F5, Inc.

Greetings and welcome to the F5, Inc. first quarter fiscal year 2023 financial results conference call. At this time, all participants are in a listen-only mode. A brief question and answer session will follow the formal presentation. If anyone should require operator assistance during the conference, please press star zero on your telephone keypad. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Suzanne Dulong. Thank you, Suzanne. You may begin.

Hello and welcome. I am Suzanne Dulong, F5's Vice President of Investor Relations. Francois Loco-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 A copy of today's press release is available on our website at F5.com, where an archived version of today's audio will be available through April 24, 2023.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 webcast by phone, dial 877-660-6853 or 201-612-7415 and use meeting ID 1373-5357. The telephonic replay will be available through midnight Pacific time, January 25th, 2023. 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. Against the backdrop of a continued tough environment, our team delivered first quarter revenue at the midpoint of our guidance range and earnings per share above the high end of our range. We came into Q1 expecting we would see deteriorating close rates and that the dynamics concentrated in EMEA and APAC in Q4 would spread to North America. In Q1, we experienced heightened budget scrutiny and more pervasive deal delays across all geographies. The dynamics are particularly challenging on larger transformational-type projects, which for us tend to be software focused. Like last quarter, new multi-year subscriptions were most affected. We noted last quarter that we were not planning on year over year growth from new software business this year. However, in Q1, it was down a double digit percentage year over year. Based on customer feedback, we believe we are seeing the impact of financial decisions resulting from broader economic uncertainty pervasive budget scrutiny and spending caution as opposed to technological, competitive or architectural decisions. In contrast to what we saw on new software business, software renewals performed largely as expected in the quarter. At the same time, improving supply chain conditions aided our hardware revenue, making it possible for us to ship systems to waiting customers. In addition, our Q1 maintenance renewals were particularly strong, which in the past has correlated with customers sweating assets. Despite the environment, we continue to expect 9% to 11% revenue growth for the year, albeit with a different mix than we initially forecasted. Given the demand trends of the last quarter, it is challenging to call our revenue mix with precision. However, With supply chain improvements and the benefit of our system redesign efforts coming to fruition, we continue to see a second half acceleration in our systems revenue. In addition, based on the solid maintenance renewals we experienced in Q1 and now forecast for Q2, we expect global services revenue will be stronger than we initially anticipated for the year. As a result, we expect the combination of stronger systems revenue and global services revenue to offset software headwinds in the year. We also continue to expect non-GAAP earnings growth in the low to mid-teens for FY23. We remain committed to maintaining double-digit non-GAAP earnings growth this year and on an annual basis going forward. And we will continue to evaluate our cost base and take further action as needed to achieve this goal. In the current environment, customers are focused on minimizing their spend and optimizing their existing investments while also continuing to drive revenue. We are confident that we are well positioned to help them do exactly that. For instance, during Q1, we closed a significant multi-cloud networking win with a tier one North American service provider. The customer selected F5 distributed cloud services as the core for its next generation managed service offering based on the platform's ability to deliver a scalable, agile, and dynamic infrastructure. This is the second such win for the platform. F5 distributed cloud services makes it possible for service providers to monetize their substantial network investment, including investments in 5G. The platform enables a managed service offering that solves critical challenges for enterprise customers, like simplifying the deployment and operations of applications across multi-cloud and edge environments. Customers also remain focused on application security, and F5 Distributed Cloud Services is also winning security use cases. In Q1, a healthcare customer selected our managed web application firewall and API protection solution after a proof of concept evaluation against both their incumbent CDN provider and a cloud-native solution. The customer selected F5 distributed cloud services because it proved more effective against threats while also being easier to manage. Our solution also met the customer's stringent regulatory requirements. Finally, customers are focused on total cost of ownership. As a result, we continue to drive good traction with our next-generation hardware platforms, R-Series and Velos. These next-generation platforms can dramatically reduce customers' total cost of ownership by offering cloud-like benefits for on-premises systems. Clearly, the enterprise spending environment has changed from six months ago. That said, the breadth of our portfolio positions us well. The number of applications continues to grow, and those applications and the infrastructures needed to deliver, secure, and manage them continue to get more complex. Customers need a partner like F5 who can help them simplify, reduce total cost of ownership, and make the most of the budgets they have. Our broad solutions portfolio, combined with the consumption model flexibility we offer, squarely addresses these requirements. Now, I will turn the call to Franck.

Franck? Thank you, Francois, and good afternoon, everyone. I will review our Q1 results before I speak to our second quarter outlook and provide some additional color on our FY23 expectations. We delivered first quarter revenue of $700 million, reflecting 2% growth year over year. Global services revenue of $360 million grew a strong 5% in part due to the high maintenance renewals Francois mentioned and also reflecting previously announced price increases. Our revenue remained roughly split between global services and product, with product revenue down slightly year over year, reflecting softer demand across all geographies and representing 49% of total revenue in the quarter. Continued supply chain improvements enabled systems revenue of $173 million down 4% year-over-year. Q1 software revenue grew 3% to $168 million against a tough comp last year. Let's take a closer look at our overall 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 $129 million, or 77% of Q1's total software revenue. Perpetual license sales of $38 million represented 23% of Q1 software revenue. Within our subscription business, as Francois noted, new multi-year subscriptions performed significantly below plan in Q1, while renewals performed largely as expected. Revenue from recurring sources contributed 68% of Q1's revenue. This includes revenue from term subscriptions, SaaS, and utility-based revenue, as well as the maintenance portion of our services revenue. On a regional basis, revenue from Americas was flat year-over-year, representing 57% of total revenue. EMEA grew 14%, representing 26% of revenue, and APAC declined 7%, representing 16% of revenue. Enterprise customers represented 62% of product bookings in the quarter, service providers represented 21%, and government customers represented 17%, including 6% from U.S. Federal. I will now share our Q1 operating results. Gap gross margin was 77.9%. Non-gap gross margin was 80.4% in line with our guidance for the quarter and below where we expect to be for the year. Gap operating expenses were $454 million. Non-gap operating expenses were $378 million in line with our guided range. Our gap operating margin was 13%. Our non-gap operating margin was 26.5%. Our gap effective tax rate for the quarter was 24.5%. Our non-GAAP effective tax rate was 21.4%. GAAP net income for the quarter was $72 million, or $1.20 per share. Non-GAAP net income was $149 million, or $2.47 per share, above the top end of our guided range of $2.25 to $2.37 per share. EPS was aided in part by currency gains related to a weaker U.S. dollar in the quarter. I will now turn to cash flow and the balance sheet. we generated $158 million in cash flow from operations in Q1. Capital expenditures for the quarter were $13 million. DSO for the quarter was 62 days. This is up from historical levels primarily due to strong service maintenance contract renewals in the quarter and to a lesser degree, back-end shipping linearity resulting from ongoing supply chain challenges. Cash and investments totaled approximately $668 million at quarter end reflecting the pay down of approximately $350 million in term debt remaining from our SHAPE acquisition. During the quarter, we repurchased approximately $40 million worth of F5 shares or approximately 263,000 shares at an average price of $152 per share. Deferred revenue increased 12% year-over-year to $1.76 billion, which is up from $1.69 billion in Q4. This increase was largely driven by particularly strong service maintenance renewal sales reflecting the trend of customers sweating their existing infrastructure while recalibrating budgets. Finally, we ended the quarter with approximately 7,050 employees. I will now share our outlook for Q2. Unless otherwise stated, my guidance comments reference non-GAAP operating metrics. We expect Q2 revenue in the range of $690 to $710 million, with gross margins of approximately 80%. We continue to expect our gross margin will improve in the second half of the year for two main reasons. First, we expect some of the ancillary supply chain-related costs, like expedite fees, will begin to abate. Second, with our engineering efforts to redesign around some of the more challenged components nearing completion, we expect to be less dependent on the broker market, where cost for critical parts has been exorbitant. We estimate Q2 operating expenses of $368 to $380 million, and our Q2 non-GAAP earnings target is $2.36 to $2.48 per share. We expect Q2 share-based compensation expense of approximately $64 to $66 million. Given our Q1 results and our Q2 expectations, I also want to elaborate on our FY23 outlook. We continue to expect revenue growth of 9% to 11% for the year. Given the demand trends we have seen in the last four months, we expect our FY23 revenue mix will reflect revenue contribution weighted more towards hardware and services and less towards software than we expected a quarter ago. Our FY23 software growth is likely to be lower than the 15% to 20% we initially expected due to budget scrutiny and project delays pressuring new software contracts. This is offset by the probability of stronger systems growth given supply chain improvements and the benefit of our system redesign efforts coming to fruition. In addition, based on the strong maintenance renewals we experienced in Q1 and forecast for Q2, we now expect global services growth of mid-single digits, which is up from low to mid-single digits growth we forecasted previously. As Francois noted, we continue to expect non-gap earnings growth in the low to mid-teens for FY23. We remain committed to maintaining double digit earnings growth this year and on an annual basis going forward. We will continue to evaluate our cost base and take further action as needed to achieve this goal. I will now turn the call back over to Francois. Francois?

Thank you, Frank. In closing, I would ask you to take away three things from this call. Number one, that despite the environment, we remain committed to delivering double-digit earnings per share growth this year and on an annual basis going forward. Number two, While we believe 9% to 11% revenue growth for the year is achievable, if we get demand signals that tell us it is not, we will exercise operating discipline and adjust our cost base in order to achieve our earnings goals. And number three, we have built a strong business model with nearly 70% recurring revenue, product revenue that is split 50-50 between hardware and software, and global services revenue that has proven durable. The result is a diversified and resilient revenue base, which when combined with operating discipline, enables us to drive revenue and earnings growth in this environment. Operator, please open the call to questions.

Thank you. We will now be conducting a question and answer session. If you would like to ask a question, please press star 1 on your telephone keypad. The confirmation tone will indicate your line is in the question queue. You may press star two if you'd like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star keys. One moment, please, while we poll for questions.

Thank you.

Our first question is from Sammy Badry with Credit Suisse. Please proceed with your question.

All right. Thank you very much for the question, or this opportunity to ask questions. I have two. First one is, could we just decompose the services revenue growth? You mentioned price increases and then maintenance renewals. Could you kind of split that reported number into each, like what was stronger? Was it more renewals, et cetera? We can just decompose that. The other question I have is, you know, clearly the IT landscape has shifted. And I think the big question myself and other investors are asking ourselves is if there is incremental risk through the year, as far as demand or demand signals changing, and let's just say they get worse, how will those signals manifest themselves into F5's business and results? And, you know, a good example, a question we get is, you know, if things decay or deteriorate, does that mean that product orders sitting on your backlog get canceled? Is that kind of the deterioration that would yield that kind of output? And, you know, to get your comments on those two questions.

Sure, Sammy. So I'm going to start with your first question, and then I'll let Francois take the second. It's Frank. So we didn't give an exact split out, but I would say it's roughly even between the two. I think the renewal rates continue to go up, particularly on those services business, and we've seen less discounting, given the environment that we see of people continuing to sweat assets, putting focus on that. and taking the price increases that were put in place a couple of quarters ago, and we're starting to see the benefits of that come through to the services revenue. So I'm not going to give you the exact split, but I would think of them as roughly equal between the two. And I'll let Francois talk to your second question.

In terms of the overall environment, yes, the overall IT spending environment has deteriorated quite meaningfully over the last six months. And we're seeing that mainly in terms of softer demand than clearly what we were seeing six months ago. Now, the way you would see that in our results, it's not in order cancellations because the appliances that our customers buy from us are typically mission critical to deliver on applications that actually need the capacity. So we haven't seen any trend in order cancellations, nor do we expect to see any of that. In fact, our customers have been pressing us to ship to them the backlog that we have built over the last couple of years and a lot of the orders that they've placed that we haven't delivered on. And so we continue to work hard on our improvements in supply chain in order to be able to meet that. Where you are seeing this different environment in our results, and clearly we're seeing a number of software projects that have been delayed, a lot more scrutiny on deals, and that is actually affecting our software growth rates, and you're seeing that in the result. And we've seen it, frankly, across the board in terms of software demand in software, but also software demand in hardware this quarter than we had a quarter or a year ago.

Thank you.

Thank you. Our next question is from Tim Long with Barclays. Please proceed with your question.

Thank you. Two, if I could. Sorry. Could you talk a little bit about, you know, the software businesses, kind of which pieces of it you're maybe seeing more of an impact than others? Is it some of the SaaS businesses or it sounds like a lot of the term deals? But anything you can split apart there to let us know, on that. And then related to that, why are we still talking about the distinction between hardware and software? I don't think you guys really sell the solutions that way. So could you just give us an update why we still need to look at that distinction? Thank you.

Thank you, Tim. I will take your two questions. So let me start on the the question of where are we seeing the software demand on software. I think if we split the software between existing contracts that have renewals or true forward or expansion versus new contracts, the renewal of business on existing contracts largely performed as expected. And where we saw most of the software demand was on new contracts and new projects. which, you know, we had said we expected this year, you know, in the past three years, new software business had grown pretty significantly year on year. We expected coming in the year that new software projects would be flat year on year. And what we saw in the first quarter was more of a, it was down double digits relative to last, you know, last Q1. So this is where we saw more of the pressure. Whether it affected more of the SaaS business or the term subscription business, I would say it was quite indiscriminate across product lines, what we saw. But of course, the most significant impact in terms of in-quota revenue was really in these multi-year term subscription deals. That's really what was a bigger impact on Q1 revenue. In terms of the hardware software distinction, Tim, it's a good question. Look, I think this year certainly, and there was also that effect last year, that there is a dynamic around hardware where, you know, last year we had a lot of demand that we couldn't really ship because of supply chain issues. And this year we're looking to improve on our supply chain and be able to, you know, to to ship all the orders that we've had in our backlog. And we've made a lot of progress on the supply chain to be able to do that. But it's true that a lot of our customers consume both hardware and software. We think there's going to continue to be a trend from our customers towards more software-first environments. And that's because of the way they want to consume the technology ultimately. But when we look at the total performance of the company, we focus less on that distinction than driving earnings growth, specifically double-digit earnings growth, and we're absolutely committed to driving that, regardless of the dynamics between hardware and software.

Okay. Thank you.

Thank you. Our next question is from Alex Henderson with Needham. Please proceed with your question.

Great. Thank you very much. I'm hoping you could address a little bit about what your backlog in systems looks like. I think it was running, you know, 40% to 50% of Ford four-quarter product sales in systems. And, you know, I was hoping you could give us some insights there in terms of, you know, what the backlog is at. And then second, obviously, getting the R series out is a in March of last year was an important milestone, but there was a lot of application functionality that you needed to get built into it in order to solve individual customers' needs in order to replace the i-Series. And I was hoping you could give us an update on where you are on that, and do you think that that then creates post, say, the June quarter, a refresh cycle on the large install base of I-Series.

Alex, let me start with the backlog question. I'm going to turn it over to Francois for your second question. So on backlog, what we've talked about is that we will disclose that once a year if it's material, meaning more than 10%, but we weren't going to talk specifics in any one given quarter. I will say, similar to Q1 last year when we talked about percent move up, We were down a bit more than 10% this quarter in backlog from where we ended in Q4. And that was largely a result of our ability to ship based off of some of the product redesigns that we were able to achieve. And so we were quite happy with seeing that reduction in backlog from a customer satisfaction standpoint. And then Francois, I think we'll talk to your second question.

So Alex, on the R-Series, there have been two factors that have sort of gated the rampant growth of the R-Series over the last several quarters since we launched it. First is what you mentioned, the number of use cases and applications that R-Series could cover relative to the I-Series. And second was our ability to build and ship R-Series, which has been significantly constrained with some of the components. The good news is both of these factors are going away over the next couple of quarters. So on the supply chain factors, we are seeing better component availability and also access to broker markets where we are still constrained. We still have constraints on our series. We still had MQ1 and we'll still have MQ2. But a lot of the redesign efforts that we have already done will be complete by the end of our second quarter. And so we are seeing lead times on R-Series will be improving in our second quarter and beyond. And then the second aspect in terms of the application, the number of use case that R-Series can cover will pretty much be at parity with I-Series, if not in the June quarter, in the September quarter. So in both cases, there's a lot of progress. There is a lot of demand for R-Series I think you should expect that our series will certainly grow into FY24 to become the vast majority of what we ship in terms of appliances.

Great. Thank you. Thank you.

Our next question is from Sameek Chatterjee with JP Morgan. Please proceed with your question.

Hi. Thanks for taking my question. Francois ask you to sort of shed a bit more color on in terms of budget scrutiny, which regions as well as customer... We're having a hard time hearing you.

You may want to speak up.

Hi. Can you hear me now?

Yes. Much better.

Thank you. Okay. Hi. So first question was really more about sort of Francois' comments on the budget scrutiny that you're seeing. Which regions and maybe customer verticals as well are you seeing the most sort of scrutiny from? And Where do you stand in relation to like as you sort of are in the early days of fiscal 2Q in terms of either quantifying it in terms of a sales cycle or conversion cycle? Are you continuing to see those sort of conversion cycles get extended or timeline get extended? Or are you starting to find the sort of levels set to a longer duration in terms of the conversion cycle? And have a follow-up. Thank you.

Thank you, Sameek.

So in terms of where we saw software demand in software, it was – you know, across the board in terms of verticals and geographies. You know, so if you remember in Q4 I said, you know, the international EMEA and Asia Pacific in particular were quite affected. We actually did see that clearly in North America as well this quarter. And it was also, I would say, across most of our verticals. I think it was more pronounced in the technology sector large tech companies going through substantial revisions of their budgets, and to some extent, I would say financial services. These are perhaps where the effects were more pronounced. In terms of the rest of the year, it's too early to have full visibility on the rest of the year. I would say our expectation is that the dynamics that we have seen in our first fiscal quarter as it relates to software will largely continue in our second fiscal quarter. But beyond that, it's too early to speak to the visibility.

Got it. And thanks for that, Francois. For the follow-up, I mean, you mentioned customers are sweating the assets a bit more, which is sort of you're recapturing some of that on the services side. But in terms of the systems demand and the There is obviously a supply chain piece here, but how are you thinking about sort of the upside to system demand as some of the maybe software transformation projects get delayed and drives some level of sort of utilization of hardware appliances, which always had sort of great performance? So how are you sort of looking at the upside on the system side from that delay as well? How would you quantify that?

You know, I think, Sameek, in terms of the system demand, as we said earlier, we also saw softness in systems demand this quarter. So this effect on budgets and scrutiny from our customers at large affected both the software and the hardware demand to an extent. The upside in demand, frankly, is, sorry, In hardware revenue for the year is, you know, we said at the beginning of the year, we felt our hardware revenue forecast was really a shipping forecast. And, you know, the upside and the stronger second half that we see in hardware is really driven by ability to ship more hardware. So you should see a step increase in our hardware, you know, revenue in Q3 and Q4 from the first half of the year because of the improvements we've made on supply chain. In terms of demand specifically, I don't think the pressures of software would necessarily create stronger demand on hardware at this point in time in the environment, because I think our customers are really trying to sweat their assets and try and limit the utilization to not exceed the capacity that they already have in place to the extent they can. I think that can only go on for so long, at which point they will have to buy and add capacity. But I do think that the improvement in supply chains, as lead times improve, we will see some demand that is latent, that has been gated by the fact we're not able to ship. So a lot of customers, because we haven't been able to ship orders that they placed two, three, four, five months ago, and they haven't been able to project or implement their solution, are not able to place the next order. And I think as we resolve that, we should see some improvement there in demand from these customers.

Thank you. Thanks for taking my questions.

Thank you. Our next question is from Amit Daryani with Evercore. Please proceed with your question.

Thanks for taking my question. I guess I have two as well. Franco, maybe just going back to this product systems discussion a little bit, the risk or the fear folks would have is, listen, the macro remains soft and IT budgets remain under pressure. why wouldn't customers push out or sweat their appliances more? And so then, you know, maybe just talk about how do you have confidence that this appliance or systems business recovers in the back half if the macro remains challenging and the backlog can remain strong?

Well, I would say, look,

Where we have strong visibility is for us to achieve the revenue forecast we have in hardware, we don't necessarily need a very strong fundamental recovery in hardware demand than we have today because of the visibility we have on revenue and our ability to ship, including our backlog. In terms of what I think, there's a real question as to when do I think this recovers and demand picks up again. It's difficult to predict, but what I can tell you is this. The fundamental drivers of what gets customers to buy F5 hardware or software are still there. They are tied to the growth in applications, and applications continue to grow, the complexity of these applications, and the deployment models, the fact that these applications increasingly live in hybrid and multi-cloud environments. all of these drivers are fundamentally there. So demand can be suppressed, you know, for a period of time, a couple of quarters, three quarters, four quarters. But where we have a ton of confidence is that it is going to come back because the fundamental drivers of our business and what our customer is doing are still there and will continue, including, I should say, you know, attacks on applications that drive demand for security for applications. So all of those things are part of, you know, what gives us a lot of confidence that it's going to come back. In this current environment, the fact that we've built the flexibility that we have built around our consumption models and our deployment models plays very well because some customers have pressures on CapEx, others on OpEx, and our ability to serve them one way or the other you know, is one mitigant, if you will, and it's one of the aspects that we think provides the resilience that you're seeing in our business and operating model.

Got it. That's really helpful. And then if I could just touch on the software side, you know, I know you folks talked about, you know, the growth will be sub the 15% to 20% range that you talked about previously. Is there anything about what the new range would be or, you know, what does the trajectory of software look like as we go through fiscal 23rd? And then does this alter at all what you're seeing, your longer-term expectations you've had from the software business beyond just this year? Thank you.

Let me start with the last part. It does not alter our long-term view, Samik, because of the drivers that I'm just taking you through. We think our customers will continue to deploy software in – sorry, will continue to deploy our software in cloud, in hybrid cloud environments. architectures are evolving to be multi-cloud architectures, and that absolutely favors F5. If I go back to where we were five years ago when we were hearing customers say, everything's going to go to a single cloud location, and we're not sure we're going to need an F5 ADC. Today, we are positioned where the architectures are going. They're going to multi-cloud. We're very well positioned in these architectural conversations. And so what we're not seeing is a shift away from S5 from an architecture perspective. We're seeing just financial decisions and pressure. So we're very confident that the drivers of long-term software growth for S5, security, modern applications, and multi-cloud environments are going to be there and drive the 20% plus growth that we've talked about in the long term. In the shorter term, Yes, we have said it's less likely that we will be in the 15% to 20% range we've mentioned. There is a path to get there. It's a narrower path than it was a quarter ago because it would imply a change in the second half in terms of the demand patterns that we have seen on software. And so whether things would rebound this quickly for us to be able to see that That's unclear, and that's why we're saying that it's less likely that we would deliver 15% to 20% growth. You will note, however, Amit, that I mentioned our business and operating model earlier. Part of the benefit of the balanced model that we have built is you're seeing the improvements we've made on supply chain allow us to have perhaps upside on the hardware revenue and also upside on the services revenue. So, on balance, you know, we feel our 9 to 11 percent revenue range is still achievable.

Perfect. Thank you.

Thank you. Our next question is from Mehta Marshall with Morgan Stanley. Please proceed with your question.

Great. Thanks. Maybe two questions for me. If you could just kind of lay out maybe most often what some of these larger new software deals are associated with, you know, are they tied to kind of cloud migrations or security upgrades or, you know, kind of thinking about hybrid architectures, that would just be helpful to kind of figure out what other indicators we could be looking at when thinking about the software, new software growth coming back. And then maybe just on the second question, You know, product gross margins are staying depressed for a little bit longer. You know, just how are you guys thinking about kind of the progression of getting rid of some of these supply chain costs or broker fees throughout the year or just the time that it might take to get back to some of the product gross margins we've seen in the past? Thanks.

Thanks, Mayda. I'll take the first one.

Frank will take the second one on gross margins. So the large software projects, they're tied to all of the factors you mentioned, but they're typically infrastructure modernization or application modernization. So these would be companies that have had, say, our hardware in in their environment and they're deciding to move either partially or wholly to a software-first environment. This could be a private cloud or it could be a public cloud implementation with lift and shift. More often than not, they are actually setting up these software environments while keeping part of their application estate on hardware. So they will pick a set of applications that they really want to modernize and move to an environment that's more automated, whether it's in a public cloud or even in their own private cloud, where there's higher levels of the automation that gives them faster time to market, better deployment timeframes, et cetera, et cetera. So that's the type of project for the large kind of multi-year subscriptions. We have also a number of other projects that are now with NGINX. They're just typically new applications, new modern applications that have been in test and development, and they're moving into production. And when they move into production, there is a need for strong networking and security capabilities that NGINX bring as a complement to, for example, Kubernetes orchestration. So we're seeing a lot of these projects. And now with our distributed cloud offerings, we're also offering SaaS solution. And that is, I would say, a nascent part of our business, but it's a different model of deployment where it's typically a long tail of applications that would not have had a traditional ADC in front of them in the past. Customers are choosing to protect them with a SaaS security solution from F5. So those are, I would say, the three types of implementations. But, of course, the multiyear sort of subscription are more anchored on the first model that I mentioned.

Peter, in relation to gross margins, particularly product gross margins, our view of that for the year has not changed. And we talked about the supply chain improvements starting to benefit our product gross margins really in the latter half of this year, even all the way up into Q4. But that the real benefit that we were going to see is going to be an FY24 in terms of product gross margin improvement. We still had purchase price variance and expedite fees that were working through the components that make up our box builds, you know, through this year. And we still have got, you know, a few critical components where we are having to go in the broker market. So largely we will start to see improvement in Q4, but more of it you will see in FY24.

Great. Thank you. Thank you.

Our next question is from James Fish with Piper Sandler. Please proceed with your question.

Hey, guys. Thanks for the questions. On the software number, I don't get the reluctance to not give a number at this point. I get, you know, we're kind of missing the 15 to 20 percent. But it's the main question we're getting after hours. Any clarity on that would be helpful, Frank. And should we be assuming this kind of net new business double-digit decline in new recurring software should continue for the remainder of the year, or are you expecting this to kind of improve as that new business comp gets easier in the second half of the year? And just I have a quick follow-up after.

Sure, and I appreciate the question, Jim. We, again, as Francois mentioned a second ago, we are not updating our 15 to 20% guidance because we do still see a path to get there. Again, it's a harder path. I think that we're not necessarily expecting to change an environment. And part of the reason why we're not updating the back half is because the visibility is cloudy right now in terms of demand. And when we came into the year, we talked about over 50% of The revenue that we expected as part of that 15 to 20% growth was going to come from new business activity. And that we didn't expect that to glow, but we didn't expect to see, you know, the types of percentage declines that we saw in Q1. And so just with the lack of visibility that we've got right now, we don't have a new range to offer to you today. But we do feel like it's less likely that we will be in that range.

Okay, and then Francois, I'm surprised no one's asked about it at this point, but on the strategy side with this Lilac deal, why Lilac? What's the competitive advantage? And is it more to align with product overlap against some of your kind of newer competitors like an Akamai or Cloudflare? Is it more to be able to offer that SaaS-like experience inside a customer's environment and just trying to understand why couldn't this get done with NGINX and Volterra already? Thanks, guys.

Thank you, Jim. So, yes, on Lai Lai, let me start with, you know, we acquired Volterra a couple of years ago and really launched the platform with our security offering about a year ago. And we've seen, you know, very, very good traction with distributed cloud services over the last 10 months. And so we want to build on that traction. We recently started with a CDN offering in the distributed cloud services platform that was based on an OEM agreement with Lilac. And this was essentially a TalkAid acquisition to insource that technology and the team in order to be able to secure the offering for the longer term and also work with this team to continue to improve on the offering and deliver increasingly innovative edge services on the Volterra platform. So we're pretty excited about the team joining us and being able to, you know, accelerate our innovation on that front. And it completes our offering, you know, in terms of web application, firewalls, API security, DDoS protection, anti-bot, and now CDN into the, you know, into the bouquet of services that we offer on distributed cloud.

Helpful. Thanks for the response.

Thanks, Jim. Thank you. Our next question is from Simon Leopold with Raymond James. Please proceed with your question.

Hi, guys. This is Victor Truen for Simon Leopold. You noted that the fundamental demand around F5 software is still largely intact, but are there specific factors that you can point to that gives you confidence that the slowing isn't a reflection of more secular headwinds like cloud migration versus, you know, the cyclical slowing that you're noting?

Yeah, Victor, I think, you know, It's interesting because I would say that migrations to the public cloud, if you want to call them like lift and shift type migrations, we have seen that to be more of a tailwind to F5 than a headwind. But even more than that, what we have seen over the last couple of years is that customers are not migrating applications to a single cloud. Increasingly, customers are leveraging multiple different environments for their applications, multiple public clouds, private cloud, and on-premise. And that actually is an architectural model that is ideally suited for the portfolio that we have built, which is essentially an infrastructure agnostic portfolio of application security and delivery services. And so we feel very strongly that as that trend accelerates in large enterprises and that multi-cloud and hybrid cloud you know, becomes more and more the mainstream deployment way that enterprises deploy their application portfolios, you know, it is going to drive growth for F5 and specifically for F5 software and SaaS services. So that's where, you know, our confidence comes. And I mentioned those drivers earlier, you know, multi-cloud environments, security, modern applications. All three will contribute to the long-term growth of our software, which is why we feel our views on that are absolutely intact. What we are seeing right now, again, is not an architectural or a competitive issue. It is largely a macro-driven, very cautious spending environment that is kind of indiscriminate across product lines.

Well, I mean, so prior to the, you know, kind of macro, you know, headwinds that we started seeing, did you observe, you know, any of those trends that you mentioned, you know, regarding multi-hybrid, you know, cloud trends? And, you know, did you see, you know, you observed those trends and that kind of gives you, you know, the confidence, you know, that that will resume when things normalize?

Yes, Victor. I mean, we saw them, which is why, you know, If you look at our software growth in 2021, I think it was in, I think it was around 37%. And if you look at our software growth in 2020, the first three quarters of 22 prior to the change in the environment, our software growth was also close to 40%. So we, and it came from you know, these three drivers, more deployment of modern applications that we serve with NGINX, now with distributed cloud services, you know, more needs for security in front of applications that we serve with all security solutions, shape, distributed cloud, big IP, and more deployments in multi-cloud environments with our large customers.

Great. Thank you. That's helpful.

Thank you. Our next question is from Tom Blakey with KeyBank Capital Markets. Please proceed with your question.

Hi, everyone. Thank you for taking my questions here. I guess my first question is also, well, both questions are on software as well. The numbers you've given for us here are you can kind of back into, I believe, strong double-digit growth in the renewal, you know, kind of true-up business in the quarter. Is there anything one-time? and that number or anything that kind of would lead us to believe that you don't have any visibility into fiscal 23, that growth kind of remaining?

Yeah, we did not experience any sort of one-time benefits. I think however you want to think about the perpetual business versus the subscription business, but there was nothing unusual in the quarter.

Yeah, I'm sorry, I'm just focusing on the subscription business with regard to renewals and troughs. And then, as you mentioned, I'm sorry, Frank, go ahead. No, no, no, absolutely, Tom. All good. Oh, and then just on the perpetual side, you've been a little bit above, you know, trend line the last couple years, the trend line of the last couple years. What kind of visibility do do you have into this perpetual business line in a pipeline there? Comments from Francois, maybe. And maybe if you could juxtapose that with your comments about pause and a slowdown in spending just doesn't really jive with you kind of like beating the last couple of quarters pretty handily from a perpetual license perspective.

That'd be helpful. Yeah, Tom, let me start with that.

And if Francois wants to add, he certainly can. Again, we think some of the power of our model is the flexibility of the way customers want to consume. And in some cases, people have OpEx budgets. And in other cases, they have CapEx budgets. And so in certain instances, I think they'd rather consume on a CapEx basis. And some of that will come through perpetual. It's not something that we try to spend a ton of time forecasting the split between the two. We're happy when the revenue falls in either. And so, you know, for the last couple of quarters, you may have seen that tick up from what was sort of a, you know, low $30-ish million a quarter business to the upper $30, low $40 million. But, you know, generally those are customer preferences and how they want to consume our solutions.

Okay. So just same type of visibility, but always having perpetual software.

Okay. Thank you very much.

Thank you. Our next question is from Jim Suva with Citigroup. Please proceed with your question.

Thank you very much. Your commentary about the hardware being stronger, especially with your outlook and such, and the mixed shift to more towards that, which will impact things, I understand it all, but the question is, is Is that impacted at all due to the supply chain issues during the past year or two in that maybe customers are absorbing some of the orderings that they did and then this is going to face a headwind? Because normally I would think about customers buying both the hardware and software kind of together.

Jim, is it affected by the supply chain The answer to that is yes, because we have a lot of orders that we were not able to ship last year, and we have made a lot of improvements in supply chain, both from our suppliers and the general environment, and our own redesign of our platforms that give us better visibility on what we're going to be able to ship to customers over the next three quarters. And we've always said we wanted to be able to get all this these orders to our customers as soon as possible and reduce our lead times, which we believe actually will be a tailwind to demand when we're able to reduce our demand. So yes, it is affected by that, but that's part of why we see the subside in hardware for the year. It's because our view today of what we'll be able to ship has actually improved from where it was three months ago.

Okay. That makes a lot of sense. And then just, you know, given the macro cautiousness, how should we think about capital deployment? You know, stock buyback, M&A, any changes there? Are you kind of hoarding, not hoarding, reserving a little more for organic functions? Or how should we think about capital deployment versus maybe, you know, six, 12 months ago?

Our outlook on capital deployment has not changed. We still expect to spend 50% of our free cash flow on share repurchase this year. As we mentioned earlier, we did pay down the term loan debt associated with the SHAPE acquisition, which was a little over $350 million use of cash in the quarter. that reflects the change in our cash balance and the $40 million share repurchase we did in Q1. And, you know, we obviously, you know, announced Lilac, which was an undisclosed sum. It was a small acquisition that we did today. And so the balance of the activities and how we said we're going to use our capital has not changed, and we don't anticipate that it will change going forward.

Thank you so much for the clarifications. It's greatly appreciated.

Thank you. Our next question is from Fahad with Loop Capital. Please proceed with your question.

Thank you for taking my question. I want to revisit the software issues again. If you look at perpetual, it's grown fairly steadily. So can you maybe help us understand in terms of renewals, what the net retention rates are maybe anything cohort analysis that uh you said it was in line so maybe if you can just elaborate a little bit more and then furthermore i guess the question also is how should we be thinking about your exposure to legacy applications versus new modern applications and if there's anything you can share with us on how that mix is trending

Let me start with the legacy and modern applications and how the mix is trending. I would say it's actually trending in line with the population of applications overall, which is that legacy applications are growing, I would say, in the single-digit percentage range in terms of the number of these applications out there deployed in the world. Whereas modern applications, we think are growing in the 30% range in terms of the number of them that are going into production on an annual basis. And so over time, there will be a lot more of the modern applications than the legacy applications. Where this gets blurred, though, is that we're also seeing a number of legacy applications get modernized. where folks are adding modern component to an application that is already in production, has already been generating revenue. And this is where I think F5 has a specific advantage, is that yes, we play modern applications with components like NGINX and increasingly our distributed cloud services. Yes, we play in legacy or traditional applications with platforms like Big IP, But for a lot of our customers, they want to have implementations that involve modernizing a legacy application. And especially in an environment where customers are looking to consolidate vendors to simplify their operations, our ability to deliver on both of these requirements and actually deliver a single commercial vehicle where you can have both your modern and legacy application services is critical. And so that's one of the ways that we've positioned the companies to be able to serve both needs. Over time, it will skew more towards modern applications as they grow faster. Got it.

We're not offering any new metrics on software like net retention rates. I will say that, as we mentioned, for the renewal side of the business, which includes the SaaS businesses, the true forwards associated with the business and some of the second terms of our multi-year subscription agreements as largely came in as we expected. The shortfall that we experienced was largely due to the new software business that just didn't drive growth in the way that we would have expected it in Q1.

I have one more follow-up. Francois, now that you've had a few years post-EngineX shape acquisitions under your belt, can you maybe give us an update on how the progress is in integrating these acquisitions into F5. Is it, you know, are you able to sell and integrate these acquisitions and upsell your solutions? Any update on how the integration of these assets have gone and how do we think about next year? I'm sorry, fiscal 23.

Yes, absolutely. So let me take them quickly in order. I would say on NGINX and SHAPE, the integrations are largely complete. And so on NGINX, you've already – so they're complete both from a, if you will, product perspective in terms of capabilities. We have ported from F5 or Big IP onto NGINX. So we can offer, for example, security on NGINX. And increasingly, we're offering our customers a single pane of glass to be able to get visibility on both NGINX and big IP deployments. And they're also complete from a go-to-market perspective, whereby we have now enabled our mainstream go-to-market marketing and sales resources to be able to promote and engage customers on NGINX. We've done the large thing on Shape. We're a little behind that, but I would say almost 80% there, where we now have the integration complete. Shape is available in Big IP. Our customers who have Big IP can turn on Shape anti-bot capabilities quickly. Shape is also available in our distributed cloud platform as a standard anti-bot defense offering. And we've also done a lot of the go-to-market integration By the way, those integrations, when I say from a go-to-market, they are quite critical because they have allowed us to continue to drive better operating leverage from a sales and marketing perspective. So if you look at our sales and marketing expense, I think it was 31% or so of revenue in 2020, and it's 29% in 2022. uh despite the you know the revenue pressures we had because of supply chain so you see operating leverage there and you look at our overall um you know opex as a percentage of revenue has gone from roughly 54 and a half percent in 2020 down to 50 to 51 implied in our uh fy 23 uh guidance so the the integrations have also enabled us to you know drive the right synergies and operating leverage uh and then in terms of the I don't know if you're asking about, you know, Volterra, of course, is newer, and so we're still going through that, but we've already done a chunk of the integrations by deploying all of our security capabilities onto that platform that we call now distributed cloud, and we're getting quite a bit of traction. Where all of that is going is that ultimately, you know, we are going to offer our customers a single console and a single pane of glass from which they can manage all their security policies, from which they can get visibility to all their deployments with F5, whether it's hardware, software, or SaaS, and whether it's in legacy or modern environment. And in that regard, we're positioning to be quite a unique player that can cover all these models in a way that's agnostic to the underlying infrastructure.

I appreciate the answer. Thank you.

Thank you. Due to time constraints, we'll be taking our last question from Ray McDonough with Guggenheim. Please proceed with your question.

Great. Thanks for fitting me in. Just two, if I could. I understand you're not giving any new software metrics right now, but can you talk about how contract duration trended on renewals? You know, I understand you were selling three-year term license deals in that cohort. It's really the first cohort of renewals that you're seeing. Are you seeing any contraction of contract duration? And then the second question would be, you know, I appreciate the comment around double-digit EPS growth and the commitment there, but how should we think about cash flow growth and cash flow margins normalizing as you kind of lap the change towards more annual invoicing terms this year?

Sure. Race, why don't I take both of those. The first in terms of changes in duration of the contracts, we are certainly sensitive in monitoring that, but we have not seen any discernible change in contract duration on the second-term renewals or on the primary contracts that we are putting in place. And so that has not impacted us at this stage. In terms of the commitment to our double-digit EPS growth and cash flow, we are – You know, we will see the benefits of some of the slowdown in the new flexible consumption programs that will then yield more actual cash in the back half because we're not adding on as much of the upfront revenue recognition in relation to the cash that we were receiving. So we will start to see the benefit of that and see that normalized out a bit. Part of the other benefit that we're going to see for cash flow is that, you know, the supply chain issues that we've had and the extra purchase price variance and expedited fees, those will largely come out and those will, you know, help our cash flow from operation. So both of those, I think, will start to see a normalization, but it is one of the more difficult areas to predict in the model going forward.

Makes sense.

Thanks for the color. Appreciate it. Thank you. This concludes today's question and answer session.

This is the end of today's conference. You may disconnect your lines at this time. Thank you for your participation.