F5, Inc.

Hello and welcome. I'm Suzanne Dulong, F5's Vice President of Investor Relations. Francois Loco-Denoux, 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 A copy of today's press release is available on our website at F5.com, where an archived version of today's audio will be available through October 24th, 2023. The slide deck accompanying today's discussion is viewable on the webcast and will be posted to our IR site at the conclusion of our call. To access the replay of today's webcast by phone, dial 877-660-6853 or 201 612-7415 and use meeting ID 1373-9739. The telephonic replay will be available through midnight Pacific time, July 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. We have summarized factors that may affect our results in the press release, announcing our financial results, and in detail in our SEC filings. In addition, we will reference non-GAAP metrics during today's discussion. Please see our full gap to non-GAAP reconciliation in today's press release and in the appendix of our earnings slide deck. Please note that F5 has no duty to update any information presented in this call. With that, I will turn the call over to Francois.

Thank you, Suzanne, and hello, everyone. Thank you for joining us today. In my remarks today, I will speak to the quarter's results and the current customer spending environment. I will then highlight some notable customer wins from the quarter, including some emerging areas where we are seeing good early traction. Overall, customer caution persists with customers continuing to sweat assets amidst tight budgets and lingering macroeconomic uncertainty. Despite the tough environment, our team is executing well and we delivered third quarter revenue at the midpoint of our guidance range with earnings per share well above the high end of our range. From a demand perspective, we are seeing some early signs of stabilization. Q3 demand played out slightly above our beginning of quarter forecast, which was up from Q1 and Q2 this year, though still off from FY22 levels. Our global services team delivered strong 8% growth, driven by a continuation of customer trends from the first half of the year, including strong maintenance renewals and price realization. With customers sweating existing assets, we also continue to see higher maintenance attach rates on older deployments. Our product revenue grew 1%, with systems revenue growing 5% and software revenue declining 3% year over year. While systems revenue is benefiting from supply chain normalization and our efforts to substantially work down backlog, systems demand remains constrained. In contrast, we are seeing some positive signs in software demand. Total software revenue was down 3% year-over-year against a strong Q3 2022 compare. However, total software grew 32% sequentially. And within software, our subscription software revenue grew 4% year-over-year to a record high $152 million. This reflects strong growth in our software renewals and interim expansions, or true forwards, as well as some stabilization in new term subscriptions from the first half. Moving from revenue to our operating results, we are also demonstrating operating discipline and driving operating leverage. Our Q3 non-GAAP gross margins of 82.5% improved more than 200 basis points from Q2. This was slightly ahead of our guidance and reflects the combination of expected supply chain easing and price realization. as well as some of the ancillary supply chain costs like broker and expedite fees finally working their way out of our inventory as planned. In addition, our Q3 non-GAAP operating margins of 33.2% improved 600 basis points from Q2 and more than 400 basis points from Q3 FY22. As a result of these improvements, as well as some tax favorability, we significantly overachieved our non-GAAP EPS expectations in the quarter and now expect to deliver double-digit non-GAAP earnings per share growth for FY 2023. We believe our growth opportunity is fundamentally linked to the continued growth of applications and APIs and the need to secure, deliver, and optimize those apps and APIs. As part of our efforts to capture that growth, we continue to drive innovation, advances, and integration across our product families, including F5 BigIP, F5 NGINX, and F5 Distributed Cloud Services. I will call out some customer highlights from each product family from the quarter. Our BigIP family, which serves traditional applications either on-premises, co-located, or in cloud environments, continues to take share from competitors who have failed to invest in innovation. From a hardware perspective, the value proposition with our next-generation platforms is resonating with customers, with our R-Series and Velos platforms representing more than 70% of Q3 systems bookings. On the software side, BIG-IP's data plane performance, automation capabilities, and lower total cost of ownership continues to differentiate our offering and drove multiple wins in the quarter, including wins at a major American airline, a multinational automobile manufacturer, and a major UK retail and commercial bank. We also saw strong demand for F5 NGINX in the quarter. NGINX serves modern, container-native, and microservices-based applications and APIs. We continue to see large enterprises adopt NGINX for their cloud and Kubernetes workloads. We have repeatedly demonstrated that when applications are built with NGINX from the ground up and those apps grow, we grow with them. We saw this in several NGINX growth opportunities in the quarter, including a multi-million dollar term-based subscription renewal that grew by an extraordinary 10x from initial inception. The customer, which provides a large collaboration platform, is streamlining deployments in both public and private clouds using F5 Engine X as their single platform for load balancing, caching, and telemetry. Over the last several years, we have invested both organically and inorganically to build a portfolio of SaaS and managed services called F5 Distributed Cloud Services. Since launching Distributed Cloud in February of 22, we have been expanding our offerings and building momentum for multiple security use cases. A great example of this is a win with a global financial services industry application provider that wanted to standardize its web application firewall and API protection, or WAP, policies and deployments in APAC and EMEA to reduce time to delivery. Their existing disjointed application security and complex policy tuning was a challenge, as was managing apps and APIs across distributed environments with a small team. Today, F5 Distributed Cloud Services is protecting their apps and APIs with WAP and multi-cloud networking, reducing their time to delivery from months to minutes. It is early days still, but we also are seeing encouraging signs that our distributed cloud services are intercepting the market specifically in two emerging categories. API security, and multi-cloud networking. On API security, with the growth of modern applications using containers and composed of distributed microservices, the number of API endpoints is exploding. CISOs tell us they struggle to know how many APIs they have, where they all are, who is connecting to them, and to what extent they are secured. Doing so requires robust API discovery and protection capabilities like those we offer in our distributed cloud API security service. When a North American service provider experienced a serious cybersecurity incident, which caused them to lose their entire virtualization infrastructure at multiple data centers, they turned to us for urgent help. F5 Distributed Cloud Services' superior features, functionality, and value beat a competitive offering, and we worked with the customer to emergency onboard the platform including advanced WAP, bot defense, and API security. Once deployed, the customer immediately started migrating sites, restoring their services. We are also seeing strong early traction in our distributed cloud multi-cloud networking offerings launched just this past March. 85% of respondents cited in our 2023 State of Application Strategy report since they already are managing multi-cloud environments. Securely connecting applications between on-premises, multi-cloud, and edge environments at scale is a tough task for any organization. Our secure multi-cloud networking solutions change the game. Our ability to package networking, security and distribution of applications and APIs is unique. Until now, customers have been forced to manage and secure these layers in isolation, often leading to operational complexity, network latency and weak security. Our multi-cloud networking solutions reduce operational complexity for our customers and make it possible for them to securely connect distributed networks and applications across public clouds, on-premises data centers, and edge locations. Customers are beginning to understand the power of our secure multicloud networks' ability to provide end-to-end visibility, control, and security across all of their applications. This empowers them to move workloads to the cloud, between clouds, and even to the edge while maintaining end-to-end visibility and consistent security policy. FI Distributed Cloud uniquely unifies the visibility, control, and security for every application and API so that applications can be delivered without constraints and with the security today's threat environment demands. Early traction for our secure multi-cloud networking offerings includes a win with one of the world's largest independent providers of insurance claims management systems. FI's multi-cloud networking now enables their global SaaS offerings. The customer first deployed our distributed cloud WAP in February of 2022 to protect a business-critical public cloud workload. In early 23, the customer was abruptly asked to leave a data center, forcing them to lift and shift workloads to the public cloud in just two weeks. They used F5 distributed cloud for this emergency lift and shift. In fact, the project went so smoothly that they opted to expedite moving their global data centers to public clouds. now the customer has standardized on f5 distributed cloud for their secure multi-cloud networking needs spanning across multiple clouds and protecting external and internal applications and apis these are just some of the customer challenges we help tackle in q3 while we are not in a position to predict with precision when customer spending patterns will return to more normal levels F5 is well-placed to benefit when they do. We are encouraged both by the early signs of stability in Q3 and with the resonance our application and API-focused approach is having with customers. We are making it possible for our customers to secure, deliver, and optimize their applications and APIs with a consistent approach no matter what environment they are deployed in, data center, co-located, private cloud, or public cloud. And this is a critical capability and differentiator in today's hybrid multi-cloud network world. Now, I will turn the call to Frank. Frank?

Thank you, Francois, and good afternoon, everyone. I will review our Q3 results before I discuss our fourth quarter outlook. We delivered Q3 revenue of $703 million, reflecting 4% growth year-over-year. Our revenue remained roughly split between global services and product, with global services representing 53% of total revenue. Global services revenue of $374 million grew a strong 8% due to continued high maintenance renewals as well as the impacts of the price increases introduced last year. Product revenue totaled $328 million, representing growth of 1% year-over-year. Systems revenue of $155 million grew 5% year-over-year. Software revenue totaled $174 million, down 3% from a tough compare in the year-ago period. Our software revenue is comprised of both subscriptions and perpetual license sales. Subscription-based revenue hit a new high in Q3 in both dollars and as a percentage of software revenue. Our subscription revenue totaled 152 million, or 87% of Q3's total software revenue, and as Francois mentioned, grew 4% year-over-year. Perpetual license sales of 22 million represented 13% of Q3's software revenue. Revenue from recurring sources contributed 75% of Q3's revenue, which is a new all-time high as a result of the strong subscription contribution. Recurring revenue includes subscription-based revenue, as well as the maintenance portion of our services revenue. On a regional basis, revenue from Americas grew 3% year-over-year, representing 57% of total revenue. EMEA grew 16%, representing 26% of revenue, and APAC declined 6%, representing 18% of revenue. Looking at our major verticals, during Q3, enterprise customers represented 66% of product bookings, Service providers represented 13%, and government customers represented 21%, including 8% from U.S. federal. Our Q3 operating results were strong, reflecting our previously announced cost reductions and overall operating discipline. GAAP gross margin was 79.8%. Non-GAAP gross margin was 82.5%, an improvement of more than 200 basis points sequentially. GAAP operating expenses were $457 million. Non-GAAP operating expenses were $346 million, slightly lower than our guided range, and reflecting a partial quarter benefit from the cost reductions we announced in April. Our GAAP operating margin was 14.7%. Our non-GAAP operating margin was 33.2%, representing a sequential improvement of more than 600 basis points. Our GAAP-affected tax rate for the quarter was 16.4%. Our non-GAAP-affected tax rate was 18.1%. This is below our target range for the year, largely driven by a non-recurring benefit associated with the filing of our annual federal income tax return during the quarter. Our GAAP net income for the quarter was $89 million or $1.48 per share. Our non-GAAP net income was very strong at $194 million or $3.21 per share, well above the top end of our guided range. of $2.78 to $2.90 per share. This reflects the combined impact of our gross margin improvements and operating expense discipline, as well as a Q3 tax benefit. I will now turn to cash flow and the balance sheet, which also remains very strong. We generated $165 million in cash flow from operations in Q3, driven by our improved profitability and strong cash collections. Capital expenditures for the quarter were $15 million. DSO for the quarter was 56 days down from 62 in Q2 and closer to our historic range as a result of earlier invoicing related to improved shipping linearity as our supply chain continued to stabilize. Cash and investments totaled approximately $696 million at quarter end. Deferred revenue increased 9% year over year to $1.79 billion. driven by the high service maintenance attach rates we've seen throughout the year and continued growth in subscription as a percent of our software mix. As we committed to on our last call, we repurchased $250 million worth of shares in Q3. Finally, we ended the quarter with approximately 6,500 employees, which reflects the headcount reductions we announced in April. I will now share our outlook for Q4. We expect Q4 revenue in the range of $690 to $710 million, with gross margins of approximately 83%. Unless otherwise stated, my guidance comments reference non-GAAP operating metrics. With the full quarter benefit from the cost reductions announced in April, we estimate Q4 operating expenses of $338 to $350 million. Incorporating our year-to-date results, we have now narrowed our estimates for our FY23 effective tax rate to approximately 20% for the year. As a result, we are targeting Q4 non-GAAP earnings in the range of $3.15 to $3.27 per share. We expect Q4 share-based compensation expense of approximately $55 to $57 million. Year-to-date, we have used 68% of our free cash flow towards repurchases. We remain committed to returning cash to shareholders and continue to expect to use at least 50% of our annual free cash flow towards share repurchases. I will now turn the call back over to Francois. Francois?

Thank you, Frank. Customers made F5 the standard for securing, delivering, and optimizing traditional applications. Now with compelling and differentiated solutions for modern applications and APIs, as well as those mission-critical traditional apps, we are being architected into new areas and use cases across our portfolio. Our holistic application and API focused approach enables newfound consistency across environments and across hardware, software, and SaaS deployment models, which reduces risk, lowers operating costs, and delivers better digital experiences. In closing, I ask that you take away three things from this call. Number one, we are seeing some early and encouraging signs of demand stabilizing. Number two, We are seeing demonstrable proof points that the differentiated solutions portfolio we are creating through a combination of organic and inorganic innovation and technology integration is well aligned with how application architectures are evolving. And number three, we are delivering on the operating discipline we committed to and expect to produce additional leverage in FY 2024. Operator, please open the call to questions.

Thank you. We will now be conducting a question and answer session. If you'd like to ask a question, please press star 1 on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press star 2 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 key.

One moment please while we poll for questions. Thank you.

Our first question is from Ray McDonough with Guggenheim Partners. Please proceed with your question.

Great. Thanks for taking the questions. Maybe first for Frank, how did the true forward portion of renewals perform this quarter relative to the last? And assuming it has improved, which it seems like it has, do you think we're at the tipping point where customers simply need to add capacity, which will continue to drive relative strength in renewals going forward? Or is it too early to tell whether or not that's bottom?

Ray, thanks so much for the question. So the true forwards, when we set out our plan at the beginning of the year, you know, we had higher expectations than what we've seen throughout the course of this year. That having been said, it was a strong quarter, you know, for renewals and included in that would be our true forward number. It's early to indicate that we've seen an absolute bottom and things are going to grow from here. What I was incredibly encouraged though from was that, you know, the expansion that we saw in some of our second terms, As Francois mentioned, we're quite high on a few large deals, and we are seeing a stabilization right now in the demand environment, which is better than what I can say for the last couple of quarters. So, again, early signs, but not yet ready to call it a trend.

That makes sense. And maybe if I could, a follow-up for Francois. You mentioned you're obviously seeing signs of macro stabilization here. Can you unpack that a little bit more? I mean, how broad-based is the stabilization, maybe from a vertical perspective and from a product perspective? Are you seeing each vertical kind of stabilize, or is there kind of give and takes between where the spending is kind of more firm than others?

Ray, so I think it's best to maybe contrast a little what we saw this quarter versus what we saw in the first two quarters of the year. You know, what hasn't changed first is this, that customers, you know, continue to scrutinize spend. You know, we continue to see deals being delayed, some deals being pushed out, and we continue to see a behavior across all verticals where customers are, you know, looking to defer spend as much as possible and sweating their assets where they can do that. Those behaviors have not changed, and as a result, you know, Even though we saw stronger demand in Q3 than in our first two quarters of the year, demand was still lower than from the 2022 levels. What has changed is, number one, we didn't see things getting worse this quarter. And I'm saying in general across verticals than they did in the first half of the year. So we feel we have kind of reached a stable level. I think in our March quarter, There was, you know, a lot of uncertainty specifically in the financial services sector. You know, right after the bank failures, there was uncertainty, you know, still about interest rates, debt ceiling for in the U.S. specifically. And so, you know, spending financial services almost came to a halt then. And that, I want to call it almost irrationality, has come out now. So there are still, you know, deal delays and scrutiny. But even though deals are being scrutinized, you know, they are getting, you know, approved. So that's specifically to that vertical, I think, has changed. And then I think we've seen in a couple of areas with deals that have been delayed where, you know, customers really needed to implement these projects, and they have moved forward with these projects. And I would say that's been the case in financial services and in a couple of other enterprise verticals. Service providers, I would say, are still looking to sweat their assets as much as possible, and we're seeing that behavior continue across the board.

Great. Thanks for the color. I appreciate it.

Thank you. Our next question is from Sameek Chatterjee with J.P. Morgan. Please proceed with your question.

Hi. Thanks for taking my question. go back to the comments about the stabilization of demand and dig into that a bit more. I mean, you did comment about the stabilization in a quarter when we saw systems revenue decline significantly as you sort of have walked through the backlog. So I'm just wondering when we interpret those comments related to both hardware and software, is that, should we be interpreting this as sort of a more normalized mix based on what you're seeing in the macro and that sort of as we think about fiscal 24, means that you're sort of looking at a $700 million or $2.8 billion analyzed sort of number as being where the floor is, where you track if the macro remains the same. Is that the way to sort of interpret the demand stabilization comment?

Hi, Samig. Okay, so let me unpack that.

There was a lot in there. You know, when I talk about demand stabilization, it's really the fact that if you look at the first two quarters of the year, you know, things were getting, you know, progressive. They were worse in March than they were in January, and they were worse in January than we felt they were in September. But, you know, when you back to where we were, you know, at the end of June, we didn't feel things had further worsened, and so things had stabilized. That's really the origin of my commentary. As it relates specifically to hardware, Sameek, as you know, demand has been soft on hardware throughout the year. And it's been soft largely because of the macro environment and customers sweating their assets. Also, customers needed to digest a lot of shipments that we have now been able to make. Customers have placed orders last year. They have not been able to get the equipment and they needed to get the equipment, and get it installed and deployed. So all of that is happening. As a result, we have worked through our backlog, and our backlog has come down significantly, which is why you're seeing hardware where it is in Q3. And frankly, when you look at even next quarter, Q4, I would expect hardware to probably be even down from the levels you saw in Q3. in terms of where demand is at today. As it relates to what this means for 2024, as you would expect, it's too early for us to be guiding to 2024. We've said in the past that cycles of this nature in the past have been four to six quarters. We feel we are three quarters into it. So you can infer from that where potentially demand would return. We do expect, by the way, demand to return in 2024. When exactly, we don't know when. But we do expect demand across the board to return and hardware demand to be higher next year than it is this year. However, I would ask you to keep in mind that because we have been able to shift so much of our backlog, We said last quarter that there would be six to eight points of headwind on total revenue growth next year based on, you know, the way we worked the backlog this year. And so I would keep that in mind when you're thinking about revenue for next year.

Got it, got it, got it. In front of the question that I'm getting a lot from investors really is about AI and the investors are expecting an inflection again in terms of application growth because of AI use cases. really more about your application security capabilities. How do you think they're positioned to navigate sort of that inflection and application growth? And how do you think about the challenges in managing that growth as well at the same time?

So, you know, for us in AI, Samir, we're of course, I think like a lot of our companies, I think we've got focused in three three areas. Uh, one that I'd say is generic to other companies, which means we are, you know, looking to leverage the new capabilities to enhance our productivity. Uh, and you know, we, we, as you know, we're, we're, we're focused on earnings growth. We said we want to deliver a double digit earnings growth, which we are now confident we will this year, but continuing to drive that, uh, we want, we want to drive more productivity over time. And these tools would, would, uh, you know, would help us do that in certain areas. uh the the other two areas that are really specific to our business to make is one uh we have been using ai already especially in our security products part of the rationale for the shape security acquisition was also to bring in ai capabilities and ai expertise in the company that has allowed us to profile uh you know application traffic at a very granular level which is an incredible powerful capability and we're going to enhance these these capabilities with new machine learning models going forward. And I would expect that in security in particular, you will see us move more and more to AI enabled security, which is where increasingly what we think it will take to solve security problems. And we have a lot of data being in front of 40% of the world's websites. borrowing over 300 million websites and being in 40% of the world's web applications, we feel we have a lot of access to data that can fuel these machine learning models. We will also see some opportunities in terms of new workloads, though that is still early days and probably harder to define in the short term. But what we see happening is a lot of the new AI related workloads, we think have two attributes that will be interesting for F5. Number one is these are kind of next generation modern workloads built with an API first approach, which will create a lot more API connections and API calls and accelerate this explosions of APIs. Those APIs need to be connected and secured and orchestrated. And we are levered to that opportunity in API and API security And number two, these workloads or the data they have to access is quite distributed, which also will accelerate adoption of multi cloud architectures, and we are levered to that multi cloud opportunity. And so we think those two attributes of AI related workloads will play well to the to the opportunity for F5 down the road.

Great, thank you. Thanks for taking my questions.

Thank you. Our next question is from Simon with Raymond James. Please proceed with your question.

Thanks for taking the question. I was looking at really where the systems revenue had been prior to the pandemic and wondering how you would think about the idea that a normal revenue run rate might be in that sort of 170 to 180 million a quarter. Clearly, a lot has changed over since, I guess, late 2019. Could you maybe help us think about sort of the puts and takes to, even if we don't know the timing, to sort of get a better sense of what should be the sort of base run rate for hardware?

Yeah.

Simon, I don't think we're, you know, we can, kind of direct you to what is or should be the base one rate for hardware. But I think what we can share with you is this. Our perspective is that the trajectory of the hardware in terms of the number of units that we have out there should be declining in the mid single digit percentage. And it could be a little more than that, it could be a little less than that, but it's in that zone. And when you look at the sort of overall normalized trend of the number of units we have under obligation, the number of hardware units that are out there and deployed, and you look at a longer trend than the last couple of years, you'd see that's kind of the trend that we're seeing. Over the last couple of years, if you just look at revenue, of course, there's been substantial disruptions. uh you know the pandemic has been a positive one the supply chain has been a negative one the macro has been a negative one but if you if you ignore the short-term disruptions and you just look at a long-term trend of the you know the number of hardware units you have out there you should think about it as a kind of declining in the mid single digits now i i would add though simon that part of what we think is a is an important strength of the f5 model is that we now deploy in hardware, in software, and software as a service. And we're seeing that customers really value the flexibility that they have in the SI model, because not all applications are in the same environment. And they want the ability to sometimes have applications funded by hardware in the private data centers and maybe other applications supported by software or SAS. And what we're seeing inside of a single large enterprise two or three of these deployment models come through and what customers value is the consistency of, you know, delivery policies and security policies across these consumption models. And so we're going to continue to offer this flexibility and it's core to how we intend to continue to drive earnings growth in the business.

That's helpful. And just maybe as a follow-up, in terms of the software trajectory, what sort of signals might you suggest we look for in terms of sort of things getting better and things getting back on normal, apart from just sort of the macro? What kind of advice would you give the analysts?

Simon, you know, in terms of specific metrics, more to come.

You know, the delivery approach that Francois was describing, one of the reasons why we have gotten away from trying to, you know, specifically guide to a mix is because, again, we give customers flexibility and we do not try to specify which one we think is the better approach. We leave that, you know, to the customer to make that decision for themselves. And so, we will see some fluctuation and volatility between what's software and what's hardware. I think when we actually see the SaaS business, particularly around distributive cloud, over the next few years become much more substantial, that volatility will continue to decrease as more and more of that business will come to us in a roundable fashion. And so as that business continues to grow, you can be looking to us for more metrics around that that will give some more forward-looking data points of where that expectation and that software revenue will come.

Thank you very much.

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

Hey, guys. Following up on a few of the questions asked here already, but what are you seeing demand-wise or demand stabilization between the product side, meaning on the ADC side versus security? And really asking also, you know, what percentage of your customers are actually using products from both as we're trying to understand what penetration opportunity you guys have left.

Hey, Jim, the so let me let me give you a sense by byproduct in sort of what we're seeing in terms of demand. So where, as I said, the hardware demand has been soft. Where it has been the softest is in the ADC space where customers are really looking to, you know, delay purchase orders and where they can sweat their assets. Security, stand-alone security has been more resilient than in ADC. But the security that is attached to ADC, of course, is affected in the same way that ADCs are. We have also seen a strong demand for NGINX. We had quite a strong quarter on demand for NGINX for largely modern application deployments, as well as renewal and expansion from existing opportunities. And where we are seeing also very strong growth, but of course from a small base, is in our distributed cloud opportunity, which is really in security, you know, offering application security in front of a lot of applications, but deploys a service, increasingly seeing more opportunities for API security, which is a nascent but growing and exciting market, and also securing multi cloud networking. So you're connecting applications across cloud and doing so in a secure way. these areas are growing rapidly, but from a small base. And this is where we're seeing a different trend in demand. That I think is kind of, when you look at the overall portfolio, this is how we see the various demand levels.

Makes sense. And Frank, maybe for you, you guys keep mentioning expansion opportunities and expansion rates being pretty strong. I know you're not quantitatively giving them, but can you qualitatively kind of give us some color around what you saw versus the first half of the year with net retention rates, you know, be it on recurring revenue or just the recurring software piece, and also trying to understand how much of growth is being constrained by, you know, the transition to recurring sources, particularly the SaaS side of things as you collect more revenue over time but less up front. Thanks, guys.

Sure. So, yeah, that dynamic, I would be excited to see, Jim, but we have not yet seen that where the SaaS piece has overtaken the term-based subscription side of the business. That still is the majority of our software revenue. In terms of net retention rates, it was strong in the quarter. It is, you know, that part is part of our renewal base of revenue, which has been, you know, frankly, much closer to plan than new business. New business activity was challenged in the quarter in relation to what we expected to do at the beginning of the year, but much better than what we had seen in the first half of the year. And so in totality, again, the net retention that we have seen in our recurring base of revenue and the renewal base of revenue has been growing and strong. But the new business opportunities that we see, those are the ones that are still challenged in relation to what we expected to do at the beginning of the year. but they were largely in mind slightly better than the revised expectations that we set last quarter.

Thanks, Frank. Thank you. Our next question is from Meadow Marshall with Morgan Stanley.

Please proceed with your question.

Great, thanks. Maybe first question, was there any difference in the mix that you ended up seeing in the quarter versus expectation? I guess I'm just asking because the backlog seems to have been exhausted, but yet the system's number was maybe a little bit lighter than expected. So just are more customers kind of opting now for virtual editions as they move back towards kind of thinking about hybrid cloud? And then I have a second question just on, you made a point of talking about the share gain opportunities. Just what has been the best entry point or targeted sales program to kind of identify and go after some of these customers? Thanks.

Thank you.

And in a way, your two questions are related because it comes down to this, you know, flexibility of the model we've built of offering hardware, software, and SaaS. So, you know, to the first part of your question, was there any, you know, Relative to our expectation in terms of the mixed hardware software, I think we were pleased to see that a couple of the bigger software deals that we had been expecting for a while actually did come through and were not delayed. And so that helped the overall software performance for the quarter. And we think also speaks to the stabilization in terms of customers still not returning to, of course, 22 levels in terms of new projects and starting these new, especially big software transformational projects, but at least the ones that are absolutely necessary for customers to move through with them. So that's on the software side of things. I think on hardware things, we had expected to be shipping our backlog throughout the the year and we're pleased that we're able to do that. We're pleased that we are returning to normal lead times. Our lead times are almost at normal levels at two weeks, which is really important for our customers to get their equipment because we think that will be a catalyst for future demand once they've digested these projects and implemented them. In terms of share gains, Mera, we have been, so in the ADC, traditional ADC market specifically, we believe that we are gaining share. Uh, largely because of the investments we've made in next generation platforms and next generation software and the flexibility of the model. We, we, we are delivering. So, you know, uh, we, we, you know, meta, we have rolled out the R series and bellows platforms this quarter. I think over 70% of the shipments that we made in hardware were on the new R series platform. So, adoption of that platform. has been phenomenal. We think it's the fastest adoption we've seen in a transition like that ever. And it speaks to the capabilities of the new platforms and the new software that brings client-like benefits to the hardware on-prem environment. And so the combination of these investments we've made and the CapEx model, the OpEx model that we offer, continuing to offer perpetual and subscription models, really is powerful and relative to our competitors in the ADC space, we are taking share and in some cases specifically taking customers away coming to F5 because of the investments we've made. We are also going strongly after the WAP market, that is web application firewall, API security, DDoS and bot protection as a service. This is a market meetup where we are a new entrant with distributed cloud. but we are gaining customers very rapidly and aggressively attacking the incumbents in the market. We are quite differentiated in API security and bot defense in particular, and also in networking applications between cloud, the secure MCN opportunity being a new and emerging market where distributed cloud has a very strong offering. So these are areas where we feel we are gaining share and hopefully we'll continue to gain share in quotas to come.

Great.

Thank you.

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

Great. Thanks. So last year you had a pretty steep decline in your systems business. You cited supply chain and Now you're up low single digits and you're suggesting that your backlog has already been resolved. That really doesn't imply a particularly strong headwind as we go forward of 68%. So can you reconcile why that headwind of 68% would be there given you haven't really produced meaningful, strong top line growth in that business? And then conversely, You're citing a 6% to 8% headwind going forward. Your comps on the software side were extremely difficult over the last year, but now I've gotten quite easy with declines in the September quarter last year and are setting up for pretty easy comps over the next year. So if I look at the software side of it, is it reasonable to think that we're going to now see a meaningful shift to software growth and therefore it's still possible to produce revenue growth on the product side as we go into 2024. I know you don't want to give guidance, but you have given guidance on 68% headwind, and so what should we be thinking about as the offset to that in these easy software comps?

Yeah, Alex, it's Frank. I'll start and see if Francois wants to add anything, but the The long short the 16% is more specific to the systems business and that's specifically related to the level of backlog that we had going into FY 23 and so obviously it's been a boost to our recognized revenue in relation to where the demand has been for FY 23. But going looking ahead at FY 24 that's the six to 8% that we've referenced, which is largely associated with the hardware business. The demand side of the equation has been challenged in both. Obviously, it's been better in Q3 than what we saw in the first half of the year, but it's stabilized at a much lower level than where we were in FY22. And so we do expect there to be a change, and we do expect specifically in systems to see a much larger change than where we have been in FY23 in terms of demand. But that intersection between, you know, that 6% to 8% total revenue headwind that we saw as recognition in 23 that will not be there in 24, that's the piece where, you know, we're hesitant to know exactly what point in 24 we'll see that change in the system span. On the software side of the equation, you know, we have seen great traction, obviously, in the renewals that we've mentioned. We have seen, you know, a challenging new environment so far. That will likely also change. But we are seeing that change likely come more in the form of SAS revenue, which will not necessarily recognize in the same rate. And FY24 is what we've seen in our term-based agreements. And so it's too early to tell right now exactly how that will all play out. You know, we'll have more to talk about that on the next call. But that's the early indication and the way to reconcile some of the comments that we made.

Thank you, Frank. And I would just add so that it's absolutely clear. When we talk about, Alex, the six to eight points headwind, it's not demand headwind. In fact, we expect demand next year in hardware to be higher than this year. But it is a shipment headwind that's impacting recognized revenue. So I wanted to be clear about that.

Just to clarify, it sounds like you don't expect your software revenue to recover enough to offset the headwind on hardware. And it sounds like your hardware expectations for demand is less than the headwind as well. Are we thinking that the outlook should be fairly flat or even down on the revenues? Because that's the implication you're giving us on hardware. on these commentary relative to the product side of the equation.

Well, look, Alex, we're not ready to guide for 2024. What we've said about the six to eight point headwind on total revenue is no different than we said last quarter. And it is simply math that we say, look, we want to make sure that one knows that the you know this this year given given that we're shipping all of our backlogs you know we're shipping the equivalent of six to eight points more of revenue than than the demand we've had for for hardware we're not ready to guide for where revenue would be in 2024 but it's clear that that six to eight point headwind is is going to challenge growth uh for next year that being said i also want to be clear uh you know we we have been on a march of of double digit earnings growth and we want to remain on that march uh you saw that we took a number of actions uh to drive earnings growth this year and we're confident we'll achieve double digit earnings growth we had said from 2022 when we started with the supply chain challenges that we expected to work through these challenges in our model and start showing the improvements in the back half of 2023. And you're seeing this quarter gross margins made a step improvement as we started to work out through these expensive components. And we have been quite disciplined around price realization with the price increases that we drove last year. And you saw also that operating margins made a 600 basis point jump sequentially And we expect to continue this operating leverage next year. So this is, you know, our plan on continuing to drive earnings growth.

Good. Thanks.

Thank you. Our next question is from Michael Ng with Goldman Sachs. Please proceed with your question.

Hey, good afternoon. I just have two questions. The first is on the strength of software. You know, it's clear you had strength and renewals and true forwards. I think last quarter there was some weakness in new deals. I was just wondering if you were seeing some improvements there and whether you think software revenue can grow in the September quarter. And then I just have a quick follow-up.

Uh, sure. Michael, thanks for the question. Um, yes, we, we did see, you know, an improvement in the new business activity though. It was still down from where we were, you know, a year ago. And so, uh, it was a positive sign to see again, as Francois mentioned earlier, some of the irrationality, uh, come out of the buying behavior, uh, still many more deal approval levels than what we would have seen a year ago. Um, but the deals are actually getting approved. So we're really happy to see that come through. And we're obviously not guiding to a mix on software versus hardware sequentially, but we do have a lot of faith in the software business, obviously. Last quarter was a challenging quarter. This quarter came back closer to the expectations that we had for the business. And we'll talk more about the actual outcome next quarter.

Great. Thanks, Frank. I just want to circle back on some of the double-digit earnings growth commentary. I think in the past you guys have said you expect double-digit earnings growth for fiscal 24 as well, more so on cost cuts, you know, recognizing the uncertainty in the top line. Is that still the case, and do you still expect at least 300 basis points of margin expansion next year? Thank you.

Absolutely. So yeah, Michael, when we made those comments, obviously we had had an outlook of 7 to 11%. We're higher now on EPS for where we're going to be in FY23. We're really happy about that. Some of that is coming from a tax benefit. And so when we take a look at our pre-tax income for FY24, it's certainly our aspiration to be double digit. How the things like tax and share repurchase and stock price of those share repurchases come into play, it's just too early to, you know, to give any specific guidance further than that on FY24. But we're really, really happy with the progress that we made, the leverage that we're seeing, particularly in our gross margins and operating margins. It's exactly what we thought was going to happen and, you know, more to come on FY24.

I think on the second part to the question around operating margins, look, we said we expected operating margins in 2024. to be around 33%, and we still feel that that opportunity is there, and we tend to drive to that.

Thanks, Frank. Thanks, Francois. Thank you.

Due to time constraints, our last question is from Sebastian Nagy with William Blair. Please proceed with your question.

Hi. Thanks for squeezing me in, guys. Can you maybe just talk a little bit about how competition for F5 has changed, particularly as you've entered some of these new markets, like API security, multicloud networking, and then maybe expand a little bit on some of the key points of differentiation that's allowing you to take share from incumbents here?

Can you just repeat the first part, the beginning of the question?

Yeah, just maybe, could you talk a little bit about how competition has changed as you entered some of these new markets around API security, multiple networking, et cetera?

Yeah, thank you.

So, like, so in API security, it's a nascent market. There are, you know, a few startups that are in the mix. But what, a couple of things about API security, one is, uh it is a big data problem uh because you have a lot of ap companies are dealing with a lot of api calls and detecting threat patterns requires really being able to find a needle in a haystack sometimes with sophisticated attackers and so to really win in api security you really have to have ai and ml capabilities as well as the capacity to mitigate these attacks and where F5 is differentiated is in our ability both to discover APIs and all the API patterns and then to protect against API attacks and mitigate potential attacks. And we're seeing that players that don't have the capabilities to do both don't have the same kind of competitive position. So that's where the landscape is in API security and we're progressing quickly as well. in the market now with distributed cloud. In the multi-cloud networking space, it's again an emerging market, but we think it's going to grow rapidly because we're seeing most of our customers are now using multiple clouds. In our latest State of Applications Strategy Report, we found that close to 90% of our customers are now using multiple clouds, and increasingly, they need to connect applications or portion of applications across these clouds. And what we're seeing in the competitive landscape there is there are a couple of players that have capabilities to do that really at layer three, at the networking layers, maybe layer three, layer four. But we're seeing increasingly enterprise need not just layer three to layer four networking, but also layer seven security. to really connect these applications securely, and one has to go with the other. And essentially, S5 is now with all of the integrations we've made on our distributed cloud, taking from our organic innovation and taking from our acquisitions, from Shape and Threadstack and Voltera, and some capabilities from Big IT, we're essentially the only player today that can secure application and APIs across cloud, across any environment, and connect these applications and APIs across cloud in any environment securely. And we think that that is where this market is going to play out, you know, going forward. So we're pretty excited about our opportunity in this space.

Great. Thank you. That's very helpful. Thank you.

This concludes today's call.