F5, Inc.

Please stand by. We're about to begin. Good afternoon, ladies and gentlemen. Welcome to the F5 Incorporated fourth quarter fiscal 2022 financial results conference call. At this time, all participants are in a listen-only mode, and please be advised that this call is being recorded. After the speaker's prepared remarks, there will be a question and answer session. If you would like to ask a question during this time, simply press star 1 on your telephone keypad. If you would like to withdraw your question, press star 1 again. And finally, if anyone has any objections, please disconnect at this time. And at this time, I'd like to turn the call over to Ms. Suzanne DeLong, Vice President, Investor Relations. Please go ahead, ma'am.

Hello and welcome. I am Suzanne DeLong, F5's Vice President of Investor Relations. Francois Locodinou, F5's President and CEO, and Frank Pelzer, F5's Executive Vice President and CFO, will be making prepared remarks on today's call. Other members of the F5 executive team are also on hand to answer questions during the Q&A session. A copy of today's press release is available on our website at F5.com, where an archived version of today's audio will be available through January 24th, 2023. Visuals accompanying today's discussion are viewable on the webcast and will be posted to our IR site at the conclusion of our call. To access the replay of today's call by phone, dial 800-770-2030 or 647-362-9199. and use meeting ID 3209-415. The telephonic replay will be available through midnight Pacific time, October 26, 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 risk, 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. I will speak first to our fourth quarter results before discussing fiscal year 22 and our outlook for fiscal year 23. Against the backdrop of a rapidly changing environment, our team delivered fourth quarter revenue at the top end of our guidance and earnings per share above the high end of our guided range. As Q4 progressed, we witnessed increased budget scrutiny from customers and elongating selling cycles. particularly related to new projects and new architectural rollouts. These dynamics were especially evident in our Q4 software revenue. While we had a strong pipeline for new multi-year subscriptions headed into the quarter, customers' macro concerns led to lower close rates and lower software growth than we expected. We had some customers pause large-scale digital transformation projects in favor of business as usual. We also had customers resize projects with more conservative initial usage estimates. And we saw foreign exchange headwinds contribute to budget and spending challenges with customers in both EMEA and APAC, including customers who delayed projects with the hope that currency would stabilize. Conversely, Q4 marked a significant improvement in our systems revenue versus prior quarters, thanks to better availability of several critical components in the broker market. These scarce components came at higher costs, which are reflected in our Q4 product growth margins. However, our priority was and will remain fulfilling customer demand for systems, which stayed strong throughout the year. We were able to partially offset higher product costs, and continued operating discipline and a favorable tax rate enable us to outperform our Q4 earnings per share target in the quarter. When I step back and look at FY22 as a whole, I readily acknowledge that the year did not look the way we envisioned when we began it. Despite supply chain challenges and growing customer caution beginning in Q4, we saw persistent customer demand and our sales teams drove record-breaking bookings for the year. In addition, we achieved several important milestones. First, with portfolio and consumption model diversification, we drove our product mix to 5149 software hardware, a noteworthy accomplishment in our transformation journey, and very different from where we were just five years ago when software represented less than 15% of our product revenue. Second, With the expansion of our application security portfolio and increasing demand for securing applications and APIs, we have grown our security business to $1 billion in revenue. Security-related revenue now represented 37% of our FY22 total revenue. Third, 69% of our total revenue was recurring in FY22 with a double-digit three-year compound annual growth rate. Over time, higher levels of recurring revenue will continue to add predictability and stability to our model. Finally, we launched three significant new platforms during the year, leveraging customer-focused innovation across the continuum of deployment models. These launches included expanding and unifying our SaaS offerings through F5 distributed cloud services, as well as our next-generation R-series and Velo systems. These milestones are representative of how significantly we have evolved F5 over the last five years. F5 is stronger and better balanced with a more resilient revenue base and an operating model capable of delivering significant leverage. Over the next year, our business is likely to benefit from tailwinds to our systems business as a result of improving component availability. It's also likely to bear some weight from macroeconomic headwinds. In the balance, We expect to deliver FY23 revenue growth of 9% to 11%. We also expect the combination of revenue growth and operating leverage will enable us to deliver non-gap earnings growth in the low to mid-teens, which means we also expect to deliver on our Rule of 40 benchmark in FY23. Further, we are committed to operating the business to maintain the Rule of 40 and double-digit earnings growth on an annual basis going forward. Frank will speak to our outlook in greater detail in his remarks. Before I pass the call to him, though, I will talk to several of the reasons why we believe we will deliver strong revenue and earnings growth this year. First, hybrid IT is here to stay. Our multi-cloud infrastructure agnostic approach means we can create a more unified experience across customers' desperate environments. We are enhancing automation and driving operational efficiencies and corresponding cost efficiencies. Our ability to create a more seamless application environment for our customers is already an advantage. It is likely to become even more so as customers look to reduce operating costs and complexity. Second, Demand for security use cases is likely to remain resilient. Customers rely on our security solutions, including DDoS protection, advanced vulnerability defense with web application firewall, and bot fraud, abuse, and API protection to protect them across what feels like an ever-increasing attack surface. With the February launch of our SaaS-based F5 distributed cloud services, we are now an attacker in a rapidly growing segment of the overall security market. Third, we expect a combination of a resilient systems business and gradually improving component supply will contribute to drive systems revenue growth in fiscal year 23. Beyond 2023, with customers embracing hybrid IT, we expect hardware demand will prove more resilient and longer-lived than expected just a few years ago. Near term, we also see the opportunity to take share from traditional hardware competitors undergoing structural change. Fourth, our breadth of form factors and consumption models makes us an ideal partner for customers who are likely to be prioritizing their investments, optimizing costs, and may want to shift from one consumption model to another. Whether hardware, software, SaaS, or managed service, perpetual license, or subscription, via an OPEX or CAPEX budget approach, we are flexible. In an environment of shifting priorities, Removing friction and enabling customers to consume how and when they want is a distinct advantage. And finally, we are a trusted and operationalized partner of the largest enterprises, service providers, and government entities around the world. In good times, and especially when faced with adversity, organizations tend to rely heavily on the partners they know and trust. We have worked for decades to earn that trust. Our customers count on us. on our deep understanding of how to protect and optimize their application, and on our continuous innovation. It's these factors, among others, including our very sticky install base and our growing base of recurring revenue, which help give us confidence in our outlook for next year. Before I conclude, I will highlight two interesting customer use cases from Q4. The first is an example of a multi-year subscription renewal with a sizable expansion. In this case, the customer, a global retailer, had a goal of automatically flexing its capacity into its public cloud environments as spiky traffic demands warranted. The customer augmented its existing on-premise BIG-IP hardware with scalable virtualized BIG-IP software in the public cloud. With our deep automation capabilities, we fully automated the deployment and configuration of the FI stack enabling them to burst capacity as needed. Automation also simplified how their developers consume infrastructure and best of breed cloud services. In an example of an F5 distributed cloud services SaaS win in the quarter, we worked with a global transport company based in South America that needed to protect its multi-cloud applications, but did not want the complexity or inefficiency of disparate cloud native services. the customer selected F5 distributed cloud services as a one-stop comprehensive security solution, including web application firewall, advanced bot defense, API security, and DDoS. With F5, the customer gained more consistent security across its multi-cloud environments, improved protection against bots, and is now more self-sufficient for its security and traffic management with a single platform to support expansion to other regions. In both of these use case examples, F5 delivered automated multi-cloud solutions that dramatically simplified our customers' operations and improved their ability to scale their businesses. And we did so with a form factor and consumption model that best fit their needs. Now I will turn the call to Franck. Franck?

Thank you, Francois, and good afternoon, everyone. I will review our Q4 results before moving on to briefly recap FY22 results. I will then speak to our FY23 and first quarter outlook. We delivered fourth quarter revenue of $700 million, reflecting 3% growth year-over-year with 3% product revenue growth and 2% global services growth. Product revenue represented 50% of total revenue in the quarter and was split 49% software, 51% systems. Q4 software revenue grew 13% to $172 million. Systems revenue of $178 million was down 5% year-over-year. Rounding out our revenue picture, global service delivered $350 million in revenue. Let's take a closer look at our software growth. Our software revenue is comprised of subscription-based and perpetual license sales. Subscription-based revenue, which includes term subscriptions, our SaaS offerings, and utility-based revenue, totaled $131 million, or 76% of Q4's total software revenue. The remaining 24%, or $41 million, came from perpetual license sales. Let's talk first about subscriptions and their performance in the quarter. Multi-year subscription renewals and our SaaS solutions performed as expected. However, as Francois noted, as the quarter progressed, we began to see increased budget scrutiny from customers and elongating selling cycles, particularly related to new projects and new architectural rollouts. While we had a strong pipeline of new multi-year subscriptions headed into the quarter, these dynamics led to lower close rates on new deals. We believe budget pressures also led to a strong mix of perpetual software sales in Q4 with an increasing number of customers preferring CapEx-based consumption models. Revenue from recurring sources, which includes term subscriptions, SaaS, and utility-based revenue, as well as the maintenance portion of our services revenue, totaled 67% of revenue in Q4. On a regional basis, Americas delivered 6% revenue growth year-over-year, representing 61% of total revenue. EMEA declined 3%, representing 23% of revenue, and APAC declined 2%, representing 17% of revenue. Enterprise customers represented 66% of product bookings in the quarter, service providers represented 13%, and government customers represented 21%, including 12% from U.S. Federal. I will now share our Q4 operating results. Gap gross margin was 78.9%. Non-GAAP gross margin was 81.4%. This was below our guidance of 82% to 83% as a result of the higher systems revenue mix in the quarter and higher costs associated with procuring and expediting critical components in the broker market. GAAP operating expense was $445 million. Non-GAAP operating expense was $379 million in line with our guided range. Our GAAP operating margin was 15.4%. Our non-GAAP operating margin was 27.3%. Our GAAP effective tax rate for the quarter was 10.4%. Our non-GAAP effective tax rate was 14.1%. GAAP net income for the quarter was $89 million or $1.49 per share. Non-GAAP net income was $158 million or $2.62 per share. I will now turn to cash flow and balance sheet. We generated $154 million in cash flow from operations in Q4. Capital expenditures for the quarter were $9 million. DSO for the quarter was 60 days. Similar to last quarter, this is up from historical levels due to the back-end shipping linearity in the quarter resulting from ongoing supply chain challenges. Cash and investments totaled approximately $894 million at quarter end. Deferred revenue increased 14% year-over-year to $1.69 billion, up from $1.64 billion in Q3. This increase was largely driven by subscriptions and SaaS bookings growth and, to a lesser extent, deferred service maintenance. Finally, we ended the quarter with approximately 7,090 employees. I will now briefly recap our FY22 results. For the year, revenue grew 3% to 2.7 billion. Product revenue of 1.3 billion grew 6% from the prior year and accounted for 49% of total revenue. As Francois noted, we achieved a significant milestone in the year with software representing 51% of product revenue. Software revenue grew 33% to 665 million for the year, while systems revenue declined 13% to 652 million. Global services grew 2% to 1.4 billion. FY22 software growth came from both subscriptions and perpetual license growth. Since FY19, we have driven total software revenue growth at a 41% compounded annual growth rate, subscription software at a 58% compounded annual growth rate, and perpetual license at a 10% annual growth rate. In FY22, revenue from term-based subscription models, including renewals and interterm expansions or true forwards, continue to represent the majority of our software subscription revenue. With the launch of F5 distributed cloud services in February, we have introduced a new growth vector for our software business with a SaaS-based consumption model. We are thrilled with the early customer traction for the platform, but scaling ratable SaaS revenue takes time. We are transitioning all of our previously available SaaS services, including solutions from Shape and SilverLine Managed Services, to F5 distributed cloud services, creating a unified delivery platform for customers. We fully expect F5 distributed cloud will be a meaningful contributor to our revenue in the future. We will look to disclose both its revenue contribution and other relevant, ratable revenue metrics as the business grows and matures. Our software revenue growth is driving us towards a higher recurring revenue base. In FY22, 69% of our revenue was recurring, up from 66% in FY21, and reflecting an 11% compound annual growth rate since FY19. We closed FY22 with approximately $231 million in product backlog, the vast majority of which is systems-based. This is up more than 80% from approximately $125 million in product backlog in FY21. While backlog orders are cancelable, we continue to see very low to nonexistent cancellation rates. Two years ago, we began disclosing the portion of our revenue derived from security solutions. Francois mentioned we delivered $1 billion in security revenue in FY22, representing 37% of total revenue. We estimate our standalone security product revenue, which includes solutions sold exclusively for security use cases in either software, SaaS, or hardware deployment models, grew to approximately $440 million. This reflects a 30% compounded annual growth rate since FY19. I will now turn to our FY22 operating performance. Gap gross margin in FY22 was 80%. Non-gap gross margin was 82.6%. Our gap operating margin in FY22 was 15%, and our non-gap operating margin was 28.9%. Our gap affected tax rate for the year was 16.4%. Our non-gap affected tax rate for the year was 18.1%. Our FY22 annual tax rate was lower than expected, primarily due to a discrete benefit from filing our fiscal year 2021 state income tax returns. Gap net income for FY22 was $322 million, or $5.27 per share. Non-gap net income was $623 million, or $10.19 per share. I will now share our outlook for FY23. Unless otherwise stated, my guidance comments reference non-GAAP operating metrics. As Francois noted, we expect to deliver 9% to 11% revenue growth in FY23. This view incorporates a balance between tailwinds to our systems business from gradually improving component availability during the year and macroeconomic headwinds. It also factors in current customer caution. In FY23, we expect the dynamics around budget scrutiny and caution around new projects will be similar to what we experienced in Q4. As a result, we expect software growth of 15% to 20% for the year. We expect systems revenue growth in FY23, with growth weighted towards the second half when supply chain risk related to critical components begins to abate. Finally, we expect low to mid single-digit revenue growth from our global services. Shifting to our operating model, we expect supply chain pressures to remain acute in the first half of the year and to gradually improve in the second half. This dynamic will impact our FY23 operating model trends, likely outweighing our usual seasonality. Specifically, revenue gross margin and operating margin expansion are expected to be more weighted in Q3 and Q4 of FY23. We expect FY23 gross margins of approximately 81% with the combination of moderating supply chain costs and price realization from our previously announced price increases flowing through as we progress through the year. We expect continued operating expense discipline will result in non-GAAP operating margin in the range of 30% to 31% for the year. We expect our FY23 effective tax rate will be 21% to 23%. And we expect to deliver non-GAAP EPS growth in the low to mid-teens for the year. As Francois noted, with results in these ranges, we would achieve our Rule of 40 target for FY23. We are committed to maintaining it and double-digit earnings growth going forward on an annual basis. Our FY23 outlook incorporates the expectation that we will allocate 50% of our free cash flow for the year to share repurchases consistent with our balanced approach and the commitment we made at our last analyst day. Included in this expectation is that we pay down the $350 million remaining on our term loan related to the SHAPE acquisition when it matures in January of 2023. I will now speak to our outlook for Q1 FY23. We expect Q1 revenue in the range of $690 to $710 million with gross margin of approximately 80%. We estimate Q1 operating expenses of $370 to $382 million. And our Q1 non-GAAP earnings target is $2.25 to $2.37 per share. We expect Q1 share-based compensation expense of approximately $61 to $63 million. I will now turn the call back over to Francois. Francois?

Thank you, Frank. To reiterate a few key points, we believe we are positioned to deliver FY23 revenue and earnings growth. We are well aligned with our customers' most pressing application challenges, including easing the complexity of protecting increasingly distributed applications and managing and scaling complex hybrid IT environments. With a $1 billion in growing security business and an increasing mix of SaaS-based solutions, we are well positioned for the future. Our innovation and successful transformation efforts to date have substantially expanded our portfolio, driving balance in our hardware-software mix. As a result, we have a stronger business model and increased confidence in our ability to deliver sustained revenue and earnings growth. In the balance of what we see are likely both tailwinds resulting from improving component availability and microeconomic headwinds in FY23, we expect to deliver meaningful top-line growth and double-digit earnings growth. In FY23 and beyond, we expect to continue to exercise operating discipline, driving to the rule of 40 and double-digit growth on a sustainable basis annually. This concludes our prepared remarks today. Operator, would you please open the call to Q&A.

Thank you very much, Mr. Lokodonu. Ladies and gentlemen, at this time, any questions or comments, simply press star one. And just a reminder, if you find your question has already been addressed, you can remove yourself from the queue by pressing star one again. Take our first question this afternoon from Tim Long of Barclays.

Thank you. A few here, if I could. Number one, you know, all related to software here. About three years ago, I think, is when you started with the pretty large term deals, and there was a few really big quarters there. Just curious on those handful of deals that really contributed a lot back then. They should come up for a three-year renewal. Could you just talk a little bit about those deals in aggregate? Were they renewed? Were they renewed larger? What kind of... did we see them, or were those deals lost or pushed out? And then I have more follow-ups.

Hi, Tim and Francois.

So as far as what we've seen both throughout 2022, which was really the first year where we had a number of these deals to renew, and what we saw in Q4 of 2022, renewal on these large deals were very strong. And by that, I mean that they renewed, and in addition, the, you know, the expansion that we've seen on these deals has been really healthy. So we're really happy with the renewals. As it relates to what we saw overall in Q4, where we had a shortfall was really on new business. And it really was, you know, we had the pipeline going into the quarter for a stronger number into software. on new business in particular. And the close rates ended up not being what we expected them to be because we saw a different customer behavior towards the end of the quarter, you know, as per the mentions in the prepared remark around deals being delayed, some being resized, and some being postponed by customers. largely as a reaction to microenvironment pressures and expectations for the recessionary environment. So all of that dynamic really only played out in new business, but as far as the existing deals that we needed to renew, they happened with a strong renewal rate and good extension.

Okay. And then you updated the security number there, which is helpful. Also at that analyst day a few years ago, you gave $100 million revenue number into the cloud vertical. I'm hoping you could give us some kind of update on how business to the cloud vertical has transpired over the year.

Tim, I don't have an update for you there. Our cloud business in general has continued to grow pretty substantially. What we are seeing more and more, Tim, is customers augmenting their on-prem or private cloud environment with applications going into public cloud, and they're leveraging for that our software, of course, but not just big IP software, but increasingly we're seeing them do that with NGINX software. And what we're seeing more and more is hybrid cloud being here and being here to stay with large enterprises who want to automate environments both on-prem and in the public cloud, and we've positioned our technology to be able to do both. So with the growth that we're seeing in hybrid cloud environment, our business, of course, in the public cloud and the number of applications we support in the public cloud has grown.

Okay, thank you. Thank you. We'll go next now to Samy Badri at Credit Suisse. Hi. Thank you very much for the question.

So I have two for the team. The first question is on a comment, Francois, that you just made that kind of piqued my interest here. You said that hardware revenue is likely more durable and may take share. And I think you said either from companies and existing customers or something along those lines. Can you just give us some color here? Are you taking share from software companies, hardware companies, other foreign factors? Maybe you could just expand a little bit on that comment. It's a little bit different from what we've been used to hearing before. The other question is for the systems revenue growth and the path through fiscal year 23. I think, Frank, historically there's been a discussion where fiscal 1Q of 23 is the low point of systems revenue capture, and then we ramp up through the year, and fiscal 4Q was the kind of peak of systems revenue capture. Could we just go through that systems path just to understand the glide path a little bit better?

Sammy, I'll take the first part and I think Frank will take the second part. So on my commentary on hardware, let me just comment on three segments quickly. Let me start with the ADC segment. So in the ADC segment, we have been taking share from our traditional competitors throughout 2022 and before. And we feel that This is happening for a couple of reasons. Number one, we have continued to invest in our hardware franchise and have brought new features and capabilities that help customers automate their environment. And as a result, when customers are really trying to create these hybrid cloud implementations where they have to have hardware on-prem, but they also need to have applications in public cloud, they can go to F5 as a partner that can help them balance the load between public cloud and on-prem environment. A good example of that, I'll give you, we have a customer, a global retailer, that really needed to deal with spiky traffic on their website in the peak retail season. They're using F5 on-prem for hardware, and they're using our virtual edition in the public cloud, and they are bursting into the public cloud with our virtual edition where necessary, but built with automation that allows them to go from one to the other. So the investments we've made there, you know, have really created a unique proposition for our ADC business, and we're seeing more and more customers want to move to these automated hybrid cloud environments. The second element driving hardware is security. We continue to grow our security hardware business across, you know, application security, encryption, decryption, and protection against ransomware, And then we've also seen strong performance and resilience in the service provider market for hardware, driven by 5G traffic, where we have seen augmentation of capacity on both 4G and now 5G infrastructure. So these are the drivers really on the hardware business. Of course, we have been challenged to ship all of that demand, as you have seen with the backlog in 2022, but we expect that to steadily increase to 2023. Franck?

Yeah, and Sammy, broadly speaking, on your question, it's a bit still of a supply chain issue. And where we see the supply chain right now, it's actually improved. with generally fewer vendors decommitting to us and improvement and component availability. There remains a few critical components that we have still gotten some decommits on. We were fortunate in Q4 and buffered in Q1 some of our ability to go to the broker market and access those components. I can't promise that we will continue to be able to do that because these have been in and out of the market. What I feel strongly about is that certainly Q3 and Q4 are going to be the big shipping quarters for us for systems. The mix between Q1 and Q2, I feel less confident about that today, but there are a lot of efforts that our engineering team has been successful in re-spinning and redesigning. Some of those have come in early. The balance of those should be done by the end of Q2, the beginning of Q3, and that's what gives us confidence in the back half. But whether Q1 is the low point or Q2 is the low point, that is still TBD depending on, you know, a few of these critical components. But the good news from our perspective, you know, the supply chain is definitely improving broadly.

There are just still a few things that are at risk for us. Got it. Thank you. Appreciate it. Thank you. We'll go next now to Alex Henderson of Needham.

Great, thank you so much. I was hoping we could talk a little bit about the mechanics that you're assuming into the current quarter and forward year guidance. You talked about some pipeline erosion during the quarter. You talked about closure rates weakening and delays in projects. So I was hoping you could talk about what you're assuming when you look forward in terms of those metrics? Are you assuming they stay at the current depressed rates, rebound back to where they were prior, or get worse from here? And particularly, are the projects that have been delayed expected to stay delayed or be canceled outright given the environment?

Hi, Alex.

So when we look to 2023 and our guidance for software specifically, our assumption is that what we have seen in terms of the renewal of existing multiyear subscriptions, that the healthy renewal rate that we're seeing on these projects continues. And we've seen that throughout 2022. And from the utilization that we see in these projects from customers, we don't expect a materially different behavior from customers on renewal rates. We are, on the other hand, assuming that we will see more projects delayed or that they will be resized and sized down by customers. and that there will continue to be way more scrutiny on especially these big multi-year projects than there were in the last year. And so that will affect the new business in terms of new multi-year subscription agreements. And so we don't expect, we're not planning on year-over-year growth coming from these large new projects in 2023. And for reference, Alex, when you look at our total software business, the new business still represents over half of our total software business. And so we have still a meaningful dependency on this new business. And that's the part that will be affected in 2023 with this macro environment. Now, if you go beyond 2023, we actually expect that the rate of these new projects will come back up. We expect to continue to have a healthy rate of renewals and expansion. And over time, we also expect our SaaS and managed services business to scale and grow. And so with these factors, we still consider as a long-term growth rate for our software, a 20% plus growth rate.

to be the right target for us.

Great. One last question. The systems business, can you talk about the mechanics around the transition from the I-series to the R-series as 23 progresses? Would you expect by the back half that more of the product, clearly it's going to be more, but a larger percentage or meaningful percentage change in the mix between I and R?

Yes, Alex, we expect that the transition between I-series and R-series will accelerate in 2023, and especially in the back half of 2023. I don't have the exact mix for you here, but I think, Alex, you should be assuming that exiting 2023, the large majority of what we will ship will be R-series rather than I series.

Great. Thank you very much. I'll see the floor. Thank you. We take our next question now from Samic Chatterjee at JPMorgan.

Hi. Thanks for taking my question. I guess for the first one, I'm just still trying to understand your guidance on the systems revenue for fiscal 23 a bit. You had a big step up here in the systems revenue from buying components from the broker market. I just want to understand if you're embedding that you can sort of continue on that path and essentially F4Q is sort of where you build on top of by going into the broker markets and buying from there to satisfy sort of demand from your customers. Or if you were to do that, is there more downside to the gross margin expectations that you outlined in terms of premium cost for that? And I have a follow-up. Thank you.

Sure, Smeag. So when I start with that, and certainly Francois can jump in, the assumption is actually that there is an improving gross margin as we work through the quarters, largely because we are not actually dependent on the broker market to get some of these critical components that we have gone through our redesigns and respends. And we are now shipping product without the critical components that have plagued us for the past six to eight months. That work is expected, as I said, to, you know, be largely completed by the end of Q2, beginning of Q3. And that is baked in as our assumption into our gross margins and our operating margins for the year.

Yeah, and, Sadiq, I think the general – let me just add to that.

The general – what we've seen in the supply chain just over the last 90 days is Generally, we've seen more stability than we had in the prior quarters. And by that, I mean we're seeing less decommits than we had seen before. Other decommits continue to happen. We are hearing from suppliers that they're starting to get a little more capacity at fabs on their supply. And generally, specifically to us, we have seen also more progress made by our suppliers on extending capacity. So these aspects give us more confidence in hardware going into 2023. But I would say, as Fong pointed, probably the biggest factor for us is the engineering work that we've done inside of S5 to design around the most constrained components. Part of that has already delivered. and more will deliver in the next three to six months. And that's why we feel we should have a very strong back half of the year on hardware.

And Francois, I guess for the second question of the follow-up here, I know creative to your portfolio and particularly with the growth in software starting to moderate a bit, you're seeing customers prefer sort of the CapEx model or the OpEx model in relation to your portfolio. That's sort of different from what we're hearing from most of the other companies where they tend to see customers move more towards an OpEx model, particularly if they're concerned about the macro. And I'm wondering if you think there's something there in terms of how the virtual editions are set up, in terms of the convenience of spinning them up or setting them up relative to also the magnitude of the architecture changes that a customer has to do. Are there opportunities Are there alternatives there that you're thinking of in terms of making that transition easier for customers that doesn't look like a big lift and shift for them in some cases because it does sound like you're seeing more of a sort of trend that's different from what we're hearing the customers really prefer going into a tough macro.

Yeah, I think the general trend at a macro level

I think over time, there will be more customers that are buying subscriptions and buying SaaS services than there are today. I think that's the general micro trend in the industry, and I think we will follow that trend. The good news for F5 is that we have positioned our portfolio to be able to serve all these consumption models, perpetual license, subscription, or SaaS, and also to be able to serve customers in hardware or in software, or in software as a service. And so where we feel this is an advantage is that there are a number of customers. So there's different behaviors by customer segment. And there's different behaviors at different points in time. Already in the quarter, we have seen some customers that have OPEX pressure and still want to move forward with a project, but they want that project to be capitalized. And so these are customers that would have gone to an OPEX subscription model. And because we are able to offer a CAPEX project, they are able to move forward with the project, but they would not have been able to move forward otherwise. And so I think in a year of constrained budget in 2023, we are going to see more of that, of potentially some customers going to CapEx, others that were on CapEx moving to OpEx. And the flexibility that we offer, we believe, is actually a strong advantage. Over time, I think the trend that I described at the beginning is still the trend. But the flexibility that F5 provides is quite a strong advantage.

Thank you. Thanks for taking my questions. We'll go next now to Paul Silverstein at Cowen.

Thanks. Francois, I apologize that this has already been asked. I'm actually going back and forth between two different calls. But going back to your comments about softness, the delays, the downsizing, et cetera, can you quantify for us how many customers, how many projects you're talking about? Is this widespread or is this – a handful, several handfuls of very large projects that you're referring to in terms of just how pervasive the weakness that you're referencing?

I would say, Paul, first of all, it was most acute in EMEA and APCJ, where it was the combination of, you know, of course, inflation, you know, currency exchange volatility, and folks feeling the crisis coming and wanting to really restrain budget. So this is where it was most acute. In terms of the number of customers, it's not hundreds of customers, but it is definitely in double digit. number of deals where we saw that. Typically, those are deals that are million-dollar-plus deals. And so that just gives you a sense of the impact of these deals being pushed out.

Francois, did I hear you say it was most acute in EMEA and Asia-Pac? Was that the comment?

Yes.

Was there any appreciable weakness in North America, U.S. in particular?

We saw a little bit of this in North America, but overall, I would say there wasn't a meaningful, I would say, change in customer behavior in North America to date. Now, in our guidance, Paul, we are assuming that we will see more of this in North America, of this scrutiny on budgets, And deals being delayed and forced out. But I mean, to give you an example of the behavior, Paul, we had some companies that were large multinationals with multiple billions of euros of revenues, changing their process to say that any deal above $200,000 has to be approved at the board level. So that gives you a sense of the level of scrutiny we saw, especially in Europe and Asia-Pac. But that behavior was a lot less in North America today.

And your concern about North America in terms of looking forward, that's just being prudent or there's signs based on your conversations with North American customers that would caution you about the future outlook?

I would say we've not heard...

directly from North American customers to date that they, you know, they were going to change their patterns and do this. So I would say it's a combination of being prudent and feeling that just the North America will not be immune to these changes in customer patterns over time, whether it happens this quarter or two quarters from now, you know, I can't predict that fall. But our working assumption is that we're going to see it here in North America.

And just to tie this up, Francois, my last one here. Juniper tonight announced simultaneously with you, they referenced a little bit of the macro that you're referencing, but not meaningful either in the quarter in their guidance. And I'm just wondering, at the risk of asking an unfair question, is it something specific to your product market that would account for the discrepancy between what you appear to be experiencing and what they appear to be experiencing, or, I mean, it sounds more widespread or more generic, and it sounds more FX plus perhaps the Russian impact on Europe in terms of why it's worse outside of North America or meaningfully different, but any thoughts you can share?

Yeah, a couple of things on that. First of all, I should say what I've described is something we've seen mostly in the enterprise segment. So I wouldn't say that we've seen a substantial change in approach in the service provider segment. Service provider was strong throughout 2022 and was strong in Q4. So that's a difference in terms of the segment that I'm focused on here. And then as it relates to Going forward, as I said, we've not to date seen it in North America, but we expect that we will see. I should also add, what I'm seeing as a behavior I do not think is specific to our product segment, because it's processes that are changing in our customers that affect IT spend in general. And so the deals that I mentioned were pushed out. We haven't seen actually any deals lost to competitors. So the competitive dynamics haven't changed. We still, you know, continue to win more than our fair share of deals. So I don't think it's F5 specific or product specific. I think it's certainly in Europe and Asia-Pac. I think it's broader.

Is it balanced across both or is it mostly Europe? It's balanced across both. I appreciate the responses. Thank you. Thank you. We go next now to Meta Marshall at Morgan Stanley.

Great. Thanks. I just wanted to get a sense of, with your customers, what are the biggest inhibitors to kind of the R-series transition today and them still opting for I-series? And then, you know, should we assume that the vast majority of the gross margin headwinds are primarily due to the broker purchases for the I series, or are they kind of across both I and R series? Thanks.

Thank you, Meera.

So, the biggest headwinds to transitioning to R series are two, really only two. One is qualification of the broker. So for customers that don't operate R-Series today, they have to go through a qualification cycle. But we have done some things to make that cycle as short as possible. And the second issue is component availability and our ability to ship to demand on R-Series. Those are the two gates, Medha. Now, I should say what we are seeing so far is that the ramp to R-Series in terms of demand It's the fastest ramp that we have ever seen in a transition from one generation to the next. And we expect that to continue because of the capabilities in our series. Of course, price performance is one, but the ability to operate in this more automated environment that customers want to have when they want to balance traffic between on-prem and cloud or private cloud and public cloud environments. So that's why we're seeing a fast ramp to R-series. And then as it relates to broker buys affecting gross margins, that is true both on I-series and R-series.

Great. Thank you. Thank you. We go next now to James Bishop, Piper Sandler.

Hey, guys. I just wanted to circle back to Alex's question from earlier a little bit. Appreciate the color on the perpetual versus term and SaaS, but is there a way to think about how each of these three buckets finish the year in aggregate? And as we're thinking about this 15% to 20% growth, you had mentioned that still over half the business in software is on new, but roughly where should we finish then? for new business versus renewals in fiscal 23 for software?

I appreciate the question, Jim. We are not splitting out those components at this point, but I think some of the guidance that Francois said in his discussion point on if you take a look at the midpoint of our guidance on software range, and we need more than half of that coming from new business, that will sort of give you some sense for the renewals plus the true forwards plus the SaaS business is less than half of that number. As we think about how that's going to continue to grow, I'm not going to say at the end of FY23, but clearly as we take a look out, particularly as the SaaS business matures more and more over the coming years, we expect that contribution to come down such that that new business contribution to the overall 20% growth rate is not nearly as strong as it has been at the point where we have to where we are today. And so that's the anticipation that we've got in the longer term of the 20 plus percent growth rate. And those are the dynamics that we see compounding upon themselves, you know, particularly as we reach the second or the third or the fourth a renewal cycle within these flexible consumption programs on top of the growth in the SaaS platform that's frankly still nascent in its overall revenue contribution to the company.

Maybe just to switch gears off of software and top line stuff, but on the free cash flow side, that conversion rate continues to come down and I get it's something you and I talked about around unbilled receivables given the term transition. um and some of the uh inventory purchases but at what point does that free cash flow conversion rate begin to you know inflect higher and start normalizing um a little bit more and is there a way to kind of normalize the cash flow for those higher inventory purchases going on yeah jim certainly our hope is that you know the the double purchases for the platform that we've had this year the expedite fees

um and you know the the purchase price variances uh we believe uh you know have hopefully peaked out uh you know in in fy 22 maybe the beginning of fy uh 23 but that things will start to improve from there and you will really be looking at a convergence point that is that is much healthier uh than what we have seen so far in fy 22. So we do expect pre-cash flow to certainly tick up in FY23 much more so than what we saw in FY22. But I'm not going to give you an exact forecast of it at this time. The dynamics that have driven that down, though, are starting to dissipate and will dissipate even further once these redesigns are done. And we are purchasing components at a much better rate, as well as you know, more and more of the second and the third year clips in where you're not getting as much revenue as you are from free cash flow from the flexible consumption programs.

Thanks, Frank. Yep. Thank you. We'll go next now to Simon Leopold of Raymond James.

Hi, this is Victor Truen for Simon Leopold. You noted the delays from international customers. Was this primarily driven by FX? Maybe can you help us quantify the demand impact that you've observed from goods becoming relatively more expensive for international customers? And a quick housekeeping question. You're under the assumption that F5 transacts mostly in US dollars. Is that a correct assumption?

Yeah.

Yeah, that's a correct assumption. So the question, was it driven by FX? Yes. FX, of course, had a large impact on that. But of course, if you are specifically, I would say, in the world of hardware, if you're a customer purchasing in euro or yen, and we've done a price increase, two price increase that have increased hardware a little over 20%. And on top of that, you've had significant devaluation of your currency. your budget does not buy you as much as it did. In software, that is a little less pronounced because there hasn't been as much of a price increase in software. But despite that, we saw these deal delays in software, primarily internationally, and I would say it's a combination of inflation, currency devaluation, and just macroeconomic environment and people preparing for a tough economic environment and changing their approach to spend.

So your outlook assumes that the FX environment kind of stays as it is and doesn't kind of incorporate any improvement in your outlook for next year?

That's correct. Okay. Thank you very much. Thank you. Thank you. We go next now to Amit Daryanani at Evercore.

Hi, this is Lauren on for Amit. So two from me. Can we first kind of start on backlog and kind of how you're thinking about maybe a potential work down in fiscal 23 and kind of your comfort around maintaining gross margins at around 80%. And then the second, the EPS guide for the full year is low to mid-teen growth, but the Q1 guide implies about down 12%. So how are you thinking about kind of the ramp as you go throughout the year? Thank you.

Sure. So why don't I start on the back half of that question on the ramp. Obviously, you know, the year-over-year Q1 to Q1, we did not have the same type of headwinds in revenue in Q1 last year that we do this year associated with And so that is anticipated in our guidance on, you know, declining Q1, but, you know, ramping fairly dramatically, especially as we get to Q3 and Q4.

And so those will, that's the back half of the question. Well, the second question is to, you know, the first part of the question.

Yep, yep, sorry. I apologize. Oh, on backlog. So as we think about backlog for the year and working down that backlog, from a customer satisfaction standpoint, we would like to work down that backlog as quickly as possible. We are actually getting multiple requests, particularly from our sales force, on how quickly can we get boxes out in order to improve the outlook for new orders coming in. And so as quickly as we can work down that backlog, we will. Where we end up at the end of the year, I do not know in the blend between the demand environment that we expect to see versus our capacity to ship, which is mostly what our outlook on systems revenue is based on.

Got it. Thank you. Yeah, sure.

Thank you. And due to time constraints, we will take our last question this afternoon from Jim Suva of Citigroup.

Thank you very much. I heard you mention something about second half of fiscal 23 being more back half loaded for demand or I guess deliverable. Was that on both the hardware and the software? And was it more from your discussions of your customers or more just you can't get all the components together to complete the various items? Because I'm just kind of wondering on a software side, it seems like it would be a little bit early to say back half loaded for something nine months from now. Thank you.

Yeah, Jim, the guidance was purely about the ability to ship systems and the rework that we are doing and the component availability for those new builds. And so that's our expectation is that Q3 and Q4 are going to be a much stronger systems revenues quarters than Q1 and Q2 for us.

Thank you for the detail. That's great. Thank you. Thank you. And this will conclude today's call. You may now disconnect.