F5 Inc (FFIV) — Q2 2024 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 Francis 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 here 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 A copy of today's press release is available on our website at f5.com, where an archived version of today's audio will be available through July 28, 2024. We will post the slide deck accompanying today's webcast 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 13745541. The telephonic replay will be available through midnight Pacific Time, April 30, 2024. 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 Q2 highlights as well as our expectations for Q3 in FY '24. Frank will then review the details of our Q2 results and provide additional color on our outlook. Overall, customers remain cautious as a result of lingering macroeconomic concerns and what currently looks like generally flat IT budgets for calendar 2024. Against this backdrop, we delivered a solid Q2 with revenue near the midpoint of our guidance range. Our software subscription renewals continued to perform well, driving 20% total software revenue growth compared to a year ago, including 28% subscription revenue growth. We also delivered non-GAAP earnings per share growth of 15% with EPS of $2.91 per share at the high end of our guidance range. As we look into our second half, we remain on track to deliver on our FY '24 revenue outlook. We expect continued strong performance from our software subscription renewals, and our renewals base provides good visibility into the back half of FY '24. We also remain committed to continued operating discipline, and we are raising our FY '24 non-GAAP EPS outlook to a range of 7% to 9% growth from our prior range of 6% to 8% growth. Frank will discuss our outlook in greater detail in a few minutes. Before he does that, I will spend a few minutes speaking to the hybrid multi-cloud ball of fire our customers' IT teams are living in, explaining F5's differentiation in addressing this ball of fire and highlighting some notable customer wins from Q2. The current state of application security and delivery for large enterprises has IT teams in crisis. The increasing complexity and the associated cost and risk they are battling is not incremental. It is untenable, and it is growing even more so by the day. Just a few years ago, customers believed that by now, their applications would be consolidated in the public cloud. Instead, today, they are grappling with a more complex and costly set of challenges than ever before. 88% of our customers report they are currently operating applications across a combination of on-premises and cloud environments. On average, organizations are operating across 4.5 different types of environments. Most organizations have hundreds of applications, each with a set of associated APIs distributed across these multiple environments. And because modern applications have decomposed monolithic applications into smaller components, those components are more fragmented and distributed. As a result, APIs and data also are more distributed. The result of this expansion and distribution is amplified security risks across a larger attack surface area. These challenges will be further intensified by the inevitable widespread adoption and proliferation of AI. This complexity is preventing organizations from operating at the speed their businesses demand. Manual tasks, inconsistent security controls, operational silos, lack of available talent, escalating cloud costs, and inefficient traffic routing are slowing them down. We have affectionately named this set of escalating challenges the ball of fire. During Q2, we spoke with more than 1,600 customers and partners about the ball of fire at our global AppWorld events. These events gave us the opportunity to explain how our distributed app security and delivery platform can mitigate customers' ball of fire challenges. We have significantly expanded and evolved our solutions portfolio over the last several years. Today, only F5 can truly support the demands of today's hybrid multi-cloud application infrastructures. More specifically, we are the only solution provider that secures, delivers, and optimizes any app, any API, anywhere. F5 is highly differentiated in addressing customers' pain points in this ball of fire in several ways. First, app security. F5 offers the most effective and comprehensive app and API security platform in the industry. While several providers offer point products for specific threat vectors, F5 has built an integrated and comprehensive suite of best-in-class capabilities, all delivered through a single platform. Why does this matter to our customers? Because our customers can consolidate solutions addressing all of their app security needs with a single platform and without making trade-offs on efficacy. Second, simplification. We make hybrid multi-cloud ridiculously easy. Only F5 has a solution footprint that extends to all environments in the ball of fire, including public clouds, at the edge and customers' on-prem environments. F5 radically simplifies the work of connecting these disparate infrastructure environments as well as the applications deployed in and across them. Why do customers care about this? Because we enable the hybrid multi-cloud flexibility their businesses demand with the simplicity their IT operations require. And third, standardization and automation. F5 uniquely streamlines customers' operations with consistent policies, comprehensive automation, and rich analytics. This enables customers to consolidate vendors and toolsets, rationalize operational silos, and automate life cycle management of their on-premises deployments. The result is far less toil for NetOps, SecOps, and DevOps teams. Why does this matter to customers? Because it results in more cost-effective and scalable IT operations. It is the combination of these three points of strong differentiation along with the role that F5 plays embedded in the flow of application traffic that create F5's unique position and enable us to extinguish the ball of fire for our customers. We empower our customers to run at the speed their businesses demand. Let me offer a few customer examples from Q2 to illustrate how these capabilities are manifesting today in our customers' real-world use cases. The first two customer examples I will speak to highlight our application security capabilities. The first example is an API security use case. Last quarter, we spoke to the substantial increase we are seeing in the volume of API-targeted attacks. Customers tell us API security is one of their most significant concerns and with good reason. APIs represent a critical avenue for attack, potentially exposing backend systems and data. We foresaw this API crisis coming and last year, launched a comprehensive and AI-ready API security solution available via F5 Distributed Cloud Services. Our differentiation stems from our ability to go beyond API discovery through traffic analysis. In addition, we performed continuous monitoring, code scanning, API testing analysis, threat surface mapping, and enforcement. We do all of this in a holistic, easy-to-deploy solution that provides complete visibility, architectural flexibility, and management through a single pane of glass. During Q2, a large multinational networking and telecommunications company needed a solution to mitigate an explosive rise in API and web application attacks on its digital wallet solution. This solution supports more than 400 million wallets across 24 countries, processing over 2.8 billion transactions worth more than $40 billion every month. To protect their consumers' financial transactions on a global scale, this use case demanded the highest level of app and API security efficacy with no trade-offs on performance. The customer is standardizing on F5's Distributed Cloud Services, application, and API security as the basis for its new industry network and API security globally, ensuring coverage for new markets worldwide with heightened security for financial transactions. The second app security example is a bot mitigation use case. In Q2, a multinational beverage company leveraged our Distributed Cloud Services platform for advanced bot mitigation. During a proof of concept, F5's solution discovered 99% of the customers' traffic was coming from bots and it blocked millions of fraudulent attempts. As a result, the customer deployed F5 across its branded marketing and consumer-facing sites and thus far has saved nearly $3 million in fraud. This deployment is also an example of the success of our land-and-expand strategy as the customer previously deployed F5 for load balancing and WAF. The next customer win I will highlight exemplifies how F5 is able to simplify connecting disparate infrastructures, making hybrid multi-cloud ridiculously easy for our customers. An energy company in our APAC region selected a combination of BIG-IP VELOS hardware and Distributed Cloud Services to improve application security and scalability while also driving operational efficiency and reducing costs. Following the acquisitions of several companies, the customer wanted a new shared infrastructure that united their disparate on-premises operating environments and positioned them to move to the cloud. Ultimately, this customer opted to consolidate multiple vendors onto F5, leveraging our hardware and SaaS offerings. The final two customer wins I will highlight demonstrate how we streamline customers' operations with consistent policies, comprehensive automation, and rich analytics. During Q2, an American auto insurance provider selected F5 Distributed Cloud Services to increase their business velocity through automation. The customer faced the ball of fire. The evolution of their multi-cloud infrastructure led to tool fragmentation, inefficient modern application deployment, inconsistent security, and the lack of manageability and visibility. The customer evaluated several point solutions in addition to F5's platform approach. We demonstrated our ability to improve velocity through automation while also providing consistent and more effective app security and faster response times. The customer ultimately consolidated onto F5, replacing their existing WAAP provider with Distributed Cloud Services. In another example from Q2, a multinational bank and financial services company expanded their F5 BIG-IP footprint. Leveraging both software instances in public clouds and hardware and traditional data centers, F5 is enabling a fully automated self-service ADC and security solution for all of their load balancing and firewall needs. As a result, the customers' speed of provisioning new application services has gone from weeks to minutes, and F5 has captured a 2x increase in spend over the last 5 years. Before I pass the call to Frank, I will close with some brief commentary about how we are innovating to target and capture emerging AI opportunities. There is no question that AI will accelerate the growth in the number of applications and APIs. It will also exacerbate the ball of fire. Last quarter, we spoke about F5 as an AI enabler and discussed some early use cases where customers are deploying F5 in support of AI initiatives. In addition to innovating and evolving our portfolio to ensure we are optimizing for AI, we also are engaging customers in architectural discussions about the AI readiness of their environments. We already are working with customers on three specific AI-related challenges. The first is API security because API security is AI security. As APIs proliferate, for example, through the adoption and deployment of AI services for inferencing, there is a critical need for a solution that automatically discovers and secures those endpoints. As I mentioned earlier, F5 has the most comprehensive, AI-ready API security solution available today via F5 Distributed Cloud Services. The second AI-related challenge is secure multi-cloud networking. With increasingly distributed applications and APIs, customers need high-throughput connectivity across on-premises, cloud, and edge for AI inference. Distributed Cloud Services is unmatched in its capabilities to connect, secure, and manage distributed apps and APIs across hybrid and multi-cloud environments. The third AI-related challenge is high-speed data ingestion. In use cases where customers want to ingest data for multibillion-parameter AI models, they need high-performance load balancing, and no one is better at high-throughput load balancing than F5. We expect that enterprises broadly embracing AI adoption over the next 1 to 2 years will bring a host of additional AI-fueled use cases for F5 solutions. Our platform approach, our continuing innovation, and our role in the line of traffic of millions of applications that will ultimately leverage AI puts us in a unique position to partner with customers as they work to solve both current and future AI challenges. Now I will turn the call to Frank. Frank?

Thank you, Francois, and good afternoon, everyone. I will review our Q2 results before I elaborate on our Q3 and FY '24 outlook. We delivered Q2 revenue of $681 million, reflecting sales that were down 3% year-over-year with a mix of 56% global services and 44% product revenue. Global services revenue of $381 million grew 5%, in line with our expectations, which reflect our lapping the benefit of prior price increases. Product revenue totaled $300 million, down 12% year-over-year, reflecting a lower level of backlog-related systems shipments than the year-ago quarter. Systems revenue of $142 million declined 32% year-over-year. Total software revenue grew 20% over the year-ago period to $159 million. Subscription-based revenue contributed $140 million or 88% of the total software revenue, representing growth of 28% from last year. Within subscriptions, renewals were strong. As expected, demand for new subscriptions was flat year-over-year, given customers' current spending caution on new projects. Rounding out our software revenue, perpetual software contributed $18 million. Revenue from recurring sources contributed 75% of Q2's revenue, up from 65% a year ago. On a regional basis, revenue from the Americas grew 1% year-over-year, representing 57% of total revenue. EMEA declined 6%, representing 26% of revenue, and APAC declined 9%, representing 17% of revenue. Looking at our major verticals, we saw relative strength from enterprises with enterprise customers representing 69% of product bookings in the quarter. Government customers performed well, representing 19% of product bookings, including 7% from U.S. Federal. Finally, following the strong Q1, service providers represented 13% of Q2 product bookings. Our Q2 operating results reflect the usual seasonal patterns as well as our continued operating discipline. GAAP gross margin was 79.3%, non-GAAP gross margin was 82.1%, an improvement of approximately 170 basis points from Q2 of FY '23. As expected, our operating expenses ticked up in Q2 given payroll tax resets as of January 1 as well as costs associated with our global AppWorld events. Our GAAP operating expenses were $400 million. Our non-GAAP operating expenses were $349 million. Our GAAP operating margin was 20.5%. Our non-GAAP operating margin was 30.9%, reflecting an improvement of approximately 370 basis points from Q2 of FY '23. Our GAAP effective tax rate for the quarter was 18.4%. Our non-GAAP effective tax rate was 20%. Our GAAP net income for the quarter was $119 million or $2 per share. Our non-GAAP net income was $173 million, up approximately 13% from Q2 of FY '23. Our non-GAAP EPS was $2.91 per share, up approximately 15% from Q2 of last year. I will now turn to cash flow and balance sheet, which also remained very strong. We generated $222 million in cash flow from operations in Q2, up 57% from $141 million in the year-ago period. The significant increase is largely the result of an increase in cash received from customers and the timing of collections compared to billings. CapEx was $9 million. DSO for the quarter was 51 days, down from our unusually high 67 days in Q1 and reflecting our improved product availability and a return to normalized shipping linearity, which supported strong cash collections. Cash and investments totaled approximately $910 million at quarter end. Deferred revenue was $1.81 billion, up 1% from Q2 of FY '23. Our share repurchases reflect our ongoing commitment to returning cash to shareholders. We repurchased $100 million worth of F5 shares in Q2 at an average price of $184 per share. Year-to-date, we have used approximately 68% of our free cash flow towards share repurchases. Finally, we ended the quarter with approximately 6,450 employees. I will now speak to our outlook for Q3 and our updated view on our FY '24 outlook. First, I will speak to Q3. We expect Q3 revenue in the range of $675 million to $695 million. We expect non-GAAP gross margins in the range of 82% to 83%. We estimate Q3 non-GAAP operating expenses of $340 million to $352 million. We are targeting Q3 non-GAAP EPS in the range of $2.89 to $3.01 per share. We expect Q3 share-based compensation expense of approximately $55 million to $57 million. I will now turn to our FY '24 outlook. We have good visibility to and confidence in our subscription renewals in our second half. This visibility leads us to expect our second half of FY '24 will be stronger than our first half, reflecting the cyclicality associated with the timing and cadence of our subscription renewals. Our outlook does not assume a significant improvement in the macro environment. As Francois mentioned, we expect FY '24 revenue growth that is flat to down 2% from FY '23. This outlook is consistent with our prior FY '24 revenue outlook, albeit with more specificity on the range given we're halfway through the year. We are not revising our gross or operating margin targets for FY '24 and continue to expect non-GAAP gross margins in the range of 82% to 83%. We expect non-GAAP operating margin in the range of 33% to 34%. We now expect our FY '24 tax rate will be in the range of 20% to 22%, a slightly wider range than our prior estimate of 21% to 22%. Finally, we are raising our non-GAAP EPS growth expectations. We now expect FY '24 non-GAAP EPS growth between 7% and 9%. This is up from the 6% to 8% range we provided last quarter.

Thank you, Frank. In conclusion, F5 predicted the hybrid multi-cloud ball of fire crisis our customers now face. For the last several years, we have been innovating and evolving to create the industry's first distributed application security and delivery platform. Today, we are the only provider capable of securing, delivering, and optimizing any application, any API, regardless of its location, be it in a data center, any one of the public clouds, at SaaS, or at the network edge. Today's hybrid and multi-cloud reality brings with it untenable operational complexity, considerable cost, and escalating security risks. Broad-based enterprise adoption of AI will only compound these challenges. F5's three points of differentiation, best-of-breed app security, our ability to simplify connecting disparate infrastructures, and our ability to streamline operations through standardization and automation set F5 apart from the alternatives. When combined with the role we play in the line of application traffic, these differentiators position us to extinguish the ball of fire for our customers, empowering them to run at the speed their businesses demand. Operator, please open the call to questions.

Maybe two, if I could. First, Francois, I think the last few quarters, you talked about kind of the competitive landscape and some disruption at some of your competitors. Could you just give us an update on that kind of win rate or what you're seeing? And then second, I did want to dig into that AI commentary with load balancing a little bit more. Is it, for F5, going to be specifically for enterprise use cases? Or will you guys play in some of these other larger data centers that are seeing a lot of CapEx activity currently and maybe timing of that enterprise, if you could.

Thank you, Tim. Let me address your second question first, and then I'll return to the competitive landscape. Concerning AI, the specific use case I mentioned regarding high-capacity load balancing for data ingestion will mainly be seen in enterprises, particularly those operating their own large language models at scale and needing to ingest substantial data, whether from on-premise environments or the cloud. The necessity to ingest and distribute this data is driving the requirement for high-capacity load balancing. We're observing digital innovators—large enterprises that have significantly invested in digital transformation and are leading in this area—beginning to deploy large language models in production, which creates this demand. This is not related to hyperscaler infrastructure; it pertains to a specific enterprise need, and it is still in the early stages. Additionally, beyond high-capacity load balancing, we are noticing other AI use cases emerging. The fact that AI workloads will be distributed and will heavily depend on APIs is highlighting the importance of API security to support these workloads, with several use cases already developing. Furthermore, the ability to connect applications across multiple clouds is crucial in AI, as customers manage their data across different environments while wanting to run models in one and access data in another. Our Distributed Cloud capability allows us to connect and network applications or workloads effectively. These are the early AI use cases we're starting to recognize, and while it's still early, we are encouraged by the developments we've seen over the past 3 to 6 months. Regarding the competitive landscape, I mentioned a couple of our competitors that have shifted their business models. In the traditional ADC space, we continue to see strong traction, with momentum picking up compared to last year. Things are on track in that area, with clear examples of large enterprises in North America and globally consolidating onto F5 and utilizing multiple capabilities, including those that previously came from competitors, or replacing competitors entirely. In terms of SaaS, we're making good progress with XC, which refers to F5 Distributed Cloud Services, including displacing some competitors. Our strategy with F5 Distributed Cloud recognizes that customers prefer to have all application security capabilities integrated into one platform. We have combined API security, DDoS protection, web application firewall, and bot defense into a single offering, which is appealing to customers and enables us to outpace some competitors that have not invested as much as we have.

I guess for the first one, Francois, Frank, you have some strong momentum here on the software subscription revenue quarter-over-quarter. Just how should I think about sustainability of that momentum going forward? And maybe the same one, sort of a bit disappointed to see the perpetual revenue on the software side moderate this much quarter-over-quarter, but it also seems like that's the lowest we've seen it track. So is there any potentially sort of more downside to that perpetual revenue number? But any thoughts on both of those aspects and the outlook there would be helpful. And I have a follow-up.

Yes. Samik, why don't I start with that? So this is one of those areas that will fluctuate quarter-to-quarter. Obviously, with last quarter, we had several large perpetual deals that gave us in-quarter revenue and lifted that software number up. We were not surprised this is the way it's playing out internally in our model, to dip back down in Q2, and would expect other results, obviously, with the software guidance that we've given for the back half of the year. That subscription revenue at 88% of total software revenue was an all-time high for us. It's going to fluctuate, but I would expect that it's going to be higher as a percentage than obviously what we saw in Q1.

I believe we are observing that AI implementations will inherently be multi-cloud. This is due to customers wanting to conduct training in different environments and inference in others. For several industries, inference needs to occur at the edge, and data resides in various locations. Furthermore, these AI models must connect with other services and models, indicating that customer AI implementations are becoming hybrid and multi-cloud. Nearly 90% of our customers are now operating in hybrid and multi-cloud environments, and approximately 40% are utilizing six or more cloud environments. We anticipate this trend will accelerate as they begin deploying AI, which introduces significant complexity for securing applications, networking them, and managing a variety of tools and vendors. We have streamlined all of this into a single platform that automates the networking and security of applications across different cloud environments. We believe this value proposition will resonate well in the AI space. However, we estimate that it will take 1 to 2 more years for enterprises to deploy AI at scale widely. Currently, early use cases are emerging from large enterprises that are ahead of the curve, but we expect broader adoption will take several more quarters.

So I was hoping you could talk a little bit about the implication of a reacceleration in application growth in the context of most of the cloud companies, and we don't have Amazon yet, but other ones such as Microsoft Azure are already seeing a reacceleration after several years of the so-called efficiency movement decelerating. That growth rate does now look like it's starting to reaccelerate. And I was wondering if you could talk about whether the Hashi acquisition has any impact on you positively or negatively and what you're doing to take advantage of those two dynamics within the distribution VAR channels?

Alex, thank you. So on the potential reacceleration, if confirmed of applications, we think it has potentially two implications. The first one is more customers deploying more applications in hybrid and multi-cloud environments. And I've just talked about the implications of that, which for us, we think are net positive because it creates more requirements for security and networking across clouds. And then the second potential implication is more automation. We're seeing, as customers reaccelerate the number of workloads that they're dealing with, the need to automate application changes, provisioning of new application services, etc., grows, and that requires software that enables that automation. And we, of course, have solutions that play into that. That said, we don't compete directly with HashiCorp, and so we're more complementary to what they do. So we don't think there is really either negative or positive impact to the acquisition. We think for F5, that's going to be largely net neutral, but we will, of course, continue working with HashiCorp in a number of customers and markets.

I wanted to ask about your comments on flat IT budgets and the general caution from customers. There are several factors at play, including the strength of the dollar and the prioritization of AI investments. I'm trying to understand the reasons behind this caution. Is it influenced by foreign exchange rates or merely budget prioritization? Or is it a broader trend of customers being more careful with their spending? Additionally, are you seeing more progress in deals that include multi-cloud or security components compared to core ADC sales? How do you view this in relation to your overall business?

Thank you, Meta. Regarding the budget, I would first like to mention that the macro environment has remained stable, and we haven't observed a significant change in customer spending appetite compared to last year. However, what has shifted is the unpredictability we experienced a year ago concerning deal delays, cancellations, and last-minute changes. This unpredictability has mostly diminished. Nevertheless, customers continue to be cautious. For many, this quarter marked the start of the calendar year, and they've just now received their budgets. We noticed a bit more caution particularly in capital expenditures, especially concerning hardware, due to the current macro conditions. We don't believe this is linked to foreign exchange issues. So far, we have not observed customers making AI a priority yet, as most enterprises are still not allocating substantial budgets to AI at this stage. In the service provider space, most customers are extending the use of their existing assets, with a few exceptions, but primarily they are trying to maximize the lifespan of their assets. As for your second question, I'll need a reminder.

Just whether it's taking the form of ADCs versus other portions of the portfolio?

Yes. I believe it’s a combination of factors. We are observing more opportunities with existing customers across both ADC and other areas of our portfolio, particularly in multiyear subscription agreements, which are performing very well and are favored by customers due to the flexibility they offer. Additionally, we are seeing an increase in deals related to security, especially in application security. API security is becoming a prominent use case, as more customers are realizing they lack visibility into their APIs—specifically, how many are in production, which ones are visible, and how they can discover and protect them. There’s growing traction in API security, and customers are increasingly looking to connect their clouds and applications, seeking automation solutions. This presents opportunities with our Distributed Cloud Solutions.

I have two questions. First, could you elaborate on the performance of subscription software, specifically the components related to term-based and SaaS? Second, regarding services, I understand we're seeing the impact of price increases that were first implemented in July 2022. Can you clarify if there are opportunities to periodically increase service pricing? What has the historical timeline for that been? Additionally, is a 5% growth a reasonable expectation for future services growth?

Yes. Michael, why don't I take that? Look, on the components of the subscription business in terms of SaaS and ARR, that one, ARR versus the term base, we talk about that annually, but it's not something we talk about quarterly. But the components of those businesses, we're really excited about what we're seeing for Distributed Cloud adoption, particularly the value proposition around WAAP and specifically API security that Francois just mentioned as well as our multi-cloud networking. So those are great. We do see AI having a big boost in application demand over the coming years, but it's not something that we expect a ton of revenue in FY '24 from. We are still seeing the high end of the bot market being a bit challenged, but those are the underlying aspects of what we're seeing in the SaaS business as well as strong renewals that we're continuing to experience in our multiyear flexible consumption programs. And so those are the dynamics, but we don't split the components out except for at the end of the year. In terms of the services side, you're right. The last time we raised prices was in July of '22. It's one of those things that we continue to evaluate on what's the best strategic use of price increases for our customers. And I don't have anything new to report there, but more to come in the coming quarters. It's probably been 6 quarters, and so you're seeing the lapping effect of that service revenue starting to come down. That was due to price increasing last year largely as well as some of the sweating of the assets. And so 7% is what we saw in Q1, 5% in Q2, and we do expect that to trail down in Q3 and Q4 as we lap even more of those annual increases from last year.

I have two as well. I guess, Frank, maybe just start with you. I think in the past, you talked about software growth for the full year being flat to, I believe, up modestly, I think was the statement. Given the performance you just saw this quarter, which I think was much better than expected on software, how do you think the back half of the year stacks up on the software side?

Sure. So look, we had a strong software growth number in Q2. It was in our expectation range. And largely, software to date in the first half has been ahead of our software expectation. But having said that, we did not change our outlook from flat to modest growth, but I think we'd be disappointed if we weren't at the higher end of that or better by the end of the year given the strong first half performance that we saw. Obviously, we're hitting a second half where the comparable numbers are a little more difficult. Having said that, we're really excited, particularly in Q4, about the subscription base of renewals that we're seeing on our flexible consumption programs and so have strong visibility into that.

Well, thank you. There are multiple dimensions to solving the ball of fire, and we don't think we really have competition that can address it as exhaustively as we are addressing it. So the first aspect is the completeness of the application services that are required to solve it, which very few, if any companies really have, because it goes from all of the application delivery services like load balancing authentication, but also web application firewall, all of the security services, API security, DDoS, multi-cloud networking, all of these capabilities you have to have to solve the ball of fire. Part of the complexity for customers is that they have had in the past to rely on multiple different vendors to be able to solve the ball of fire. So that's one aspect is the ability to bring it all together. The second aspect is really the ability to make multi-cloud ridiculously easy, which to be able to do that, if you're a pure-play SaaS vendor, you're not able to do that because you only offer your services in your point of presence. F5 is unique in the sense that we can offer all these services not just in the cloud, but in any public cloud or any on-premise location, and we can locate these services anywhere where a workload is. So we're taking advantage of our heritage as an on-prem vendor and our new capabilities in the cloud to offer these services ubiquitously to customers. And really, there is no other vendor in our space that brings all of that together. So in that way, we're pretty unique. And so when you take examples of that, you're asking what does it look like, this quarter, for example, we had a large bank in the U.S. that was connecting applications to multiple clouds, to Azure, on-premise and in Oracle. And we were essentially the only ones that can automate these connections for them and help them make multi-cloud ridiculously easy in their application, and we won the customer. We have similar bank customers in Europe who had the front end of their application in Azure, the back end of their application on-prem. We brought the connectivity to these components of these applications together and automated all of it for them to be able to deploy, and we won the customer. So we have these capabilities that are unique to the combination of on-prem and cloud brought together. And in that sense, we don't really think we have competition.

Francois, I believe we understand the product strategy here. My question is for Frank. Regarding stronger renewals on the subscription side in the second half, Frank, can you provide any quantification of this? What is providing confidence in those second half numbers, especially after this quarter came in below our expectations for F5's reporting and suggests a significant ramp in fiscal Q4 to about a $40 million sequential increase in fiscal Q4? Additionally, have you noticed any changes in subscription durations?

Sure. I appreciate the question. When we review this quarter's results compared to our expectations, we noticed a weaker performance in the system segment, not in the software segment. Looking ahead to the second half of the year, we anticipate seeing strength in that area, particularly concerning renewals. These renewals are coming in stronger in both quarters compared to Q2, and they'll ramp up due to when the deals were finalized three years ago in Q4. If you reflect on the past three years between Q3 and Q4, you'll observe a similar trend in the software growth we expect. This accounts for the $40 million difference you mentioned between the two quarters. The visibility comes from the strength in renewals and our outlook for what's available to renew in Q4.

Maybe to start, Frank, as we think about cash flow dynamics going forward with term renewals and the opportunity in the back half, as you just discussed, and as renewals generally become a larger portion of the mix, combined with the product availability you mentioned earlier in the call, should we expect cash flow margins to continue to trend up from here as well?

Ray, it's a great question. So the biggest dynamic of the cash flow changes between the quarters right now continue to be maintenance that just outweighs some of the subscription revenues that we've seen. And so the dynamics that you're implying absolutely are happening just on the smaller base of the overall cash flow that is coming out of that deferred revenue bucket, which is still largely maintenance related. And so I think, obviously, we had a very large accounts receivable balance going into Q2 you saw us collect and we're to a normalized level. So I think from where we had our cash flow from ops in Q2, likely, we're going to come down in Q3 and then my expectation would be back up in Q4. But that's the dynamics of the SaaS business is, as you're describing, it's not just a major portion, though, of what's driving the change in deferred right now and some of our cash flow from ops.

The response regarding the reaction at AppWorld on Distributed Cloud has been very positive. As of October, we had over 500 customers on Distributed Cloud, and that number has increased since then. We'll provide an updated figure in October as part of our annual sharing. More than two-thirds of these customers are existing F5 clients, primarily BIG-IP customers, who chose Distributed Cloud to complement their on-premises hardware or software implementations. This is partly due to our capability to integrate both hardware, software on-prem, and SaaS services into a single interface. The remaining one-third are new customers to F5. Many of these customers have moved into hybrid and multi-cloud environments, often unplanned or through acquisitions, and haven't had the chance to implement these solutions effectively. We are collaborating with customers on solutions like Distributed Cloud that facilitate proper multi-cloud operations. Correct multi-cloud management means having consistent security policies and automating the provisioning of application services and network interactions across the board. Customers are enthusiastic about the convenience this brings, addressing significant challenges they face, including operational strain, manual workload, and risks associated with inconsistent application security policies across different clouds. Overall, the reaction has been very positive, and there is an increasing awareness among our customer base of what Distributed Cloud can do, which makes us optimistic about the future.

Two for me. The first one, just following up on the competition question from the beginning. In those instances where you are displacing one of those ADC competitors going through a disruption, how do you typically land? Is it more heavily weighted towards appliances or software or SaaS? And then my second question is just around cyber and AI. As we think about the ability for malicious actors to leverage AI in their own attacks, how do you think about being able to address some of these new types of AI attacks? Or in other words, do you need new techniques and solutions? Or can you use the existing systems at a broader scale? And which of the solutions within F5 are particularly well positioned for those types of attacks?

Thank you. Let me address the question on AI and the types of attacks. We are currently utilizing AI to block significant attacks, including automated attacks on various applications. This quarter, we successfully blocked several billion API attacks through our Distributed Cloud capability, primarily using AI, automation, and machine learning. We anticipate that attackers will continue to become more sophisticated, as they are already employing generative AI for various attack methods. We are investing to stay ahead of these threats. Our bot solution is among the most advanced fraud solutions available, using AI to defend against automated attacks. We are also investing in generative AI to enhance our customers' interactions with our solutions and to enable quicker responses to evolving attack methods. This is a fast-evolving area, and we will keep investing in our security solutions. Regarding competition, you've asked about our displacement of competitors in ADC and whether it's more hardware or software focused. It's actually a combination of both. While I can't provide exact percentages, we are replacing competitors' hardware implementations with our own. We invested in a new generation of hardware over four years ago, incorporating many cloud benefits into on-premises implementations, something others have not done. This gives us an edge in terms of multi-tenancy and automation that competitors lack. In terms of software, we have also invested in creating a software footprint that is easy to use in public clouds, which is distinguishing us from competitors. Some of our agreements include both hardware and software, especially for customers in hybrid multi-cloud environments.