F5, Inc. (NASDAQ:FFIV) Q1 2023 Earnings Call Transcript

F5, Inc. (NASDAQ:FFIV) Q1 2023 Earnings Call Transcript January 24, 2023

Operator: Greetings, and welcome to the F5, Inc. First Quarter Fiscal Year 2023 Financial Results Conference Call. 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.

Suzanne DuLong: Hello, and welcome. I am Suzanne DuLong, F5’s Vice President of Investor Relations. François Locoh-Donou, 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 A copy of today’s press release is available on our website at f5.com, or an archived version of today’s audio will be available through April 24, 2023.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 13735357.

A telephonic replay will be available through midnight Pacific Time, January 25, 2023. For additional information or follow-up questions, please reach out to me directly at s.dulong@f5.com. Our discussion today will contain forward-looking statements, which include words such as believe, anticipate, expect and target. These forward-looking statements involve uncertainties and risks that may cause our actual results to differ materially from those expressed or implied by these statements. 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 François.

François Locoh-Donou: 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 multiyear 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 our 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 FY ’23. We remain 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 1 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 FI 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, rSeries 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 infrastructure needed to deliver, secure and manage them continue to get more complex. Customers need a partner like F5 who can help them simplify, reduce our 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 Frank. Frank?

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Frank Pelzer: Thank you, François, 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 FY ’23 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 François 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 François noted, new multiyear 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 subscription, 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. GAAP gross margin was 77.9%. Non-GAAP gross margin was 80.4%, in line with our guidance for the quarter and below where we expect to be for the year. GAAP operating expenses were $454 million. Non-GAAP operating expenses were $378 million, in line with our guided range. Our GAAP operating margin was 13%. Our non-GAAP operating margin was 26.5%.

Our GAAP 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 paydown 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 million 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 million 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 million to $66 million.

Given our Q1 results and our Q2 expectations, I also want to elaborate on our FY ’23 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 FY ’23 revenue mix will reflect revenue contribution weighted more towards hardware and services and less towards software than we expected a quarter ago. Our FY ’23 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 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 François noted, we continue to expect non-GAAP earnings growth in the low to mid-teens for FY ’23. 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 François. François?

François Locoh-Donou: 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.

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Q&A Session

Operator: Our first question is from Sami Badri with Credit Suisse.

Sami Badri: All right. Thank you very much for the question or at least 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, if you can just decompose that? The other question I have is, 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 unless just say they get worse, how will those signals manifest themselves into F5’s business and results?

And a good example, a question we get is, if things decay or deteriorates, does that mean that product orders sitting on your backlog get canceled? Is that the — is that kind of the deterioration that would yield that kind of output? I mean to get your comments on those two questions.

Frank Pelzer : Sure, Sami. So I’m going to start with your first question, and then I’ll let François 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 François refer to your second question. .

François Locoh-Donou: I mean 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 displaced 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 rate and you’re seeing that in the results. And we’ve seen it, frankly, across the board in terms of softer demand in software, but also softer demand in hardware this quarter than we had a quarter a year ago.

Operator: Our next question is from Tim Long with Barclays.