F5, Inc.

Good afternoon and welcome to the F5 Incorporated Second Quarter Fiscal 2022 Financial Results Conference Call. At this time, all participants are in a listen-only mode. After the speaker's presentation, there will be a question and answer session. To ask a question during the session, you will need to press star 1 on your telephone keypad. Also, today's conference is being recorded. If anyone has any objection, Please disconnect at this time. I'll now turn the call over to Ms. Suzanne Dulong. Ma'am, you may begin. Hello and welcome.

I am Suzanne Dulong, F5's Vice President of Investor Relations. Francois Locot-Denoux, F5's President and CEO, and Frank Peltzer, 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 A copy of today's press release is available on our website at F5.com, or an archived version of today's call will be available through July 24, 2022. Today's live discussion is supported by slides, which are viewable on the webcast and will be posted to our IR site at the conclusion of today's discussion. To access a replay of today's call by phone, please dial 800-585-8367 or 416-621-4642 and use meeting ID 776-9889. The telephonic replay will be available through midnight Pacific time, April 27, 2022. For additional information or follow-up questions, please reach out to me directly at s.dulong at 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. Factors that may affect our results are summarized in the press release announcing our financial results and described in detail in our SEC filings. Please note that F5 has no duty to update any information presented in this call. With that, I will turn the call over to Francois.

Thank you, Suzanne, and hello, everyone. Thank you for joining us today. As you all know, we entered our second quarter with some significant challenges that limited our ability to fulfill demand from our systems business. We are pleased to have delivered above the midpoint of our revenue guidance and at the upper end of our non-gap EPS guidance despite those challenges. Importantly, we continue to deliver strong results from our software business. With 40% year-over-year growth in the quarter, software represented the majority of our product revenue for the first time. Systems revenue declined 27% as a result of supply chain constraints, and our global services revenue was flat year over year. Our second quarter reflected another in an ongoing trend where customers continue to rapidly grow and scale both their traditional and modern applications while placing increased importance and focus on application security. This benefits F5 and translates to continued strong demand across our portfolio. While our view towards strong demand drivers remains clear, our visibility into resolution of hardware supply chain challenges is murky. Going into Q2, we discussed two primary supply chain challenges. I am happy to report that we successfully resolved the first, which was related to standard electronic components and required us to design in and qualify an alternative source. The second challenge we discussed is related to global shortages of specialty semiconductor components. While we have made some incremental progress on this issue, we continue to expect supply constraints will limit our ability to fulfill systems demand through the end of this fiscal year. Part of our efforts to fulfill system demand included shifting customers from our I-Series appliances to our next generation R-Series appliances, which launched in February. We are seeing solid traction in R-Series sales and we are ramping manufacturing. However, Semiconductor constraints, primarily from a handful of suppliers, continue to limit our ability to ship I-series and are now also impacting our ability to accelerate the ramp of R-series. As a result, our systems revenue recovery has been delayed beyond the expectations we had last quarter. Frank will review our outlook in detail later in our prepared remarks, but as a result of the delayed systems revenue recovery, we now expect to deliver fiscal year 2022 revenue growth in a range of 1.5% to 4%. This compares to our prior expectations for 4.5% to 8% growth. Our underlying demand remains strong, however, and we continue to expect to deliver software revenue growth near the top end of our 35% to 40% target for the year. In light of the sustained strength of our demand, and our view that the supply chain constraints are temporary, we are not making changes to our operating structure and therefore our margins will be impacted correspondingly near term. We obviously feel a strong sense of frustration with this change and an equally strong sense of urgency toward resolution so we can get back to reflecting the true health of the business in our reported results. We are taking every available path to resolve the issues as quickly as possible. Our suppliers expect additional capacity beginning in the last calendar quarter of 2022, which should translate into improvement during our second quarter for fiscal 2023. While the supply chain challenges are more severe than we estimated last quarter, they are temporary. In addition to seeing continued demand for hardware, we are seeing good traction across our software portfolio, including from security use cases and our ability to bring a broader solutions portfolio to customers. I will speak to our business momentum and demand drivers before Franck reviews the quarter's results and our outlook in detail. Our customers are increasingly operating both traditional and modern architectures and looking to F5 for solutions that simplify and unite their strategies for both. As an example, during Q2, an American multinational beverage company and a longtime big IP customer selected NGINX to serve its cloud and Kubernetes-based workloads and modern use cases. The customer is using NGINX to automate app content delivery, including its loyalty program and delivery services, both of which have experienced substantial growth during the pandemic. The addition of NGINX technologies to the customer's multi-year subscription resulted in a 2x expansion of the subscription upon renewal. Customers also are operating in multiple clouds and uncovering new challenges as a result. F5's infrastructure-agnostic approach to application security and delivery differentiates us from vendors who are siloed to a single environment. This means we are uniquely positioned to help customers with their multi-cloud challenges. During Q2, we were selected by the Ministry of Health for a nation in our APAC region. Not being locked into a single cloud was an important consideration for this customer. They had intentions of modernizing in a single cloud short term, but planned to expand to additional clouds in the near future. This customer selected F5 over cloud native offerings as a result of our solution's clear value add and our cloud agnostic capabilities. We enabled the customer to create a true multi-cloud architecture with both on-premises and cloud environments in a deal spanning our portfolio, including big IP hardware and software with advanced WAF and NGINX, including app protect and API management. Finally, it's clear that hybrid architectures, including on-premises data centers and as a service offerings are here to stay. Applications and workloads also are increasingly containerized and mobile. This means complexity is here to stay too, and that managing applications across disparate environments will remain a challenge for customers. Meeting that challenge is likely to require a distributed cloud architecture and platform-agnostic security and delivery technologies that provide consistent protection, visibility, and performance for all applications. legacy, modern, and mobile across environments. In Q2, we took a large step forward toward helping customers better manage multi-cloud complexities with the launch of our F5 distributed cloud services. With this platform, we are delivering security, multi-cloud networking, and edge-based computing solutions on a unified software as a service platform. Our first solution for the platform F5 Distributed Cloud Web Application and API Protection, or WAP, augments multiple security capabilities across F5 technologies in a SaaS offering. This offering reflects the first major step in our integration of our Voltera platform and F5 software security stack. F5 Distributed Cloud Services is globally available, and we are seeing strong early enterprise and service provider interest. SoftBank announced one of the first notable wins for F5 distributed cloud this quarter. The corporate information technology division of SoftBank needed to improve low resource utilization and other inefficiencies of its private, virtualized infrastructure. But its security requirements mandated on-premises deployment with an option for future public cloud capabilities. It sought a way to bring the effectiveness of cloud-native microservices and containers to its private data center and turn to F5 distributed cloud services. We are leveraging F5 distributed cloud branding to further integrate customers' experience with F5 by simplifying our product naming. You will see we have united and renamed our SaaS and managed services portfolio, including Shape, Volterra, and SilverLine under our F5 distributed cloud services umbrella. So expect to hear us refer to those solutions accordingly going forward. In summary, despite our short-term supply chain challenges, there is a lot to look forward to from F5. We have multiple current and future software drivers that are well aligned with our customers' most pressing application needs. Between BIG-IP's ability to serve and secure traditional apps, NGINX's ability to serve and secure modern apps, and the exciting opportunity to grow and expand F5 distributed cloud services, we are well-placed to enable our customers to manage and secure their growing and rapidly evolving application estates. Now, I will turn the call to Franck to review our Q2 results and our second half outlook in detail.

Franck? Thank you, Francois, and good afternoon, everyone. I will review our Q2 results before discussing our second half outlook. We delivered second quarter revenue of $634 million above the midpoint of our guidance range and reflecting a 2% decline year-over-year. Software revenue grew 40% to $152 million. Systems revenue declined 27% to $146 million. We delivered a 4% product revenue decline year-over-year with product revenue representing 47% of total revenue in the quarter and software contributing 51% of product revenue. Rounding out our revenue picture, Global Services delivered $337 million in revenue. This is flat compared to last year and represented 53% of total revenue. Taking a closer look at our software revenue, subscription-based revenue represented 75% of total software revenue in the quarter. This is down a bit from the 80% mix where it had been in the last couple of quarters, but we do not see this as indicative of a trend. Rather, it reflects some activation timing variability for a couple of large multi-year subscription agreements, as well as a small number of larger deals in the quarter where customers preferred a CapEx model. As a reminder, a significant component of our subscription business is term-based licenses that are not recognized ratably, and as such, we expect some quarter-to-quarter variability. Revenue from recurring sources, which includes term subscriptions as a service and utility-based revenue, as well as the maintenance portion of our services revenue, totaled 69% of revenue in the quarter. This is up from 64% in the year-ago period. On a regional basis, Americas delivered 4% revenue growth year-over-year, representing 57% of total revenue. EMEA declined 9%, representing 25% of revenue, and APAC declined 6%, representing 19% of revenue. In the quarter, we saw some signs of softness in EMEA. We believe this is in part related to the macro and global political concerns in the region. Enterprise customers represented 65% of product bookings in the quarter, service providers represented 15%, and government customers represented 20%, including 7% from U.S. Federal. I will now share our Q2 operating results. Gap gross margin was 80.1%. Non-gap gross margin was 82.9%. We continued to experience increased component prices, expedite fees, and other sourcing-related costs. Gap operating expenses were $433 million. Non-gap operating expenses were $358 million. Our gap operating margin in Q2 was 11.8%. Our non-gap operating margin was 26.5%. Our GAAP effective tax rate for the quarter was 22.7%. Our non-GAAP effective tax rate was 21.3%. GAAP net income for the quarter was $56 million or $0.92 per share. Non-GAAP net income was $131 million or $2.13 per share. I will now turn to the balance sheet. We generated $127 million in cash flow from operations in Q2. Capital expenditures for the quarter was $5 million. DSO for the quarter was 59 days. Cash and investments totaled approximately $922 million at quarter end. During the quarter, we repurchased approximately $125 million worth of F5 shares or approximately 610,000 shares at an average price of $205. Deferred revenue increased 17% year-over-year to $1.60 billion, up from $1.58 billion in Q1. The growth in total deferred was largely driven by subscriptions and SaaS bookings growth, and to a lesser extent, deferred service maintenance. Finally, we ended the quarter with approximately 6,700 employees, up approximately 150 from Q1. Francois shared our updated fiscal year 2022 revenue outlook in his remarks. I will recap the details of the second half outlook with you now. Unless otherwise stated, please note that my guidance comments reference non-GAAP operating metrics. I will begin with our revised view for fiscal 2022. Given persistent and dynamic supply chain pressures, which are limiting our system's revenue recovery near term, we expect to deliver fiscal year 2022 revenue growth within the range of 1.5 to 4% for the year. This compares to our prior expectations of 4.5 to 8% growth. We continue to expect to deliver close to the top end of our 35% to 40% software revenue growth target for the year. We expect global services growth of approximately 1% to 1.5% for the year, reflecting the lower expected range of system sales. Because we believe the current supply chain challenges are temporary and do not reflect the underlying growth of the business, we do not intend to adjust our operating model near term. We believe doing so would risk compromising our ability to deliver future revenue growth. As a result, we are likely to see operating margin pressure over the next several quarters. We expect non-GAAP operating margin in the range of 27% to 28% for FY22. We would expect to regain the Rule of 40 operating benchmark as we return to full manufacturing capacity. We continue to expect our full fiscal year effective tax rate will be in the range of 20% to 21% with some fluctuations quarter to quarter. We remain committed to repurchasing $500 million in shares during the fiscal year. I will now move to our third quarter expectations. We expect Q3 revenue in the range of $660 to $680 million. Given component cost and the costs related to actions we are taking to mitigate supply chain pressures, We expect Q3 gross margins of approximately 82%. We estimate Q3 operating expenses of $368 to $380 million. Our Q3 earnings target is $2.18 to $2.30 per share. We expect Q3 share-based compensation expense of approximately $63 to $65 million. With that, I will turn the call back over to Francois. Francois?

Thank you, Frank. In closing, we will continue doing everything in our power to mitigate supply chain impact for our customers. While supply chain is currently overshadowing the underlying strength of our business, we believe constraints will begin to abate as we move through the next several quarters. Our software and software as a service app security and delivery solutions will drive our future growth and our long-term opportunity. We have created a portfolio and a roadmap that is well aligned with our customers' strategic priorities, and because of that, we are more confident than ever in our position, our strategy, and our long-term opportunity. With that, operator, we will open the call to Q&A.

Sure, thanks, sir, and thank you. As a reminder, to ask a question, you will need to press star 1 on your telephone keypad. Again, that is star 1 to ask a question. Our first question comes from the line of Sami Chatterjee from JP Morgan. Please ask your question.

Hi, yes, this is Joe Cardozo on for Sami Chatterjee. You know, my first question is just on the supply challenges that you highlighted during your prepared remarks. Can you touch on some of the actions that you're taking or planning on taking to help alleviate some of the pressures from the headwinds that you're facing from the supply challenges? Like, are you guys passing on higher pricing at all? You know, are you starting to see the benefits from higher pricing as some of the other networking peers in the space have done? And then just relative to the underlying components that are being constrained for the two product offerings that you highlighted, you know, when do you start to see or when should we start to see some improvement there? You know, have you been given any timelines from the suppliers? And then, you know, what's driving your confidence around that timeline? Thank you.

Thank you for the question. Let me start on the pricing. We, you know, we have been generally philosophically quite cautious about pricing with our customers. That being said, we have seen, as you know, significant price increases and, sorry, significant cost increases. And we did affect the price increase in the last few months that was in the high single digits. And we will continue to review our costs and kind of refine our models and look at whether we need to do anything else in coming months. But we're going to continuously review that in line with what we're seeing from a component perspective. But we've already taken a first action in that area. As it relates to when things do get better. So, based on conversations with our suppliers to make, and all of this is really about the semiconductor supply chain, and it's really a handful of strategic suppliers that we have. And we do have deep and broad conversations with them on a very regular basis, including executive to executive conversations to really address the challenges that they and us are facing. And based on these conversations, We expect them to have improvements in their capacity in the fourth calendar quarter of the year, which should translate to improvement in our revenue in the first calendar quarter of 2023, which would be our second fiscal quarter. We expect these improvements from them based upon their expectations of additional FAB capacity. and what we've seen in terms of their consistent milestones around increasing that capacity. But we're not sitting on our hands and waiting for just the suppliers to make improvements. We are also driving aggressive actions on our side to drive improvements. So what are we doing? First is We are continuing to shift demand to our series, which is our next generation platform, because we expect that platform to be less constrained than our i-Series platform. And from the field perspective, in terms of customers taking on the R-Series platform, we are seeing actually excellent traction on this front because the value proposition of the platform, the price performance of the platform is just excellent. So we're aggressively shifting demand to R-Series. We are increasing the velocity of qualifying alternative sources of supply for both platforms, actually, so, you know, redesigns and qualifying additional suppliers on these platforms to alleviate the supply shortages. And, of course, we continue to make aggressive, advanced purchases with our suppliers. We have been doing that for several quarters, but we continue to do that very aggressively and providing them a lot of visibility into our forecast for future quarters. So with these actions, as I said, we expect better supply in our fourth calendar quarter that will translate into the first calendar quarter of 2023 for improvement into our hardware revenues.

Thank you. Appreciate the call, guys.

Thank you, Sameek.

Our next question comes from the line of James Fish. From Piper Sandler, please ask your question.

Hey, guys. Good afternoon. Kind of a loaded question here with two parts, of course. The big question we're getting after hours is really around that software number. And, Francois, while 40% growth is strong, it was, again, some easier compare than last quarter. Is there any way to quantify how much of that shift towards either the CapEx purchases over software as well as how much got delayed to a future period? on the software line occurred. And then, you know, on the system side, what should make us believe that we aren't in for another hardware cut here over the next quarter or two, as this is the second quarter in a row of cutting hardware? And really, I think giving us a sense around where backlog is versus the last quarter would be helpful for that.

Let me start, Jim, with the latter part of your question around hardware, and then let's go to software after that. So, Jim, the reality is that there is so much constraint in the supply chain, in the semiconductor supply chain today, that our visibility into our supply is not very long-term. It's actually very short-term. What we're doing is giving you the best visibility that we have today, just like we did last quarter. We did not anticipate in our forecast, you know, when we guided for the full year last quarter, we did not anticipate yet another significant deterioration in the availability of these semiconductor components, and also the fact that the broker market has gone completely dry. And that's why we have another step down in terms of our ability to shift for the full year. In providing the view for the full year here, Jen, we've looked to be appropriately conservative based upon what we know today. That's not to tell you that there is zero risk in the numbers we're giving you because, of course, those numbers rely on deliveries from our suppliers that are going to happen later this quarter and, of course, in Q4. So there is, of course, still some risk in the full year number, but we have looked to be appropriately conservative in how we've constructed it. based upon all of the conversations and information we have from our suppliers. On the backlog, Jim, you know we don't speak specifically to the backlog numbers, but of course our backlog has grown again this quarter by multiple tens of millions of dollars. And if you look at our demand drivers, Jim, they're pretty strong. So demand has remained strong. When we look at demand, we are on track at the first half of the year with, you know, what our plan was for the year. And so this is really a supply issue and not a demand issue. Let's go to software, and Frank was going to take that.

Yeah, Jim. So on the software number, obviously, you know, we do not sort of guide and mix on any given quarter. And, you know, if you go back in time to the first half of, Well, if you go back to analyst day in November of 2020, and we talked about software guidance in that 35 to 40% range. And, you know, after the second, the first quarter, we had 70% in the second quarter, we had 20%. And, you know, there was a lot of question marks around, would we ever be able to make that 35 to 40% range? And we ended up at 37% for the year. You know, we talked about at the beginning of this year that there was going to be less volatility and variability in that number. I think, you know, last quarter it was 47%. This quarter it was 40%. But there's no dynamic to speak of, you know, a mix shift or any other factor. It was, quote, unquote, an easier comp. But we do think about this number of growth in terms of an annual basis, certainly not on a quarterly basis. We're quite happy with, you know, where we've ended in the first half. and continue to expect reform in the second half to be near the top end of our 35% to 40% range.

Thanks, guys.

I'll yield it back.

Thanks, Jim.

Our next question comes from the line of Amit Daryanani from Evercore. Please ask your question.

Thanks a lot for taking my question. I have a question and a quick clarification, hopefully, The question I really have is on the operating margin structure. So if I look at the full-year guide, you're talking about 27%, 28% operating margin, which is down, I don't know, like 400 basis points year-over-year, even though there is some revenue growth in the model on a year-over-year basis. So I'm just wondering, what sort of revenue run rate do you think you need to get back to the 32%, 33% kind of operating margin range on a quarterly basis? And alternatively, what do you need to see from a macro basis to perhaps say, I need to get more aggressive in optimizing my cost structures. I'd love to just understand how you think of OPEX as you go forward. Is there anything you would call out in terms of why is software implied to decelerate in the back half of the year, fiscal year, versus the front half? Is there something in the renewal that's happening there or just anything you would call out that would be helpful?

Sure. So why don't I start, and then I'll turn it over to Francois. So on the operating margin side, I think what we said for the past two quarters is that our expense plan has not changed, and largely that is absolutely true. If you take a look at, you know, where the expected point of, you know, operating expenses in relation to that 8% to 9% original growth range that we had in the model, and where we also had our gross margin expectations, that would lead you to sort of the expectation of what we have for operating expenses for the full year. And so the run rate for that 32% to 33% is exactly what we talked about at the beginning of the year of what we would need. What we have seen is a shortfall in the hardware number because of the supply chain constraints, but because they are temporary, we don't think it's right to change the operating expenses to potentially hinder a longer-term growth trajectory of the business. And so that's why we have not changed the operating model.

And then, Amit, the second part of your question was about software growth.

Yeah, I guess, Francois, when I look at the guide for the full year, right, you started at low 40% growth, call it, in the first half of your fiscal year. And so just mathematically, you're talking about things decelerating in the back half of your fiscal year. So I'm wondering, is there something with the renewals that happened in the first half, or this has just been a bit more pragmatic, but just what's driving that implied decel on software in the back half?

Oh, yeah. No, I think that's what, you know, Frank was talking to this a moment ago, that, you know, when you look back at it, we guided to 35% to 40% growth First of all, for our Horizon 2, going back in 2020, and we delivered 37% growth in fiscal 2021. We guided again to 35% to 40% growth this year, and in fact, we said we would get to the top end, near the top end of that range, and we're on track to achieve that. We've always said that we weren't looking at this on a quarter-to-quarter basis, but more on an annual basis. in part because our software business is not just a, you know, ratable SAS, you know, model, that it does include term subscriptions, and therefore, there would be some variability quarter to quarter. We did say that we would see less variability quarter to quarter this year than we did last year, and we're also on track to deliver against that. So, there isn't a, you know, a different dynamic, if you will. in terms of the software business than what we have seen in the past the renewals that you just referred to the trends on those on these renewals are very very encouraging as well as the true forward and the expansions on the you know the agreements that we've signed in the past so we are you know generally very pleased with the software drivers we're seeing perfect thank you very much

You are next, Alex Henderson of Needham. Your line is open.

Great. Thank you very much. I wanted to go back to the comment you made about EMEA slowing a little bit and the decline in revenues in EMEA and APAC versus the growth in the U.S. And contrast that with the extremely strong demand conditions that you're dealing with obviously outstripping your supply. Can you talk to why there was such a splay between the U.S. results and the international results? And when you talk about Europe specifically, you mentioned a slowdown in demand there as a result of the economy. Can you feather that into the overall demand picture a little bit, please?

Yeah, so let me start there. You know, what we saw in our second fiscal quarter there, and I would say really kind of starting in February and beyond, is a slowdown of demand in Europe. We think, and it's kind of accelerated a little bit into the last month of the quarter, which was in March. We think it is attributed to macroeconomic conditions, of course, the Ukraine-Russia war, even though our business in Russia is very small, so there was no really direct impact territorially. But in terms of the whole sentiment in Europe around inflation and potentially the economy slowing down, we think that has caused some customers to be a little more cautious to scrutinize spend a little more and potentially to delay some orders that they would otherwise make. Now, in the big schema thing, we're not talking about multiple tens of millions of dollars here. It's effectively a smaller effect than that, but it was noticeable enough in our trends that we felt that we should point it out. In part because we don't yet know how this will play out in Europe in, you know, in coming quarters and whether with the continuance of the conflict and more inflation, whether, you know, this will continue and to what extent. We also had, you know, a very strong demand in the Americas, in the enterprise space, as well as service providers overall. So that contrasts a little bit with Europe.

And Alex, I do have to add that this is where you start to see or you may not see the clearest picture in terms of demand of bookings versus just recognized revenue because of the constraint that we have in hardware. And so normally, you know, in orders before, there would be a tight link But when we take a look at where some of the bigger backlog of activity was happening, it was more in the Americas that got shipped out in the quarter associated with the revenue recognition of that systems, which is going to skew this number a little bit more.

Is Europe more biased to systems and less to software? Is that part of it? And is there any change in your

supply chain in your pipeline in europe in april that would suggest continued erosion in the conditions there and then i'll see the floor thanks yeah so the the the answer to your first question is is no there's no specific activity i mean as as a whole uh europe probably is slightly higher weighted towards hardware um and apac slightly uh uh towards hardware in bookings than some of the other businesses, but it's not dramatic. I think, you know, what you will see is just where we've got more backlog and the aging of that backlog, that's, you know, some of the first things that will get shipped out and will skew some of these hardware numbers and the overall revenue by geo number, you know, until we get, you know, fully caught up on some of these supply chain constraints. And so as we talked about last quarter, we are trying to you know, very much take a customer-centric view towards meeting this demand with the limited supply that we've got, and that is going to just, you know, skew these numbers a little bit. We did point out because of some of the delays of bookings that we saw in EMEA, particularly in month three when you had, you know, the geopolitical concerns really, you know, creep up, that's That's what we saw. We wanted to point that out on the demand side of the equation too.

And Alex, just your question about April. I think the pipeline for EMEA for Q3 actually looks better than what we saw in Q2, but we are cautious because of the macro environment in Europe currently.

Great. Thank you very much for that clarity.

Absolutely.

Your next question comes from the line of Paul Silversine of Cowan. Please ask your question. Once again, Paul Silversine, your line is open. If you're on mute, please unmute your line, Paul. There seems to be no response from the line of Paul. We will now be proceeding to the next question, coming from the line of Sammy Badry of Credit Suisse. Please ask your question.

Hi, this is Ryan Ong for Sammy. Thanks for taking the question. So basically, our first question is, for customers who historically want a system, whether they will opt out into given the constraints we're seeing for the past quarter? And I have a follow up.

Yep, I'll start. So, you know, we just broadly speaking, we have not seen a hardware to software substitution in the business. And the reason for that is that when customers, for customers to move to software, Generally, they have to have considerations from not just F5, but other providers in their environment. And generally, these other providers also have elongated lead times. They also have to have done some architectural work to move to a virtualized environment, which a number of customers, you know, haven't done if they're still on hardware, so they're not ready to move to software. And for those reasons, what we've seen is the majority of customers who have, you know, larger states on hardware, the lead times, the change in our lead times alone is not a factor that is moving them to software. Now, for those on the margins who can make that move, we are working aggressively with them to make that happen, but we have seen that to be a marginal, a very marginal phenomenon to date. You know, whether that will change in the future if our lead times continue to be elongated is yet to be seen, but we've not seen any meaningful hardware or software substitution to date.

Gotcha. Gotcha. I appreciate the color on that. So my follow-up is, so does the reduction in the guidance imply that 2023 could be a much bigger revenue year, or is this demand that is essentially going away given the extent of the delays?

No, we don't think demand is going away. Let me be clear about that. We have, you know, we are seeing very strong demand. We haven't seen any trend in, you know, any order cancellations in any form. We haven't seen any loss of business to competitors because generally, you know, other vendors also have challenges with lead times. And despite all of the challenges that we're having, our lead times are worse than they used to be, but they're kind of in the mix with other folks there. And, you know, we continue to see a strong demand from our customers across the board. So we don't think that our lead times and our, you know, challenges in shipping hardware right now are causing demand destruction, if you will. Going into next year, you know, this is – we're not guiding yet to – But, of course, it's going to be about, you know, how fast can we get back to shipping to demand? And, you know, with the visibility that we have right now, you know, we think effectively our fiscal Q1 is going to be more of the same. It may even be a low point in what we see from availability of supply to date. We think we will start to see improvement in our second fiscal quarter for 2023. And our expectation is that we would be back to, you know, shipping to full demand, you know, in the back half of our fiscal 2023. Got it.

Appreciate the call. Thanks so much. Thank you.

Your next question comes from the line of Meta Marshall of Morgan Stanley. Your line is open.

Great. Thanks. I just wanted to get a sense of maybe kind of breaking down the I series and R series, you know, whether the resolution of some of the supply chain issues is kind of similar timing between some of the what we had understood as more the general componentry on the R-series versus the more specialized chips on the I-series. Are those both kind of set for calendar Q4? And then just in terms of getting customers to transition from I-series to R-series, is that timeline or kind of evaluation process going as quickly as you thought? Thanks.

Hi, Meta. Let me start with the last part. Yes, the answer is yes. We, you know, we made the decision to make our R-Series, the software that runs on R-Series backwards compatible with I-Series several quarters ago. And it's serving us well today because it's shortening the qualification cycle for the R-Series relative to what it would have been in prior cycles. And so the qualification of R-Series with customers, but also the demand is very strong. because the value proposition for this platform, you know, this next generation platform plays well to where customers are going in terms of having both traditional and modern applications served by these platforms. In terms of the transition timeline meta, you know, we've always said it takes roughly six quarters to make that full transition. And so our expectation is we're going to continue to run our series. And by the time that we exit our fiscal 2023, we expect to be, you know, almost near at 100% of serving the demand of our customers, primarily with our series. And that will ramp through the next, you know, the next five, six quarters. Your second question was about I-series and R-series constraints. So, right now, they both are constrained by semiconductor components. Um, but we are shifting, you know, more of the demand to our series because we expect our series to be less constrained because it's a newer platform, uh, going into the new year, uh, because there are less parts effectively on our series that have these, these constraints, uh, then on my series. So that's why we're, we are aggressively shifting the demand to, to our series. Uh, but we're also doing some work, uh, of course, on, on I series to be able to continue to meet the men in the next few quarters for, for customers that, really need to be on that platform for a number of reasons.

Got it. So when you say calendar Q4, that's more for resolution of R-series, not necessarily I-series is kind of ongoing, R-series is calendar Q4.

Yes, R-series is calendar Q4. I-series, we should see some improvements in also calendar Q4 in terms of the supply we get there. However, you know, going into the new calendar year, we will be continuing to shift to our series. So our series will progressively become the majority of both the demand and the revenue and shipments.

Great. Thank you.

The next question is from Simon Leopold of Freeman James. Please ask your question.

Hi, guys. This is Victor Chu in for Simon Leopold. Are you guys observing any trends in the public cloud adoption impacting the uptake of F5 subscriptions in the cloud? You know that you don't anticipate any customers prematurely moving away from systems deployments to virtual deployments, but can we see customers accelerating the shift of workloads, more workloads into the public cloud, given the constraint in supply? Is that something that could encourage them to move in that direction?

You know, I think that over the long term, we will continue to see customers, you know, rebalancing their environment to these multi cloud environments, I think our belief system, which, frankly, has been our belief for the last, you know, several years is that, ultimately, the applications will land on the best infrastructure environment for the application. And in a lot of cases, that will be public cloud. In some cases, that will be a private cloud. And in a lot of cases, that will continue to be a traditional private data center with hardware environment. I don't think that the current supply chain challenges will fundamentally alter that future destination and that future distribution of applications. And we also can see it from the customer behavior that we're seeing today. I think for customers that really need capacity for their applications and can't get hardware, the best plan B, if you will, for that is to move to F5 software on virtual machine. But to do that, of course, customers need to also have the servers available. And those also have elongated lead times in a number of cases. But moving to a cloud, a public cloud, is an entirely different kind of architectural consideration. And it takes planning. It takes quite a bit of time. And so, you know, we don't think that the supply chain challenges are particularly accelerating a move to the public cloud. But generally, we think the destination for all of our customers is multi-cloud. Most of our customers are already in multi-cloud environments. And, you know, we intend to and we've designed our portfolio to serve them for these multi-cloud environments.

That makes a lot of sense. What about for customers that are on the fence or in the process of, you know, straggling their workloads already between on-premise and public cloud? Is this not going to encourage them to move one way or the other? Is that something you envision either?

I think customer who, you know, maybe for greenfield environments, Victor, where customer are just, you know, deploying new workloads, if they could go to a virtualized environment and they have either the servers in-house available or they could, you know, use F5 software in the public cloud, which many thousands of our customers do that today. that would be a way to get to where they want to be faster. I would say that's a minority of situations today, but it's a possibility for customers that are building greenfield environments.

That's helpful. Thank you.

Our next question comes from the line of Jim Suva of CD Group. Please ask your question.

Thank you. Could you give us a little bit of color on the operating margin trajectory and kind of the steps as far as the timing and the magnitude of those steps? You talked about several of them in your prepared comments, but how should we kind of think about the timing in each of those steps? Thank you.

Yeah, Jim, why don't I start, and then, you know, if Francois has got anything to add, by all means, please do. So, you know, Francois sort of laid it out in a couple of questions ago on where we see the hardware side of the business over the next, you know, call it three to four to five quarters. And we think that, you know, largely the operating margin is going to ramp back up along with that shipment of hardware back to where we get to our rule of 40. But in the immediacy of the, you know, certainly over the next couple of quarters, we're going to be below that 37 or the 27 to 28 mark that we had set. And a lot of that is largely due to the step down in our gross margins that, you know, are impacting as well as the less revenue coming from our systems business. And so, you know, those combinations are putting pressure on the operating margin in the near term. But we do expect to get back to, you know, our rule of four operating plan when we work our way through some of these supply chain constraints.

Great. Thanks so much for the details.

Our next question comes from the line of Rod Hall of Goldman Sachs. Please ask your question.

Hi, guys. Thanks for the question. I just wanted to come back to the full year guide change. I'm calculating at midpoint about $91 million of reduction there. And I guess it's due to, you know, these ongoing supply chain challenges. But then, you know, I'm curious what the duration of that change is. In other words, are you expecting most of that to happen sooner here and then you think your supply comes in better as we get to September? Or do you have visibility all the way to the end of the fiscal year and, you know, that encompasses this? this $91 million. Can you just kind of give us an idea on timing there? Thanks.

Yeah, Rod, I'll start on that one. But so, look, I think, you know, as we lay it out in our models, you know, the lower point on the hardware side is likely not near term. It's in Q4, Q1, as we see, you know, the continued pressures that we've experienced for the past couple of quarters continue on. I think Francois noted that some of the green shoots that, you know, will be coming in calendar Q4 that will start to impact and ramp up for us. And, you know, calendar Q1 of 23, and you'll start to see that improvement. But on the system side, you know, I don't think the low point is this quarter. I think the low point is more in Q4, Q1 of 23. Well, Q1 of 23. Oh, Q1 of 23, Q4 of 22. Yep.

Okay, and then I also wanted to just check in with you regarding the, you know, back on the demand side of things. Are customers indicating to you that that's temporary? And I also noticed your DSOs have jumped up to 59 days. I assume that's due to supply, but Are people now starting to order further out, or, you know, why are we seeing that jump in the DSOs? I got two questions in there, really. Sorry about that.

Yeah, let me start on the DSO side, and then I'll let Francois pick up the first one, Rod. So, no changes at all. This is purely a factor of, you know, when we were, you know, a lot of leading up to this quarter had been a lot of the shipments, and therefore, you know, the billing going out for that hardware earlier on in the quarter. And in this quarter, it was a little bit more in month three. And so, you know, just by nature of the AR balance going up, that's the DSO calculation. There is nothing in terms of any dynamic, you know, to see there. It's just more of a function of that AR balance going up on things that are, you know, in the legitimate net 30-day window cycle. So nothing there.

Yeah, well, in terms of customer behavior, we have seen both. So, you know, some of our customers are, you know, who have, I guess, perhaps, you know, who are planning ahead and have the means to plan ahead and order ahead. We've started to see their behavior move to ordering well ahead to take into account the extended lead times. But at the same time, we also see other customers who are pushing out and delaying orders, you know, in part to, you know, create leverage and say, hey, I'll place the next order once you have shipped the order that I placed a few months back. And so, when we net out those two behaviors, we land in about the same place, which is demand is kind of where, you know, where we expected it to be, and it continues to be strong. What we are not seeing is lost demand due to supply chain delays. And that's been the trend for the last several quarters, including this last quarter.

Great. Okay, guys. Thanks a lot for the questions. I appreciate it.

Absolutely, Rod. Thank you.

Due to time constraints, we will take our last question from Jason Adder at William Blair. Your line is open.

Hey, this is Sebastian on for Jason. Thanks for taking the question. I just have one clarification and then open it in question. So just in terms of the supply chain issues, last quarter you mentioned about $60 million in revenue being pushed out of fiscal year 2022 for the specialized networking chips. I just want to make sure those lead times haven't changed at all and that's still the expectation. And it's really like the standard components and those lead times that have been pushed out further than expected and pushing revenue into fiscal year 23. Is that correct?

So let me just clarify that. The entire, you know, you're right about $60 million last quarter and the additional down guide this quarter, all of that is linked to specialty semiconductor components. Now, some of that is networking chipsets. And we also have challenges with components, semiconductor components that are not specifically networking chipsets, but they're more on the power side and power distribution, power shaping type of components. And it's the combination of all of that that's causing the delays in shipments and therefore the delays in revenues. Got it. Okay.

That's helpful. And then as a follow-up, maybe the more open-ended for you, Francois, In terms of as you guys shift more of your revenue to software, subscription, managed services, is your relationship with the partner channel, the VARs, the MSPs, is that changing at all? Are you becoming less reliant on them to generate revenue, or are you still sort of historically, as you have been historically, reliant on that channel to drive revenue growth?

No, you know, our partners and, you know, distributors and resellers and our key partners and systems integrators, they continue to be a really important part of our ecosystem. And part of what we have wanted to do as we've moved to software is embark them on that journey with F5 such that, you know, the transformation of F5 towards a software-centric business model uh, can also benefit their model. And a number of them, uh, you know, actually, frankly, some of them were ahead of us, uh, and, uh, you know, we're, we're part of, of helping us accelerate our own, uh, our own transformation. Uh, but we're seeing that a number of them have embraced these new models and have, you know, have found great ways to add a ton of value to our customers, you know, software centric model. And in fact, that has contributed to our software growth over the last, uh, several quarters. So no, we're, we're, uh, We're going to continue with a partner-centric model, and we're going to continue to innovate with our partners to bring great software solutions to our customers.

Got it. Thank you. That's all I had.

And this concludes today's call. You may now disconnect.