great, thanks so much. Looking back at your prior longer-term expectations, I think you had talked about growth rates in software in excess of 20%, and high to mid-single declines in systems. Can you give us an update on what do you think those percentages might look like in the longer term once you get through the wobble in FY ’24?

Yes, Alex, today I want to focus on fiscal years 2024 and 2025, rather than discussing beyond fiscal year 2025. Our perspective on the end markets remains consistent, and we still believe there is potential for software growth to exceed 20% in the future, depending on the markets we are pursuing. For fiscal year 2024, we anticipate software growth to be flat to modest. Looking at the three components of our software business, we expect the perpetual base to remain relatively unchanged. Our outlook for the SaaS and managed services segments is similar due to the transitions we are currently undergoing. Growth in the term subscription segment may yield some modest improvements. As we look to 2025, we do not expect growth in the perpetual or SaaS and managed services areas due to these ongoing transitions; however, we have clear visibility into our renewals and expansions in our term subscription segment. The expansion trends are strong, and we expect this momentum to continue and intensify in 2025. Thus, we anticipate a return to double-digit software growth in 2025, driven primarily by our term subscription business.

I see. Just if I can follow-up on, you talked about your backlog having been normalized, but you’ve also had orders out for components that were driven off of the tight supply environment. When do you expect the full normalization of the component costs, you know, in your cost of goods sold; is that already achieved or is that going to be something that’s going to feather in over the next year, maybe year and a half?

Alex, it’s Frank. So largely most of that has been achieved, but there are still some of the purchase price variances that are coming through in FY ’24. By FY ’25, we expect that to be fully out at a normalized level.

Could you give some sense of what the ’24 variance would be?

Alex, I think it’s probably in the range of 25 to 50 basis points of where we’ll see improvement just based off of that, in comparison to expectations for gross margins in FY ’25.

Great. Thank you so much.

Thank you for taking my question. Francois, regarding your fiscal ‘25 outlook for mid-single-digit growth, have you revised your perspective on the long-term trajectory of systems demand, especially considering that you've noticed a slight increase in orders? Additionally, could you discuss your expectations for AI demand and how it will impact both systems and the software in your portfolio? I have a quick follow-up as well. Thank you.

Thank you, Samik. Over a long period, we expect the hardware business to experience a low-single-digit decline. However, this is based on a normalization of the hardware business, which we haven't reached yet. Demand was significantly softer in 2023, but we anticipate a rebound in our hardware business for 2024, and we've already started to see signs of that in the fourth quarter. While I'm referring to a long-term trend beyond 2025, for 2024, we do expect a rebound in the hardware sector. Regarding AI's role in our business, the portfolio we are developing—comprising hardware, software, and SaaS—will enable our customers to secure and deliver their APIs and applications across various environments. AI workloads will likely consist of modern applications, many running in software environments rather than on-premises. Thus, the support for AI workloads is expected to benefit our software business more in the long run. Additionally, we have a unique advantage with our distributed cloud capabilities, allowing us to run inferences in any cloud environment and beyond. We can execute these inferences in public clouds, at the edge, or in our own cloud. Customers are increasingly expressing the desire to run these inferences on manufacturing floors, in retail branches, or in vehicles for edge cases. We have the capability to run, secure, and deliver these inferences across all environments, positioning F5 uniquely to handle AI inferences in the future, which will ultimately contribute to our software business.

Got it, got it. A quick follow-up Francois, you mentioned the green shoots you’re seeing in terms of enterprises spending and the recovery there. I think one of the pushbacks we’ve seen from investors on that front has largely been the expectation that there might be a pickup here in the back end of the year just from a budget flush perspective from the enterprises, and you might sort of see a pullback again as we enter into next year and more sort of budget cuts. Any insight you know, that you’re already getting from your customers about how budgets look for next year or in relation to whether would this sort of pickup, if anything to do with the more temporary flush of budgets before the year end? Thank you.

Thank you, Samik. I don’t believe it was related to a budget flush, as the observations we made during the resumption were specific to the quarter that ended in September. Looking ahead to next year, we don’t have clear visibility on our customers' budgets for FY ‘24. However, we do have a robust hardware pipeline as we enter the fiscal year, and it will depend on our close rates. In Q4, the close rates we experienced on our pipeline were better than in the previous three quarters. This contributes to our discussion about stabilization and positive signs in Q4, reflecting the improved close rates. We are entering the fiscal year with a stronger hardware pipeline and encouraging recent close rate data. Nevertheless, we remain cautious due to ongoing macroeconomic uncertainty. We continue to observe customers occasionally delaying deals and exercising heightened scrutiny over budgets and approvals. This trend persists, and overall, we are still cautious as we head into the year.

Yes. Thank you. Thanks for taking my questions.

Great, thanks. Maybe building on Samik’s question to start. You know, as you look at your pipeline, is your view that a lot of this is, okay, we’ve sweated assets as much as we can, or the utilization of the appliances is too high or you know, are we starting to see kind of growth in multi-cloud projects again? Just trying to get a sense of as you look at your pipeline, is it kind of traditional applications are expanding or is it use cases? And then maybe as a second question, you know, you mentioned kind of having plays as AI and inference cases grow; is that going to require productization of any kind of suites of products today or just kind of tailoring to kind of have AI ready solution? Thanks.

Thank you, Meta. Let me start with the first question regarding our pipeline. We are observing more activity on the hardware side, where some customers have been maximizing their existing assets and are reaching utilization levels that will require them to take action at some point in 2024. Additionally, there are customers who placed orders in fiscal year 2022 but have not received their equipment. They are now starting to deploy that capacity and are ready to place new orders, contributing to a stronger hardware pipeline. However, we have not yet seen a significant revival in major transformational software projects. Customers remain cautious about undertaking such initiatives, and we are not seeing any shifts in this trend as we move into the new year. Regarding AI, we have capabilities to run inferences in various environments through our Distributed Cloud. It's important for us to strengthen these capabilities and engage in a robust go-to-market strategy to ensure customers are informed as they begin deploying AI workloads. We already have the necessary capabilities to secure and deliver AI workloads, and we are prepared to act on that.

Meta, I just wanted to add that, you know, last year we talked about in our outlook, particularly in software that we were a little less than 50% of our outlook at the time was coming from the renewals and the true-forwards portion of our term subscription agreements and that’s and our SaaS based revenue. And that’s a little more than half what was going to come from new. This year as we take a look at that same formula and we look out over 60% of what we expect in that flat to modest software growth is coming from both the renewals pieces of the SaaS and managed service business, plus the renewals true forwards of our term subscription business. So we tried to take into account the fact that we don’t see these transformational projects on the horizon as we thought about the guidance.

Hey, good afternoon. Thank you for the question and for all the comments on the outlook. I just had two, both on software. You know, first, I was just wondering if you could talk a little bit about, you know, your visibility into the term business. You know, you called out term as something that would help drive the double-digit software revenue growth in fiscal ‘25, as well as potential growth in fiscal ‘24. And then second, I was just wondering if you could talk a little bit more about this migration from Silverline to DCS. It sounds like it’s a multi-year headwind, you know, something that contributed to the weakness in ARR in fiscal ‘23, but it also seems to be a headwind in fiscal ‘24 and fiscal ‘25. So maybe you could just talk about that and, you know, how that transition is rolling off and, you know, over how many years. Thank you.

Sure, Michael. Let me start with the first question and then I’ll let Francois jump in on the second on the Silverline side. So on the first on the term subscription, particularly the true-forwards and the expansions that we have seen, with the second terms coming on and we’ve had probably about seven or eight quarters now of run rate, and are getting much more comfortable with the early signs that, you know, where massive expansions continue. And so getting very, very strong utilization from that base of deployed flexible consumption programs, and this specifically covers right now BIG-IP and the NGINX portfolio within our business, as I mentioned in the prepared remarks. And that’s giving us a lot of comfort, both in FY ‘24 and more importantly, in FY ‘25. FY ‘25, we’ve got our, you know, a bigger pool of expansion revenue than we do in FY ‘24 and ‘24 is growing on top of ‘23, so all of these continue to compile upon themselves. As I just mentioned to Meta that, you know more than 60% of the outlook that we’ve got within our software revenue is coming, you know, from that cohort that we feel pretty good about seeing which is the term renewals, as well as true forwards plus SaaS and managed service renewal piece that we’ve got in the revenue stream. So both of those we feel very confident about, and it’s probably the highest visibility that we’ve got within the revenue stream.

Thank you, Frank. And to your second question, Michael on SaaS and managed services. So, like if we talk about FY ’22 to FY ’23, you saw that the ARR there was flat to slightly down. There are two reasons for that. One is, yes, the transitions we talked about started in ’23 and there was about call it roughly, you know, $12 million of ARR that we transitioned out of the business in 2023. The other reason is at the high end of the bot business, we saw quite a bit of softness, especially in the second half of the year, as customers had significant budget scrutiny and, you know, we’re reluctant unless they were under immediate attack, to really implement our more sophisticated solutions. We think over time that will change, but specifically this year with the macro pressures and budget scrutiny, we saw a lot of softness there, both in new bookings and in some churn in some cases. So that is the FY ’22 to FY ’23 transition. So from going into 2024, well, you asked about, you know, is this transition is a multi-year transition. Yes, we expect that the $65 million of revenue stream that we are transitioning will work themselves out over the next couple of years, so over FY ’24 and FY ’25 they are a headwind to total growth. However, we are quite excited by what’s happening with F5 out of the SaaS portion of our offerings, specifically SaaS on F5 Distributed Cloud. We have launched WAF offerings, the security offering, you know, about 18 months ago. We are seeing extraordinary traction on that. As I said earlier, we’ve won over 500 customers in that period, all of whom are enterprise customers, and we are seeing very rapid traction on that. We’re also seeing rapid traction on the multi-cloud networking market, where we bring both networking and security capabilities and we’re quite differentiated from anybody in the market. So that has grown fast, and we expect that portion of the business to continue to grow fast, and overtime become a majority of this SaaS and managed services portfolio.

Thank you. Two, if I could as well. First, Francois, I think you talked about replacing competitor products in the ADC, both hardware and software domain. Could you dig into that a little bit more? Is that something that you think is kind of, it’s a one-off or do you think there is a sustainable move there and how is that happening? And then second, just on the, you know, the changes in the transitions in software, it sounds like, you know, moving into Distributed Cloud services makes a lot of sense. Having looked at some of those businesses and kind of, you know, moving on from them, does that change your view of kind of synergies across product offerings or is it a sign that maybe those businesses didn’t have the same synergy and that’s why you’re not, you’re not going forward with them? Thank you.

Thanks, Tim. Let me start with the second part. It’s not about synergies. There are two aspects regarding the $65 million transition we’re discussing. One aspect involves a legacy platform on which we've built managed services, but we have now created a more modern platform with differentiated architecture through the F5 Distributed Cloud, which is gaining rapid traction. We want to transition our customers to this modern platform, and that was always part of the plan. However, we first needed to build the platform and establish all the necessary security capabilities to initiate this transition. We're excited about the progress we've made on the Volterra platform over the past couple of years and that we can start this transition in 2023. The second part of the revenue stream being retired isn't about synergies; it's related to new offerings we recently launched, which we had hoped would perform well in the market. However, due to the macro environment and the initial traction of these offerings, we decided, as announced in April, to rationalize our portfolio and concentrate on our most promising investments, which means moving forward without these products. Regarding synergies across our portfolio, we're actually quite encouraged by what we're observing. A number of customers with BIG-IP are adopting Distributed Cloud. For some applications, they have BIG-IP either on-prem or in the cloud—both hardware and software—and they want a software-as-a-service solution for other applications while maintaining consistent security engines and policies across all environments. We can deliver that with BIG-IP, along with our SaaS and managed services. Additionally, NGINX had a strong quarter in Q4, partly due to the security features we transferred from BIG-IP to NGINX, which are also now incorporated into Distributed Cloud. Therefore, the synergies, especially regarding security within our portfolio, are materializing, and we anticipate that they will accelerate over the next couple of years as we facilitate more conversions between our SaaS and deployable products. For the first part of your question regarding ADC competitors, over the past four years, we have chosen to invest in the future of the ADC franchise by developing next-generation hardware and software that bring cloud benefits to on-prem deployments, such as multi-tenancy, quick upgrades, and simplified operations, resulting in a better total cost of ownership for customers. These investments are yielding results in the market, allowing us to gain market share and displace traditional competitors, even those that are incumbents. We believe this trend is not a temporary situation; we expect it to continue. We are excited about introducing the next generation software platform on BIG-IP this year, which we believe is even more differentiated than our previous offerings in the market. We anticipate that this momentum will carry on and will be a rewarding return on the investments we've made over the last four years.

Great, thanks for taking the questions. Francois, given some of the changes you’re making to your software portfolio, it seems like in a way you’re, you’re simplifying or even converging some of your solutions. So as we think about the roadmap for Distributed Cloud in particular, what can you do to accelerate adoption and make sure you capture the potential voluntary churn that you’ve talked about or even how should we think about the priorities around Distributed Cloud next year?

Thank you. Our aim is to ensure that our customers can easily secure and deliver their applications. Distributed Cloud is gaining significant traction because it fulfills that need. Looking ahead to next year’s priorities, we plan to scale the platform to increase its availability in more markets and environments, while also adding more services. Currently, we are focused on our initial services, WAF and multi-cloud networking, with a backlog of additional services that our customers are interested in. Recently, we've integrated CDN capabilities into the platform, following our acquisition of Lilac a few months ago, and we are beginning to see customer adoption of our CDN due to its convenience for functions like load balancing and security. Our main priorities are scaling the platform and introducing new services. In terms of go-to-market strategy, we are concentrating on existing F5 customers who have our hardware or software but are looking for a SaaS solution to simplify their use of F5 for multiple applications without having to manage the lifecycle of deployable products. Of the approximately 500 customers currently using Distributed Cloud, over two-thirds are existing BIG-IP customers, while about a third are new customers who have never purchased from F5 before. We believe there are significant growth opportunities with both new and existing customers, and our focus will remain on large enterprise customers where F5 has a strong presence.

I appreciate that. And if I could sneak one more in, maybe for Frank. Certainly appreciate the continued focus on operating margins and EPS growth. But can you help us think through how we should think about cash flow margins in fiscal ‘24? I know you typically don’t guide cash flow. But should we think of cash flow growing in line with operating income, ex-some of the tax headwinds you had in fiscal ‘23, any even directional thoughts would be helpful.

Yes. Ray, as you described, I think that’s roughly correct. You know, cash flow is one of the hardest things for us to predict, but those dynamics are it should narrow a bit that net income growth with, you know, with some exceptions to the two tax impacts. Some of the restructuring expense we had last year that we don’t have this year that is real cash, but split out for non-GAAP purposes. So there are a few ins and outs, but it should be roughly, roughly close to that.

Great. Appreciate it.

Hey guys, thanks for sneaking me in. I’ll just make it simple here. You know, you guys talked about in the prepared remarks about subscription renewals performing well. Any more color into specifically what products are seeing those better renewals, but the cross-sell that you’re seeing or any qualitative or quantitative color around net retention rates understanding, you know, you have this headwind around specifically with the SaaS and MSP business about $65 million. You know, how should we think about that net retention rate within the term business or the aggregate overall when you kind of exclude even the impact of that SaaS please. Thanks guys.

Sure. Fish I’ll start and then Francois wants to add anything that would be great. So you know, within our term subscription business, which is generally our BIG-IP software, as well as NGINX, and that’s the expansion rates that we’ve seen. It’s not the easiest task in the world to convert that term into an ARR type of business, because of all the moving parts, but when we’ve tried to do that and try to convert and look at what would, you know, an expansion rate would be or net revenue retention rate. It’s north of what you would think of as the industry norm of 120%, let me just put it that way. And that combination of where it is, plus our SaaS managed service our net revenue retention rate is still north of that 120%. So that combination, you know, is what gives us a lot of visibility and firmness in our expectation of those pieces of the business that will continue to do well.

Makes sense. And just on the go-to-market side, any changes in terms of incentives or approach as we turn to page into this next fiscal year and as we have, you know, transitions now within the overall software transition.

The incentive plans between the two years are largely the same, Fish. There are always going to be a couple of tweaks here and there as we’re looking and seeing what was successful the year before and not, but nothing major.

Thanks guys.