F5, Inc. (NASDAQ:FFIV) Q1 2024 Earnings Call Transcript

F5, Inc. (NASDAQ:FFIV) Q1 2024 Earnings Call Transcript January 29, 2024

F5, Inc. misses on earnings expectations. Reported EPS is $2.32 EPS, expectations were $3.03. F5, Inc. isn’t one of the 30 most popular stocks among hedge funds at the end of the third quarter (see the details here).

Operator: Good afternoon, and welcome to the F5 Inc. First Quarter Fiscal 2024 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. [Operator Instructions] As a reminder, this conference is being recorded. [Operator Instructions] I’ll now turn the call over to Ms. Suzanne DuLong. Ma’am, you may begin.

Suzanne DuLong: Hello, and welcome. I’m Suzanne DuLong, F5’s Vice President of Investor Relations. Francois 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 A copy of today’s press release is available on our website at f5.com, where an archived version of today’s audio will be available through April 28, 2024. 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 13743521.

The telephonic replay will be available through mid-night Pacific Time, January 30, 2024. 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. 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 GAAP 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.

Francois Locoh-Donou: Thank you, Suzanne, and hello, everyone. Thank you for joining us. In my remarks today, I will speak to our Q1 highlights as well as our expectations for Q2. Frank will then review the details of our Q1 results and provide some additional color about our outlook. Q1 was our third consecutive quarter of stability with the quarter and individual deals playing out largely as expected. We are not yet hearing that customers’ budgets are increasing but the more predictable spending patterns are encouraging. Our team delivered another solid quarter with consistent performance across our geographic theaters. We had a strong performance from our service provider vertical, which correlates to unusually strong perpetual license software revenue in the quarter.

This is likely less indicative of service provider trends overall and more of a reflection of F5’s position in some key projects. We delivered Q1 revenue above the high end of our guidance range. In addition, our continued operating discipline enabled us to deliver non-GAAP operating margins of 35.5%. This is up more than 900 basis points from the year ago period. As a result of these factors and a modest tax benefit, we also delivered non-GAAP earnings per share growth of 39% with EPS of $3.43 per share, well above the high end of our guidance range. Our customers are still watching their budgets closely. As we look ahead, we are encouraged by several factors, including better predictability from customers, improving systems demand and the fact that some customers are making decisions that investments need to happen now.

We are cautiously optimistic that these factors signal an easing of the extreme customer spending caution that characterized last year. And in fact, we are seeing stronger underlying demand. Because of the backlog headwind we faced in FY ’24, despite improving demand signals, we expect our Q2 revenue will be down low-single digits from Q2 of last year. Frank will discuss our outlook in greater detail in a few minutes. As little as five years ago, nearly every large enterprise organization expected that they would move their application environments from on-premises to the public cloud or SaaS. They also expected that doing so would dramatically simplify their operations and reduce costs. Instead today, customers are grappling with a more intricate and costly set of challenges than ever before.

In our most recent State of Application Strategy research, 88% of our customers report they are currently operating applications across on-premises and cloud environments. The same research found that 38% of organizations are hosting their applications in six different types of environments. The expanding number of applications across distributed environments demands specific expertise and tools for each environment, which adds cost and operational complexity. At the same time, this expanded landscape provides cybercriminals with more potential targets, amplifying security concerns. This complexity is further intensified by the rapid growth in the number of applications, a growth trajectory that is poised to accelerate significantly with the widespread adoption and proliferation of AI.

We firmly believe that F5 is strategically positioned to support our customers as they navigate these escalating challenges across a rapidly evolving landscape. Our innovation and product portfolio evolution over the last several years has been aimed at addressing exactly these challenges. Before I pass the call to Frank, I will speak to some customer highlights from the quarter. Our F5 BIG-IP family serves traditional applications either on-premises, co-located or in cloud environments. BIG-IP’s data plane performance, automation capabilities and seamless integration into public cloud environments continues to differentiate it from competitors. Our commitment to innovation and to providing customer flexibility through a range of consumption models also has enabled us to continue to gain share in the traditional ADC space.

BIG-IP’s capabilities drove a significant win in Q1 with a North American service provider. The customer is now deploying F5 cloud-native software at scale in its 5G architecture. Over the last five years, we have invested to modernize BIG-IP and to deliver industry leading container native functions to scale and secure 5G cloud infrastructures. These investments made this win possible. Modern F5 BIG-IP software is now powering the growth from this provider’s consumer 5G handset demand and securing its overall fixed wireless access offerings, the fastest growing 5G service in North America. Turning to F5 NGINX, which serves modern container-native and microservices-based applications and APIs. We continue to see large enterprises adopt NGINX for their cloud and Kubernetes-based applications.

As those applications scale, we are seeing our NGINX opportunity scale as well. In addition, customers are also leveraging NGINX for app layer security for containers. In Q1, an APAC-based auto manufacturer selected NGINX Plus with App Protect to power and protect its next-generation connected car data and service offering. Beyond the standard car-related maintenance information, the customer is empowering a range of vehicle related services from traffic management and statistics to fleet management and automated insurance claims. The customer envisions providing rich data enabled services, including traffic data to government agencies for road maintenance and enabling automated insurance claim filing using telemetry and location data. The customer selected NGINX for this ambitious project because of its unique ability to implement WAF for containers on AWS as well as its ability to support specific requirements that could not be met by native cloud services.

F5 Distributed Cloud Services is a portfolio of SaaS and managed services which we have built from a combination of organic and inorganic efforts. The platform will have its second birthday shortly and continues to gain traction with customers as a result of its flexibility and strong capabilities. We are intercepting two exciting growth categories with Distributed Cloud, Webapp and API Protection, or WAAP, and the emerging opportunity in secure multi-cloud networking. In fact, we have seen explosive growth in the number of attacks blocked by Distributor Cloud’s WAAP capabilities with a number of blocked attacks growing more than 100% in Q1 from Q4. In one WAAP win from the quarter, a large U.S. based financial institution selected F5 Distributed Cloud Services to solve its challenge of application security in hybrid cloud.

The customer leveraged our flexible consumption program, adding API discovery and protection to manage the many fintech aggregator applications that access their financial data through APIs. F5 Distributed Cloud Services is also gaining traction in API security. In just the last 12 months, we have observed a substantial increase in the volume of API attacks. 95% of customers surveyed for our State of Application Strategy report say they have deployed an API gateway. This is a significant increase from 2019 when only 35% have deployed one. In fact, 92% of the total attacks mitigated by Distributed Cloud in Q1 were targeted towards APIs, that is up from 73% in Q4. As an example of an API security win in Q1, following multiple service impacting outages, a service provider in our APAC region selected Distributed Cloud to replace their prior API security vendor.

Distributed Cloud’s multi-cloud networking capabilities are making it possible for the customer to switch between public clouds when necessary while providing visibility and reporting via a single pane of glass. F5 Distributed Cloud Services is also gaining traction in secure multi-cloud networking use cases. In another example from Q1, a global provider of traditional and digital learning resources deployed Distributed Cloud Services. The customer was looking for consistent application-level security, multi-cloud scalability and networking. Distributed Cloud enable them to simplify their infrastructure, strengthen the management of their multi-cloud architecture and improve application security. They also deployed multiple F5 customer edge software instances in their cloud infrastructure and in their on-premises data center, enabling them to meet an aggressive cloud migration schedule.

I will spend just a 2 minutes talking about the opportunity we see emerging with AI applications. AI will accelerate the growth in the number of applications and APIs. We are seeing the start of this already in the form of AI models and new AI-driven services becoming available from start-ups and established tech companies alike. We expect that as enterprises ramp adoption of AI over the next one to two years, that adoption will bring with it a flood of new enterprise applications that leverage those AI models and the APIs of the new AI-driven services. These AI-powered applications differ from typical applications in several important ways: first, they are API-driven, both in terms of leveraging the APIs of third-party AI models and services and also in terms of exposing their own capabilities as APIs for downstream use.

Thus, API security for these AI-powered apps is critical. Customers tell us that API security is the top security service in used or planned for use to protect the integrity of AI and machine learning models. Customers also tell us that AI is driving demand for a comprehensive API security solution, inclusive of DDoS protection, bot detection and data masking and leak protection. Second, AI-powered applications tend to be comprised of many different components and data sources, which are distributed across hybrid and multi-cloud environments. F5 is an AI enabler. Effectively optimizing, managing and securing AI applications and the APIs that connect them demands a blend of specialized expertise and capabilities that align seamlessly with our solutions portfolio.

We are the application and API expert with a deep understanding of the needs of demanding applications built over decades. This expertise and the capabilities of F5 Distributed Cloud Services is a powerful combination, particularly as customers begin to deploy real-life AI use cases. During Q1, we secured a win that highlights the synergies of our product families and showcases how F5 supports and enables AI-driven use cases. An EMEA-based service provider selected the combination of F5 Distributed Cloud Services and BIG-IP to secure and deliver a first-of-its-kind AI-as-a-service offering for their B2B customers. After comparing F5’s capabilities to alternatives, the customer determined only F5 can meet the security and scalability requirements needed to deliver their offering in a cost efficient way.

These real-life use cases offer a view to how we are enabling customers to secure, deliver and optimize their applications and APIs and how we simplify the challenges of operating in a complex hybrid multi-cloud world. Now I will turn the call to Frank. Frank?

Frank Pelzer: Thank you, Francois, and good afternoon, everyone. I will review our Q1 results before I elaborate on our Q2 outlook. We delivered Q1 revenue of $693 million, reflecting sales that were down 1% year-over-year with a mix of 56% global services and 44% product revenue. Global services revenue of $387 million grew a strong 7% due to continued high maintenance renewals as well as the continued benefit from price increases we introduced in FY ’22. Product revenue totaled $306 million, down 10% year-over-year. Systems revenue of $135 million declined 22% year-over-year, reflecting a lower level of backlog-related shipments than we had in the year ago period. Software revenue grew 2% over the year ago period to $170 million.

As Francois noted, Q1 was an unusually strong perpetual software license quarter with several service providers opting to leverage CapEx versus OpEx models. Our perpetual software revenue was $46 million in Q1, representing 19% growth year-over-year and 27% of Q1 software revenue. We believe providing consumption model flexibility to our customers is a strategic advantage over competitors who restrict customer choice. The result can be quarters like this one, where we have unusual growth in perpetual software revenue. We do not believe that Q1 software revenue mix is indicative of changing customer preferences. Rather, it is a function of preferences of specific customers in the quarter. Our subscription-based revenue declined 3% year-over-year to $125 million, representing 73% of Q1’s total software revenue.

New subscriptions and renewals both performed to plan in the quarter. Revenue from recurring sources contributed 73% of Q1’s revenue, up from 68% a year ago. This is down slightly from recent levels as a result of the perpetual license revenue contribution in the quarter. Recurring revenue includes subscription-based revenue as well as the maintenance portion of our services revenue. On a regional basis, revenue from Americas was down 6% year-over-year, representing 54% of total revenue. EMEA grew 5%, representing 28% of revenue, and APAC grew 8%, representing 18% of revenue. Looking at our major verticals. During Q1, enterprise represented 64% of product bookings, service providers represented 17%, and government customers represented 19%, including 4% from U.S. federal.

Our Q1 operating results were strong, reflecting our continued operating discipline. GAAP gross margin was 80.3%, non-GAAP gross margin was 83.1%, an improvement of 264 basis points from Q1 of FY ’23. GAAP operating expenses were $392 million. Non-GAAP operating expenses were $330 million. Our GAAP operating margin was 23.8%. Our non-GAAP operating margin was 35.5%, an improvement of more than 900 basis points from Q1 of FY ’23. Our GAAP effective tax rate for the quarter was 20.7%. Our non-GAAP effective tax rate was 19.9%. This is below our initial expectations for the year as a result of IRS guidance issued during the quarter relating to foreign tax credits. Our GAAP net income for the quarter was $138 million or $2.32 per share. Our non-GAAP net income was $205 million or $3.43 per share, well above the top end of our guidance range.

This is a result of the revenue beat, continued operating discipline with $0.09 as a result of the Q1 tax benefit. I will now turn to cash flow and the balance sheet, which also remain very strong. We generated $165 million in cash flow from operations in Q1. Capital expenditures for the quarter were $9 million. DSO for the quarter was 67 days due to the back end linearity of invoicing in the quarter. Cash and investments totaled approximately $832 million at quarter end. Deferred revenue increased 4% year-over-year to $1.83 billion. Our share repurchases reflect our ongoing commitment to returning cash to shareholders. We repurchased $150 million worth of F5 shares in Q1 at an average price of $163 per share. Finally, we ended the quarter with approximately 6,440 employees.

Francois outlined our Q2 outlook at the start of the call. I’ll recap it with some additional color. We expect Q2 revenue in the range of $675 million to $695 million. We expect gross margins in the range of 82% to 83%. We estimate Q2 operating expenses of $347 million to $359 million. This is a step-up from Q1, reflecting our seasonal sequential uptick related to the reset and payroll taxes. This year, it also reflects marketing expenses related to our global App World customer events, which will take place in Q2 in San Jose and in other locations across the globe. We are targeting Q2 non-GAAP EPS in the range of $2.79 to $2.91 per share. We expect Q2 share-based compensation expense of approximately $56 million to $58 million. At this point in the fiscal year, we are not revising our revenue or operating margin targets for FY ’24.

We continue to expect to achieve our FY ’24 operating margin target range of 33% to 34%, which accounts for the normal seasonal step-up in operating expenses from Q1 to Q2. We now expect our FY ’24 tax rate will be in the range of 21% to 22%, down slightly from our prior range of 21% to 23%. Given the new outlook in our annual tax rate, we now expect FY ’24 non-GAAP EPS will grow between 6% to 8%. This is up from the 5% to 7% range we provided last quarter. I will now turn the call back over to François. François?

Francois Locoh-Donou: Thank you, Frank. In conclusion, I will reiterate that F5 is the only company capable of securing, delivering and optimizing any application, any API regardless of its location, be it in the data center, any one of the public clouds, as SaaS, or at the network edge. Amidst a complex web of environments and solutions, F5 empowers customers to establish and maintain a consistent security posture across all of their applications, enhancing security, streamlining operations and reducing costs. Moreover, we are unifying our solutions to provide customers with unprecedented levels of visibility, manageability and automation. Before we go to questions, I will elaborate on the strategy and product session we are hosting next Thursday.

We are going to use this event to discuss the hybrid multi-cloud challenges faced by large organizations worldwide including the implications of AI on applications, APIs and security. We also will provide an overview of our product families, the market opportunities we see for them and how our portfolio transformation benefits our customers and differentiates F5. We look forward to seeing several of you live in San Jose and more of you virtually. Operator, please open the call to questions.

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Q&A Session

Operator: Thank you. We will now be conducting a question-and-answer session. [Operator Instructions] Our first question is from Samik Chatterjee with JPMorgan. Please proceed with your question.

Joseph Cardoso: Hi. Thanks for the question, guys. This is Joe Cardoso on for Samik. Just one question from me. You highlighted encouraging signs of stabilizing demand trends. Can you maybe just talk to the year-over-year revenue trends that you’re seeing excluding the backlog headwinds from a year ago? And then perhaps can you just provide a bit more granularity around that comment? Like, what are you seeing specifically under the hood from a customer or product portfolio perspective, and whether you’re seeing any areas trending or any areas trending better than others? Thanks for the question.

Francois Locoh-Donou: Well, thanks, Joe. Let me start with the first part of your question. Look, we shared at the beginning of the fiscal year that even though we were guiding revenue down — flat to down to 3% down for the fiscal year, that if you excluded the backlog effect, that would amount to about mid-single digit growth. In terms of the demand that we are seeing, certainly in terms of demand, if I compare what we saw in the first half of 2023 versus the demand that we saw in Q1 and what we expect to see in our Q2, half-on-half, first half ‘23 to first half ‘24, demand is meaningfully up relative to last year. Now that is, I would say, generally broad-based across all major theaters and it’s also across most industry verticals.

We talked to some verticals are performing better than others. But generally, broadly, we’ve seen that across all industry verticals. In terms of the product trends, I would say the trends are similar across the portfolio and not different than what we described in October with continued great progress on our core franchise, BIG-IP, continued progress on NGINX and modern applications and continued strong adoption of our Distributed Cloud Services.

Joseph Cardoso: No, I appreciate the color, Francois. Thanks.

Francois Locoh-Donou: Thank you.

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

Tim Long: Thank you. Two questions, if I could. First, maybe Frank or Francois, if you could just talk a little bit about the subscription number in the quarter. I guess the perpetual is really strong, but could you talk a little bit about particularly the sequential downtick in subscription? Is this related to kind of true forwards or any kind of cannibalization or anything else in there you could go a little deeper on the software subscription weakness? And then, the follow-up for Francois, I think you mentioned something about competitive wins in more in the systems and traditional ADC area. Obviously, there’s some disruption at one of your major competitors. Could you just give a little color on how things are going competitively and how win rates are and how much room you think there is to take share in that more traditional ADC area? Thank you.

Frank Pelzer: Yeh. Absolutely, Tim. Let me take the first part and I’ll let Francois take the second part. So with subscriptions, again, as I mentioned in the prepared remarks, largely performed to our expectations. On a sequential basis, if we were purely ratable, obviously, that would be concerning. But since we obviously have got some 606 term-based subscriptions in there that will hit at different points in time. We had more renewals, frankly, in Q4 than we did in Q1. And so that’s just the natural progression on the sequential growth side there. But we’re not concerned at all about it. This is really our renewals and the new performed to our expectations and no change for our outlook for the year based off of that. But I’ll let Francois talk a little bit on the competitive side.

Francois Locoh-Donou: Tim, on the competitive side, we felt we are in a pretty strong competitive position, and I think our position of strength is, in fact, growing. And I would say, we are seeing, actually, increased inbound interest from both customers and partners into F5, and I think that’s largely due to two big factors. One factor is, frankly, we have not one, but three competitors that have gone through a change of control events in the last 12 months to 18 months. One was primarily a hardware software competitor, one has been a software competitor and one has been a SaaS competitor. And all three have had to kind of change their customer playbook as a result. And we’re seeing inbound customer interest from that. That contrasts with our approach and, frankly, the investments we’ve made over the last several years, where we have, just at this point in time, where some competitors are getting weaker.

We’re introducing a very exciting set of proposition, that rSeries has had very strong adoption in the market. We’re introducing next-generation hardware and software, that creates an exciting road map for competitors — sorry, for customers. And so the contracting sort of investment in road maps between players is really strengthening our hands. And we’re seeing a lot of accounts where historically, we had been blocked or locked out of these accounts that we have been able to crack in the last couple of quarters and we expect that to continue. In fact, just this week, we had a customer here that is one of the largest companies in America, one of the Fortune 100. We have not been able to crack that account. And we are now migrating pretty much their entire application estate from a competitor to F5.