Suzanne DuLong:

Hello and welcome. I am 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 here 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 A copy of today's press release is available on our website at f5.com, where an archived version of today's audio will be available through, October 28, 2024. We will post the slide deck accompanying today's webcast 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 13747602. The telephonic replay will be available through midnight Pacific Time, July 30, 2024. For additional information or follow-up questions, please reach out to me directly at [email protected]. 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.

Frank Pelzer:

Thank you, Francois, and good afternoon, everyone. I will review our Q3 results before I elaborate on our Q4 outlook. We delivered Q3 revenue of $695 million with a mix of 56% global services and 44% product revenue. Global services revenue of $387 million grew 3%, in line with our expectations, which reflected lapping the benefit of prior price increases. Product revenue totaled $308 million, down 6% year-over-year due to a lower level of backlog-related systems shipments than a year ago quarter. Systems revenue of $130 million demonstrates a slowing decline of 16% year-over-year. Software revenue totaled $179 million, representing 3% year-over-year growth and 13% sequential growth. Subscription-based revenue contributed $155 million or 87% of total software revenue, representing 2% growth year-over-year and 10% sequential growth. Subscription renewals remained strong in Q3 with continued solid expansion in our multi-year agreements. An exception to this trend is our Bot Defense point solution where the majority of customers are renewing, but some are opting for less sophisticated lower-cost options. Rounding out our software revenue, perpetual software contributed $24 million. Revenue from recurring sources contributed 77% of Q3's revenue, up from 75% a year ago. Recurring revenue includes the subscription-based revenue as well as the maintenance portion of our global services revenue. On a regional basis, revenue from Americas was down 4% year-over-year, representing 55% of total revenue. EMEA delivered a strong quarter with 5% growth representing 27% of revenue. APAC declined 1%, representing 18% of revenue. Looking at our major verticals, enterprise customers delivered another strong performance, representing 67% of product bookings in the quarter. Government customers also performed well representing 21% of product bookings, including 7% from US Federal. Finally, service providers represented 12% of Q3 product bookings. Our Q3 operating results were strong, reflecting our continued operating discipline. GAAP gross margin was 80.4%. Non-GAAP gross margin was 83.1%, an improvement of approximately 65 basis points from Q3 in FY '23. Our GAAP operating expenses were $396 million. Our non-GAAP operating expenses were $346 million. Our GAAP operating margin was 23.4%. Our non-GAAP operating margin was 33.4%, reflecting an improvement of approximately 20 basis points from Q3 of FY '23. Our GAAP effective tax rate for the quarter was 16%. Our non-GAAP effective tax rate was 17.5%. Similar to Q3 of last year, the lower-than-expected tax rate reflects a non-recurring benefit associated with filing our annual federal income tax return during the quarter. Our GAAP net income for the quarter was $144 million or $2.44 per share. Our non-GAAP net income was $199 million or $3.36 per share. I will now turn to cash flow and the balance sheet, which also remained very strong. We generated $159 million in cash flow from operations in Q3. CapEx was $6 million. DSO for the quarter was 54 days, in line with 51 days in Q2. Cash and investments totaled approximately $943 million at quarter end. Deferred revenue was $1.77 billion, down 1% from the year-ago period. The change is due to a higher weighting of our sales to term-based subscriptions and a corresponding lower allocation of bookings to deferred revenue. In addition, we are lapping price increases on maintenance renewals. We also have implemented some strategic go-to-market decisions, including no longer incentivizing customers towards multi-year maintenance agreements. Our share repurchases reflected our ongoing commitment to returning cash to shareholders. We repurchased $150 million worth of F5 shares in Q3 at an average price of $172 per share. Year-to-date, we have used approximately 77% of our free cash flow towards share repurchases, far in excess of our commitment to direct at least 50% of free cash flow towards share repurchases. Finally, we ended the quarter with approximately 6,500 employees. I will now speak to our outlook for Q4. We expect Q4 revenue in the range of $720 million to $740 million on the strength of our software renewals and a slight uptick in new business momentum. We expect non-GAAP gross margins of approximately 83%. We estimate Q4 non-GAAP operating expenses of $350 million to $362 million. We are targeting Q4 non-GAAP EPS in the range of $3.38 to $3.50 per share. We expect Q4 share-based compensation expense of approximately $54 million to $56 million. Our Q4 guidance implies some positive updates to our prior outlook for FY '24. We expect approximately $2.8 billion in revenue for the year. Embedded in this is the expectation for mid-to-high single digit software revenue growth, up from the flat to modest growth expectation we had at the start of the year. We now expect our FY '24 non-GAAP effective tax rate will be in the range of 19.5% to 20%, down from our prior range of 20% to 22%. With the combination of revenue growth, continued operational discipline and a tax rate that is improving compared to our prior expectations, we now expect FY '24 non-GAAP EPS growth of approximately 12%. This is up from our prior expectations of 7% to 9% growth. We are not revising our gross or operating margin targets for FY '24 and continue to expect non-GAAP gross margins in the range of 82% to 83%, which would reflect an improvement of 50 basis points to 150 basis points from FY '23. We also continue to expect non-GAAP operating margin in the range of 33% to 34%, which would reflect an improvement of 280 basis points to 380 basis points from FY '23. Before I pass the call back to Francois, I wanted to share some personal news. I've made the decision to retire from F5. I joined F5 in 2018 to help the team navigate a massive transition from a hardware-led company to one that was more software-led. Delivering our Q4 guidance will make FY '24, the third consecutive year, where software revenue is the majority of our product revenue, signaling that we have in fact successfully completed that transition. I plan to remain with the team as CFO through the filing of our FY '24 10-K likely in mid-November. Cooper Werner, who is currently our SVP of Finance, is slated to take over as CFO upon my departure. Many of you know Cooper well. He has been with F5 for 23 years, during which he has consistently taken on new responsibilities as F5 has grown and changed. He has been SVP of Finance for the last 12 years, managing our FP&A, real estate procurement and trade organizations. His extensive financial expertise and institutional knowledge have been pivotal in guiding our business model as we have executed our software transformation. Cooper is a strong and engaging leader and we expect him to be a great addition to the executive leadership team. I will continue to work with the team between now and November to ensure a smooth transition. With that, I'll pass the call back to Francois. Francois?

Operator:

Thank you. We'll now be conducting a question-and-answer session. [Operator Instructions] Our first question is from Tim Long with Barclays. Please proceed with your question.

Frank Pelzer:

Sure, Tim. So thanks so much for the kind wishes and thanks so much for the question. Yes, Cooper is going to do a great job in the role. On the software in particular, as you know, we will update some of the ARR-type metrics at the end of Q4. So I don't want to get too much into that. But I would say that when we take a look at an NRR, it still is world-class across the business. The subscription renewals in particular continue to be quite strong with some expansion. We, obviously, talked about a little bit of a challenge in the bot business, which is helping us somewhat in that number. But what really was strong was the new business activity, which we see in the pipeline, in some cases, we see it in hardware and it converts into a software deal through the course of the negotiations. But more broadly, it was the -- guidance that we had given was really based off not necessarily expecting a lot of new business activity. And in the quarter, you obviously saw that we ended up at the top end of our guidance. So you can sort of extrapolate that into a lift in new business activity.

Francois Locoh-Donou:

Hi, Tim, it's Francois. Look, I think we have seen hardware stabilize over the last several quarters as customers have digested inventory. And over the last several quarters, we have seen a number of customers still sweating their assets in the current macro-environment, but we're starting to see that change. And so for this year, we are about at the levels we think we're going to be this year. But going into next year, our view is that there -- the demand signals on hardware are pretty good. And so our expectations is that hardware, next year, will certainly not decline, possibly could be up relative to this year. And it's driven by a few use cases, Tim. Number one is we have a strong pipeline of tech refresh activity and this is largely from customers that have digested their inventory or customers that were sweating assets and no longer can do that at this point. And we're starting to see that the close rates on this pipeline are going to be pretty strong. Specifically in the service provider space where they have sweated assets very aggressively, we're now starting to see large programs come up again for CapEx in hardware in service provider. And also, we're starting to see AI as a catalyst on the horizon for hardware. So, specifically for the few large enterprises or service providers that are building large AI factories. And one of the big issues in building these large GPU clusters, obviously, is the cost of training these models. And our technology specifically are high capacity, high performance, traffic management technology, BIG-IP is perfectly suited to improve the efficiencies of these large AI factories and thereby reduce the cost of them. So we have already won a couple of opportunities in this area. We think it's going to take time to develop, but we're starting to see that as well as a potential positive catalyst for FY 2025.

Francois Locoh-Donou:

Thank you, Tim.

Meta Marshall:

Great. Thanks. Maybe to start following up on Tim's question, just in some of that better pipeline, is that Distributed Cloud, is that NGINX, clearly you're kind of talking about some of the systems upside, but just if any more kind of disclosures around what kind of the makeup of that better pipeline is? And then maybe as a second question, I know you noted better expansion as well. Is that coming from kind of new products or customers expanding in their product portfolio within F5 or higher volumes? Thanks.

Meta Marshall:

Great. Thank you.

James Fish:

Hey guys, thanks for the questions here and congrats to you, Frank, on retirement, and Cooper, on the promotion. Looking forward to working with you more, Cooper. Maybe not to pick on something you guys mentioned here, but on the Bot Manager side, shape has been kind of problematic over the last year or so based on what you guys have said? I guess, what are you guys doing to try to change the trajectory of Bot Manager and how are you thinking about any potential security bundles between Bot Manager WAF and API security pieces, especially given you talked about customers looking at lower-cost alternatives?

James Fish:

Got it. And Frank, for you, one of the questions I'm getting here after ours is around you guys talked about raising fiscal Q4 kind of outlook. Last quarter, you guys kind of gave some color around fiscal '25. So growth rate goes up this year, should we continue to expect the dollar numbers that you outlined last time as kind of a good proxy for fiscal '25 at this point or are you still feeling confident in those growth rates on higher numbers? Thanks, guys.

James Fish:

Helpful. Congrats again on retirement, Frank.

Operator:

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

Francois Locoh-Donou:

Yes. I'll start with the question on the transition in the SaaS business. Things are progressing pretty much the way we expected to. Indeed, we have about $65 million of legacy in the $200 million ARR that we shared in October. We -- some of this is products that we have retired and other is services that we intend to migrate to our Distributed Cloud platform. Those migrations have started. We are early in the curve. We did say it would be a two-year journey. So we are early in the process, but the migration are starting and largely going to plan. What we're seeing in that business is, A, on the -- as Frank mentioned earlier, on the -- at the high end of the Bot Manager business, we are seeing there some churn because we're seeing a lot of customers renewing, but some customers not renewing, wanting to move to lower-end solution or platform-based solutions. But on the flip side, in our SaaS platform on Distributed Cloud, we are seeing strong growth, strong new customer adoption, and that's driven by the bundle of offerings that we have in the platform. I mentioned WAAP earlier as an incredible offering, but it's also -- that traction is also driven by API security. So securing APIs is becoming a really big challenge for enterprises. You'll hear more about this in quarters and years to come because AI is going to make the importance of API security even greater. But we're seeing significant traction in this area in part because we have built the most comprehensive API security solution that goes from code scanning to comprehensive discovery of APIs all the way to protecting these APIs. And so it's eliminating weeks on end of manual testing and analysis in a solution that automates all of that. The -- and so the traction we're seeing is year-on-year. The number of API customers, API security customers that we have has tripled since last year. So those are the dynamics in the SaaS and managed services business.

Michael Ng:

Great. Thanks, Francois. Thanks, Frank.

Francois Locoh-Donou:

Thank you.

Alex Henderson:

Great. Thanks. First off, let me say congratulations to the two people involved in these changes. Frank, it's great working with you. And I certainly look forward to working more with Cooper who's been fabulous over the years. So my question is, first and foremost, is there any change in the sales staffing levels? Have you been seeing any increase in poaching by competitors? There's been some chatter around a couple of your competitors who have had some management changes that they pulled some pretty good people out of F5 on the sales front. Is that accurate or inaccurate? And then the second question, more to the environment. As we look at the year of efficiency to take Zuck's comment and extend it out to multi-years, which is really the right frame -- timeframe, that appears to have run its course and does it look like it's starting to show a stability in the application arena where applications are starting to reaccelerate broadly. Is that a metric that we can use to get at least a directional qualification on F5's outlook? For instance, if we see strong sales or application growth at the cloud companies, is that a read-through to you guys?

Alex Henderson:

Great. Thanks for the clarity.

Simon Leopold:

Thanks for taking the question. First, Frank and Cooper, congratulations on the job switching. Best of luck to both of you. First of all, this might be a tricky question for you to answer, but one of the anecdotes we've picked up is regarding Broadcom's price adjustments on VMware, and the thought was that this was affecting your business because it was perhaps shifting budgets for your customers. Now clearly, you put up a very strong software number this quarter. And I'm wondering if this is either despite what's happening with the VMware pricing or if there's some other explanation and maybe this number would be even better if not for that.

Simon Leopold:

Great. And then just as a follow-up. In terms of the way you're envisioning your opportunities with enterprise adoption of AI, would you expect that your opportunity would be correlated to essentially traditional server sales? And I'm presuming that really in the GPU clusters, that NVIDIA is -- basically has its own internal load balance. And so that's not your use case. I just wanted to clarify that. Thank you.

Simon Leopold:

Perfect. Thank you.

Sebastien Naji:

Great. Thanks for taking my question. I just wanted to first echo the congratulations to both you, Frank and Cooper as well. My first question is really around the mix shift between software and hardware. It just seems like over the last few years, that mix shift to software has been maybe a little bit slower than expected with many customers preferring to stick to their hardware form factors. I'm just wondering as we enter a new upgrade cycle here in fiscal year '25, could something change? Could we see a more rapid shift to more software solutions this time around?

Sebastien Naji:

Got it. That's helpful. Maybe as a quick follow-up, when you're successfully cross-selling F5 customers to some of the Distributed Cloud Security solutions, are you typically displacing another vendor or is there a lot of greenfield opportunity for things like API security where maybe they're not -- they don't have a dedicated solution for that yet?

Sebastien Naji:

Great. Thank you.

François Locoh-Donou:

Thank you, Suzanne, and hello, everyone. Thank you for joining us. In my remarks today, I will speak to our Q2 highlights as well as our expectations for Q3 in FY '24. Frank will then review the details of our Q2 results and provide additional color on our outlook.

Francis Pelzer:

Thank you, Francois, and good afternoon, everyone. I will review our Q2 results before I elaborate on our Q3 and FY '24 outlook. We delivered Q2 revenue of $681 million, reflecting sales that were down 3% year-over-year with a mix of 56% global services and 44% product revenue. Global services revenue of $381 million grew 5%, in line with our expectations, which reflect our lapping the benefit of prior price increases. Product revenue totaled $300 million, down 12% year-over-year, reflecting a lower level of backlog-related systems shipments than the year ago quarter. Systems revenue of $142 million declined 32% year-over-year.

François Locoh-Donou:

Thank you, Frank. In conclusion, F5 predicted the hybrid multi-cloud ball of fire crisis our customers now face. For the last several years, we have been innovating and evolving to create the industry's first distributed application security and delivery platform.

Operator:

[Operator Instructions] Our first question comes from Tim Long with Barclays.

Samik Chatterjee:

I guess for the first one, Francois, Frank, you have some strong momentum here on the software subscription revenue quarter-over-quarter. Just how should I think about sustainability of that momentum going forward? And maybe the same one, sort of a bit disappointed to see the perpetual revenue on the software side moderate this much quarter-over-quarter, but it also seems like that's the lowest we've seen it track. So is there any potentially sort of more downside to that perpetual revenue number? But any thoughts on both of those aspects and the outlook there would be helpful. And I have a follow-up.

Samik Chatterjee:

Okay. And Francois, I appreciate all your comments about sort of how you're helping enterprises with their AI, sort of particularly said investments. But I think on the investor side at least, not sure as much on the industry side, but there's a lot of debate about when enterprises do spend towards AI use cases. Is that more of them spending on-prem? Or is that on a public cloud? Any insights you're getting from the early use cases on that and how -- sort of where they choose to spend, dictate sort of how they utilize the F5 portfolio?

Alex Henderson:

So I was hoping you could talk a little bit about the implication of a reacceleration in application growth in the context of most of the cloud companies, and we don't have Amazon yet, but other ones such as Microsoft Azure has already seen -- seeing a reacceleration after several years of the so-called efficiency movement decelerating. That growth rate does now look like it's starting to reaccelerate. And I was wondering if you could talk about whether Hashi acquisition has any impact on you positively or negatively and what you're doing to take advantage of those 2 dynamics within the distribution VAR channels?

Alex Henderson:

And the distribution part of the question, taking advantage of those dynamics to drive channel?

Operator:

Our next question comes from Meta Marshall with Morgan Stanley.

François Locoh-Donou:

Yes. So we are -- I think it's a combination because a lot of the -- what we're seeing more opportunities with existing customers that are both ADC and other portions of the portfolio, especially in this multiyear subscription agreements that continue to do very well and our vehicle that customers love because it gives them the flexibility.

Operator:

Our next question comes from Michael Ng with Goldman Sachs.

Francis Pelzer:

Yes. Michael, why don't I take that? Look, on the sort of components of the subscription business in terms of SaaS and ARR, that one, ARR versus the term base, we talk about that annually, but it's not something we talk about quarterly. But the components of those businesses, we're really excited about what we're seeing for Distributed Cloud adoption, particularly the value proposition around WAAP and specifically API security that Francois just mentioned as well as our multi-cloud networking. So those are great.

Amit Daryanani:

I have 2 as well. I guess, Frank, maybe just start with you. I think in the past, you talked about software growth for the full year being flat to, I believe, up modestly, I think was the statement. Given the performance you just saw this quarter, which I think was much better than expected on software, how do you think the back half of the year stacks up on the software side?

François Locoh-Donou:

Well, thank you. There are multiple dimensions to solving the ball of fire, and we don't think we really have competition that can address it as exhaustively as we are addressing it. So the first aspect is the completeness of the application services that are required to solve it, which very few, if any company really has, because it goes from all of the application delivery services like load balancing authentication, but also web application firewall, all of the security services, API security, DDoS, multi-cloud networking, all of these capabilities you have to have to solve the ball of fire. Part of the complexity for customers is that they have had in the past to rely on multiple different vendors to be able to solve the ball of fire. So that's one aspect is the ability to bring it all together.

Operator:

Our next question comes from James Fish with Piper Sandler.

Francis Pelzer:

Sure. Absolutely, Jim. So I appreciate the question. And when we take a look at the results of this quarter in relation to our expectations, where we saw a softer performance was in the system side, not the software side of the business. And when we take a look at the back half of the year, that's really where we saw the strength of the pipeline in that area as well as for the renewals that we have in the outlook. And those renewals specifically are coming in -- in both quarters, they are stronger than what we have seen in Q2, but they just ramp up because of the nature of when the deals were done 3 years ago in Q4. And if you take a look back 3 years ago between Q3 and Q4, I think you'll see a similar dynamic in the software growth that we expect. And so that is really that $40 million swing that you're referring to between those 2 quarters. So that's really the visibility. It's the strength that we've seen in the renewals. It's the true forwards sense and the second or the interims of what's available to renew in Q4.

Francis Pelzer:

The duration side really has not changed. These are not universally, but almost always 3-year deals.

Raymond McDonough:

Maybe to start, Frank, as we think about cash flow dynamics going forward with term renewals and the opportunity in the back half, as you just discussed, and as renewals generally become a larger portion of the mix, combined with the product availability you mentioned earlier in the call, should we expect cash flow margins to continue to trend up from here as well?

François Locoh-Donou:

Yes. So the reaction at AppWorld on Distributed Cloud has been very positive. And most -- let me just give you some numbers there, Ray. So of the -- we shared in October that we had over 500 customers on Distributed Cloud. The number has grown since then, and we will share that number. And we said we would share it annually, so we'll share it again in October. But over 2/3 of the customers on Distributed Cloud are existing F5 customers that were typically BIG-IP customers that choose Distributed Cloud as a complement to a hardware or software on-prem implementation, and in part because of our ability to, in the future, bring both the hardware, software on-prem and the SaaS services to a single pane of glass. And the other 1/3 of customers are net new customers to F5.

Sebastien Cyrus Naji:

Two for me. The first one, just following up on the competition question from the beginning. In those instances where you are displacing one of those ADC competitors going through a disruption, how do you typically land? Is it more heavily weighted towards like appliances or software or SaaS?

François Locoh-Donou:

Well, thank you. Let me start with the question on AI and the type of attacks. So we are already using AI today to block significant attacks, including automated attacks on a number of applications. This quarter alone, we blocked several billion API attacks in our Distributed Cloud capability. And a lot of that uses AI and automation, machine learning, specifically, in AI to block these attacks.

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 [email protected]. 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.

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?

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.

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.

Francois Locoh-Donou:

Thank you.

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.

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. And the approach with these customers is, we are landing them generally on our BIG-IP platform, but then we're able to land and expand and cross-sell into the other value propositions in the portfolio once they discover the full portfolio of F5 when they start working with us. So we think that, that trend is going to continue, and we feel very good about our competitive position over the next two to three quarters. And we’re starting to see a growing pipeline that reflects that stronger position. Okay. Thank you, guys.

Amit Daryanani:

Thanks for taking my question. I have two as well. I guess first up on the software performance, I'd love to just understand if you still think for the fiscal year, flat to up modestly is the right way to think about it? And if there is any change in how you think about sort of the -- what happens to the perpetual market or the managed services or subscription as you go from here? Just an update on how you think about software stacking up for the rest of the year in any of those three buckets that changed your perspective right now?

Amit Daryanani:

Got it. And then I guess last time around, you talked about there might be a 400 basis point, 500 basis point headwind from this managed services transition you're going to take across '24 and '25. I was wondering, if there was a better sense of when do you think those headwinds would happen if it's this year or next year? And then, Frank, on the operating margin side, you had quite a bit of outperformance in the December quarter, which is really notable. And I realize you don't want to change the long-term target, but I'm wondering, was there anything one-off that enabled this upside in December or not? Thanks.

Amit Daryanani:

Perfect. Thank you.

Meta Marshall:

Great. Thanks. Francois, you noted that you weren't yet seeing kind of customer budgets change but getting to more predictable spending patterns. Just what are you seeing in terms of RFP activity, understanding people are still kind of doing evaluations? But are you starting to kind of see a pickup in the valuations that they're doing and any particular categories in which you're seeing that pickup in activity? And then second, just on the service provider piece, it sounds as if that's really just an election decision. But anything that you're -- just given how constrained service provider spending has been over the last year, just anything that you were seeing in terms of them being more active in the market or any specifics around that vertical would be helpful? Thanks.

Meta Marshall:

Great. Thanks so much.

James Fish:

Hey, guys. Thanks for the question here. Just building off of some of the prior ones. Frank, can you just help us with how much of the recurring software product was tied to that SaaS drawdown or the headwinds that we've talked about with moving this more towards the Distributed Cloud Services over time versus the term license or roughly where that SaaS ARR sits today? And what's the early feedback been from some of these customers on this transition, Francois?

Francois Locoh-Donou:

What's the second part?

Francois Locoh-Donou:

Jim, can you repeat the second part?

Francois Locoh-Donou:

Okay. Great. No, Jim, look, those -- we are -- as Frank said, we are early days in this process, Jim, and we said it's going to happen over the next couple of years, so I think it's very early to draw some kind of long-term conclusions. However, we have migrated some customers from Silverline to F5 Distributed Cloud Services. And for those customers who have completed the migration, it has gone very well. And generally, they're very happy with the outcome. So we are pleased with the early results of these migrations but more to come as we get more into it.

A – Francois Locoh-Donou:

Thank you, Jim. So our view on AI, so we have started seeing this quarter kind of the first emerging AI use cases of AI workloads that either needed to be traffic managed or load balanced or required some security. It’s early days because we think enterprise adoption and deployment of AI workloads is going to really start happening more, we think, in 12 months to 24 months. We think a lot of enterprises right now are testing some AI models and experimenting and getting through the learning curve, but they’re not at a stage of deploying in production. So we think it’s kind of 12 months to 24 months away even though we’re starting to see the first couple of use cases. That being said, from what we are seeing today, we feel very good that F5 is going to be an enabler of AI adoption and AI deployment. And we feel this way for two reasons. The first is AI workloads are heavy consumers of APIs. And so APIs play a big role in the architecture of AI workloads because they need to ingest data and information or services from other AI models and also expose their own capabilities to other AI models or data sources. And because of that, there’s a lot of API traffic in AI workloads. And therefore, API security is going to be a substantial opportunity for AI, and we are very well positioned for that with the investments that we’ve made across the portfolio, including in F5 Distributed Cloud Services. And then the second reason is that we’re seeing AI workloads becoming quite distributed because some of the compute needs to be at the edge, but the data and the data sources could be in more central locations or in public clouds or at the edge. So the fact that these workloads are distributed plays very well to the value – the core value proposition of F5 being a company that can serve any application or any API anywhere in any environment. And we’re quite unique in being in that position, so we think with AI, that is going to play to our strength.

Michael Ng:

Hey, good afternoon. Thank you for the questions. I just have two. First, on global services, very strong growth in the quarter, 7%. Could you talk about what may have gone better than expected? Are you still expecting global services revenue to grow low-single digits for the full year? And then second, I was just wondering if you could provide a little bit more color on the recurring revenue figure in the quarter, whether you could talk about the year-over-year increase or the sequential increase, kind of key factors impacting the change in recurring revenue? Thank you very much.

Michael Ng:

Thanks.

Alex Henderson:

Great. Thanks. I was hoping you could talk a little bit about the enterprise behavior patterns around what has been termed the year of efficiency, which obviously had a negative impact on new application development as well as the impact it had on existing applications, which were then shut down, downsized or cleaned up. I've heard some indications that, that's starting to shift to a reacceleration. And I would think that, that would play well to your application and particularly NGINX and other product lines. So is that something that you're seeing or are you just too early to say that there's any reacceleration of application growth?

Alex Henderson:

And then the second question was on the upgrade cycle around the rSeries versus the older iSeries. We've been now, I think, 18 months, almost 24 months into that product launch. Initially, it was hampered by inability to do a lot of the use cases. My assumption is that you have now completed all of the use cases that were on the iSeries and therefore should be seeing a meaningful upgrade cycle over the next 12 months to 18 months to that platform. Can you talk a little bit about what type of renewal cycle you expect there? Thank you.

Alex Henderson:

So the pipeline is improving and the subscription turnover should be amplified over the next two, three, four quarters is sort of the read? Thanks.

Alex Henderson:

Understood. Thank you.

Tal Liani:

Hi, guys. I have two questions, more kind of longer term, not on the quarter. SaaS is about 7% of total revenues, give or take, if I look at what you disclosed last year. What needs to happen or what can you do in order to grow SaaS revenue substantially? And I'm talking about, what are you doing on front of educating the channels and things you need to do with the channels and go-to-market and things? And the second question is related to that but kind of an aside. How much competition do you see from CDN companies like Akamai and CloudFlare are adding features and how much of a risk is it to F5? Thanks.

Tal Liani:

Thank you.

Sebastien Naji:

Great. Thanks for squeezing me in here. Can you maybe comment on how much of your software growth outlook here in fiscal year '24 is underpinned by the app growth that you've been talking about driving expansions versus your ability to cross-sell some of your existing customers to either additional security or to Distributed Cloud Services? And then as a second question, just following up on the CDN commentary. What are the types of customers that have been the early adopters of that CDN module and Distributed Cloud.

Sebastien Naji:

Got it. Thanks you, Francois.

Operator:

There are no further questions at this time. This does conclude our conference today. You may disconnect your lines at this time. Thank you for your participation.

Suzanne DuLong:

Hello, and welcome. I am 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 January 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 13741762. The telephonic replay will be available through midnight Pacific Time, October 25, 2023. For additional information or follow-up questions, please reach out to me directly at [email protected]. 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.

Frank Pelzer:

Thank you, Francois And good afternoon everyone. I will review our Q4 and FY ‘23 results, before I elaborate on the outlook Francois shared. We delivered Q4 revenue of $707 million, reflecting 1% growth year-over-year, with a mix of 54% global services and 46% product revenue. Global services revenue of $382 million grew a strong 9% due to continued high maintenance renewals as well as the price increases, we introduced last year. Product revenue totaled $325 million, down 7% year-on-year. Systems revenue of $134 million declined 25% year-over-year, reflecting a lower level of backlog related shipments that we had in prior quarters and demand that showed some signs of stabilization, albeit at lower levels than we have seen historically. In contrast, software revenue grew 11% over the year ago period, to a new high of $191 million. Subscription based revenue grew 27% year-over-year to $166 million, another record-high, representing 87% of Q4 total software revenue. Perpetuals and software license sales of $25 million represented 13% of Q4 software revenue. Revenue from recurring sources contributed 76% of Q4’s revenue another all-time high. 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 57% of total revenue. EMEA grew 16%, representing 26% of revenue, and APAC grew 4%, representing 17% of revenue. Looking at our major verticals, during Q4 enterprise customers represented 72% of product bookings. Service providers represent 9% and government customers represented 19%, including 7% from U.S. Federal. Our Q4 operating results were strong, reflecting operating discipline and a full quarter benefit from the cost reductions announced in April. GAAP gross margin was 80.1%, non-GAAP gross margin was 82.7%, an improvement of 125 basis points from Q4 of FY ‘22. GAAP operating expenses were $394 million, non-GAAP operating expenses were $345 million. Q4 non-GAAP operating expenses as a percent of revenue was below 49%, resuming pre-2019 acquisition levels. Our GAAP operating margin was 24.3%, our non-GAAP operating margin was 33.9%, representing an improvement of more than 600 basis points from Q4 of FY ‘22. Our GAAP effective tax rate for the quarter was 13%, our non-GAAP effective tax rate was 14% 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 $152 million or $2.55 per share. Our non-GAAP net income was $209 million or $3.50 per share, well-above the top-end of our guidance range of $3.15 to $3.27 per share. This reflects the combined impact of our gross margin improvements and operating expense discipline, as well as the Q4 tax benefit. I will now turn to cash flow and the balance sheet, which also remain very strong. We generated $190 million in cash flow from operations in Q4 driven by our improved profitability. Capital expenditures for the quarter were $15 million. DSO for the quarter was 58 days. Cash and investments totaled approximately $808 million at quarter end. Deferred revenue increased 5% year-over-year to $1.78 billion. We repurchased $60 million worth of shares in Q4. For the year, we used 58% of our approximately $600 million of free cash flow for share repurchases. I note that in each of the past three years, we have met or exceeded our share repurchase commitments. Finally, we ended the quarter with approximately 6,500 employees. I will now recap our FY ‘23 results. For the year, revenue grew 4% to $2.8 billion. Global services revenue grew 7% to $1.5 billion, representing 53% of total revenue for the year. Product revenue grew 1% to $1.3 billion, representing 47% of total revenue. For the second year in a row software represented roughly 50% of product revenue. Software revenue was flat compared to last year at $664 million. This was down from our initial expectation of 15% to 20% growth as a result of customers delaying large transformational projects. As Francois noted, software renewals performed largely as planned. We delivered $671 million in systems revenue during the year, representing 3% growth. I would now like to provide some additional information regarding software revenue. We said we intended to provide additional software revenue details as the SaaS business scale. As we said last October, we had several SaaS and managed service transitions planned. We started these transitions in FY’ 23 and they will continue through FY ‘24 and FY ‘25, leading to some short-term revenue variability that is not necessarily indicative of potential future performance. We believe that providing visibility to our SaaS and managed service revenue, and to the transitions that are underway, provides greater clarity on both our FY ‘24 revenue expectations and our expectation of returning to mid-single-digit revenue growth in FY ‘25. Today, I will speak the three components of our FY ‘23 software revenue. The first, term subscriptions, the second SaaS and managed services and the third perpetual licenses. We intend to continue report the SaaS and managed service portion of our revenue on an annual basis going forward. In FY ‘23, revenue from term based subscriptions comprised a BIG-IP and NGINX subscriptions, contributed $353 million to software revenue, up 9% year-over-year. Under ASC 606, sales of term-based subscriptions are recognized largely upfront as software revenue. The remainder is deferred and recognized as service revenue over the term of the subscription. The majority of our term-based subscriptions are contracted for three years. Term subscriptions included both new, renewal and true forward or expansion revenue, for both annual and multi-year subscriptions of deployable software. New revenue includes new customers, as well as new use cases or offerings sold to existing customers. In FY ‘23 renewal and true forward or expansion revenue experienced healthy year-over-year growth, offsetting the weakness in new term subscription software projects. Renewals performing largely to plan in FY ‘23 is encouraging for several reasons. First, given the current levels of customer spending scrutiny, strong renewals are a signal that customers are getting the value they demand. Second, our renewals motion is still relatively new and it is great to see confirmation that it is working as intended. The second component of our software revenue, SaaS and managed services contributed $203 million in revenue in FY ‘23, up 2% year-over-year. SaaS and managed service is comprised of our F5 Distributed Cloud SaaS offerings. Revenue from managed services including our legacy F5 Silverline offering in our anti bot and anti-fraud offerings as well as revenue from legacy SaaS offerings. SaaS and managed service sales are recognized ratably as product revenue over the term of the subscription. At the end of FY ‘23, our SaaS and managed services ARR was $198 million, down approximately 2% year-over-year. There were four primary contributors to this performance. First, we are seeing solid early momentum from our F5 Distributed Cloud Service SaaS offerings. Second in FY’ 23 our most advanced anti-bot and anti-fraud managed service solutions underperformed relative to our plan, as a result of customer spending caution and budget scrutiny. Third in FY ‘23, we began migrating customers from our legacy Silverline managed service offerings, to our F5 Distributed Cloud SaaS offering. And fourth, we began executing the planned retirement of legacy SaaS offerings from companies we acquired. Both the Silverline customer migrations, and the retirement of legacy SaaS offerings resulted in planned revenue churn. The third component of our software revenue is perpetual licenses, which contributed $108 million in software revenue, down year-over-year after unusually strong FY ‘22. In FY ‘23 71% of our revenue was recurring, up from 69% in FY ‘22. Several years ago, we began breaking out our security related revenue annually. This year our total security revenue which includes standalone security, attach security and security related to maintenance revenue was approximately $1.1 billion or 40% of total revenue. Our standalone security product revenue grew 5% to approximately $475 million. We are seeing good traction with the lower end anti bot offering delivered through Distributed Cloud services as well as from security on NGINX. Our FY ‘23 security revenue growth was affected by customer spending caution, including stalled transformational projects and the underperformance of advanced anti bot anti-fraud solution as I mentioned previously. During the year, we overcame supply chain challenges and successfully returned our lead times to normal levels. As a result, our FY ‘23 product backlog returned to pre-supply chain challenge levels and we closed the year with approximately $53 million in product backlog. I will now turn to our FY ‘23 operating performance. GAAP gross margin in FY ‘23 was 78.9%. Non GAAP gross margin was 81.5%, down 110 basis points from FY ‘22, as a result of higher supply chain costs in FY ‘23. Our GAAP operating margin for FY ‘23 was 16.8% and our non-GAAP operating margin was 30.2%, up 130 basis points from FY ‘22, as a result of our previously announced cost reductions. Our GAAP effective tax rate for the year was 18.7%. Our non-GAAP effective tax rate for the year was 18.3%. Our FY ‘23 annual tax rate was lower-than expected, primarily due to IRS guidance issued during the fourth quarter related to foreign tax credits. GAAP net income for FY ‘23 was $395 million or $6.55 per share. Non-GAAP net income was $705 million or $11.70 per share, representing growth of 14.8% over FY ‘22. Francois, outlined our annual and longer term outlook at the start of the call, I’ll recap that with some additional color. I will also provide our outlook for Q1. With the exception of revenue, my guidance comments reference non-GAAP metrics. In our FY ‘24 outlook, we’ve made the following assumptions. We expect customer spending caution will continue into FY ‘24, but we also expect customers will begin to reinvest at some point in the year. We expect our global services revenue will return to low-single-digit growth as we lap price increases. We have approximately $180 million revenue headwind in systems from FY ‘23’s backlog fulfillment. We expect to continue to take share in the traditional ADC space with BIG-IP in both hardware and software form factors. Within our software revenue, we expect continued strength from our term subscription renewals and continued growth from our F5 Distributed Cloud SaaS offerings. As I’ve discussed previously, we will have some planned revenue churn as we work through the SaaS and managed service transitions I discussed. We expect these transitions will be largely complete in FY ‘25. In FY ‘23 and in ARR associated with the transitions is approximately $65 million, a little more than half of which is associated with offerings we intend to transition onto Distributed Cloud over the next two years. The net of these assumptions, combined with the current demand levels leads us to expect FY ‘24 revenue in the range of flat to down low-single-digits from FY ‘23. Excluding the $180 million or 6% headwind from our FY ‘23 backlog reduction, our guidance range would reflect low to mid-single-digit revenue growth in FY ‘24. Whether we achieve the bottom or top end of this range, largely depends on when customers resume more normal levels of spending. We expect some continued quarter-to-quarter variability, as a result of upfront revenue recognition related to our term subscription offerings. Regardless of our revenue performance, we remain committed to driving strong profitability. From an operating perspective, we expect gross margin will improve in fiscal year ‘24 to the range of 82% to 83%, this is primarily the result of supply chain related cost pressures, working their way out of our model. We expect our continued operating expense discipline will result in FY ‘24 non-GAAP operating margin in the range of 33% to 34% for the year. On a percent of revenue basis, this would put our operating expenses roughly in line with 2018 levels, at roughly 49% of revenue. We expect our FY ‘24 effective tax rate will be 21% to 23%. In FY ‘24 we expect to deliver 5% to 7% non-GAAP earnings growth, which translates to at least 10% year-over-year growth on a tax-neutral basis. Finally, we expect to use at least 50% of our annual free cash flow for share repurchases, consistent with the approach we have discussed previously. As of the end of FY ‘23, we had $922 million remaining on our previously announced authorized share repurchase program. We also want to take the opportunity to speak to our expectations beyond FY ‘24, as we believe it will help signal how we intend to run the business longer term. As Francois noted we expect mid-single-digit revenue growth in FY ‘25. We expect to drive additional gross margin improvements, and to deliver gross margins between 83% and 84%. We expect to grow our operating expenses slower than revenue, resulting in an operating margin of at least 35%. We will continue to prioritize profitability, adjusting our operating model if needed to enable us to deliver at least 10% compounded annual non-GAAP EPS growth. Finally, we intend to continue to use at least 50% of our annual free cash flow towards share repurchases. I’ll conclude with our expectations for Q1 of FY ‘24. We expect Q1 revenue in the range of $675 million to $695 million. We expect gross margins in the range of 82% to 83%. We estimate Q1 operating expenses of $332 million to $344 million. We are targeting Q1 non-GAAP EPS in the range of $2.97 to $3.09 per share. We expect Q1 share-based compensation expense of approximately $58 million to $60 million. I will now turn the call back over to Francois. Francois?

Operator:

Thank you. Ladies and gentlemen, at this time we will be conducting a question-and-answer session. [Operator Instructions] Our first question comes from the line of Amit Daryanani with Evercore. Please proceed with your question.

Francois Locoh-Donou:

Hi, Amit. So in, in total, so we talked about it roughly $200 million in SaaS and managed services. In that $200 million there is about $65 million of revenue stream, that essentially are going to go away. Now, but that’s more than half of that is revenue streams coming from a legacy managed services platform Silverline, that we are retiring. But we intend to migrate the customers over to Distributed Cloud. So we would expect you know a portion, if not a significant portion of that, you know of that revenue stream to go on to Distributed Cloud over time. The other a little less than half of that $65 million are offerings that we are retiring completely that, you know, when we looked at our portfolio and looked at the offerings we wanted to rationalize, that we felt were underperforming. We decided to retire these offerings completely to, you know, focus on the products that are going forward and successful rationalize our cost and improve our efficiency.

Francois Locoh-Donou:

Amit there, I wouldn’t say there is a particular geography where we are -- where, that’s really different than others. I would say, North America has been probably more solid and stable than our Asia and European markets. If we look at verticals in terms of where we’re seeing stabilization, I think the enterprise market, we’re seeing more stabilization. The service provider market has been soft. That’s for a number of factors service providers continue to sweat assets, and, and be really ruthless in their prioritization, the 4G to 5G transition is a little slower than anticipated. So service providers in general have been soft than we’re kind of expecting that to continue. What we were encouraged by, especially, in the second-half of the year, but specifically in Q4 is in the enterprise space specifically, we saw some customers that had been sweating their assets, and got to kind of at the end of that cycle and started demanding hardware again or ordering hardware again. So we did see a rebound in hardware orders in the fourth fiscal quarter. Coming from A, we think some customers having sweated their assets, but also, you know, it took a long time for us to ship equipment to a number of our customers in 2023. And in Q4 we saw some of these customers that finally had received their hardware and had been able to deploy that to start ordering again. So we were encouraged by those trends.

Operator:

Our next question comes from the line of Alex Henderson with Needham. Please proceed with your question.

Francois Locoh-Donou:

Yes. So, Alex, we’re -- so today we’re talking -- so I don’t want to talk about what’s beyond FY ‘25, I’m going to talk about FY ‘24 and ‘25. Beyond FY ‘25, I think our view of our end markets haven’t really changed. And so you know in the future that opportunity to return to 20%-plus growth in software, is there based on the end markets that we are targeting. But let’s talk about FY ‘24 and FY ‘25. So FY ‘24 we’ve talked about growth in software being you know flat to modest. And that, if you take the three components of software that we’ve, we just talked about, we expect, you know, frankly, the perpetual base of the business to be roughly flattish. We have a similar view on the SaaS and managed services part of the business based on the transitions we’re going through. And potentially, you know in the term subscription part of the business is where potentially we would see some modest growth. Going into 2025 from a revenue perspective, we don’t necessarily expect growth from perpetual or the SaaS and managed services business because of the transitions that we’re going through. But we have strong visibility into our -- the renewals and expansion in our term subscription business. The expansions which are very strong from what we’re seeing and we expect that to continue and be amplified in 2025. So in 2025, we would expect you know software growth to return to double-digit, really powered by our term subscription business.

Frank Pelzer:

Alex, it’s Frank. So largely most of that has been achieved but there is still some of the purchase price variances that are coming through in FY ‘24. By FY ‘25 we expect that to be fully out in a normalized level.

Frank Pelzer:

Alex, I think it’s probably in the range of 25 to 50 basis points of where we’ll see improvement just based off of that, in comparison to expectations for gross margins in FY ‘25.

Operator:

Our next question comes from the line of Samik Chatterjee with JPMorgan. Please proceed with your question.

Francois Locoh-Donou:

Samik. Thank you. These -- so over a long period of time I think we, you know, we think that the hardware business would be more of a you know low-single, low-single-digit decline or overtime. However, that is a statement you know that is based on a normal, first a normalization of the hardware business, and we’re not there today. And that’s been as you know, the demand was much softer in 2023. And so we actually expect our hardware business to rebound in 2024, and we saw some signs of that already in this fourth quarter. And you know the -- I’m giving you more of a long-term trend kind of beyond 2025. But you know I think at least for 2024, we expect to rebound in the hardware business. In terms of where AI will play in our business, so the way to think about it Samik is, we -- the portfolio that we’re putting together, which is hardware, software and SaaS, we expect, you know, that will enable our customers to secure and deliver their API and their applications in any environment. AI workloads are going to be modern applications, some of which may run on-prem but we think a, a lot of them will run in software environment, and so it’s likely that supporting AI workloads will accrue more to our software business over time. And in addition to that, we think we have a very unique position in that with our distributed cloud capabilities, we are able to run inferences really in any cloud environment and beyond. So we can run inferences in any public cloud, we can run it at the edge, we can run it in our own cloud. And increasingly, we’re hearing from customers that they will want to run these inferences on manufacturing floors or on the retail branches for retail customers or and vehicles for some far as use cases. And we have the ability to run and secure and deliver these inferences in any environment. You know, whether it’s in the cloud or in any one of these far edge environments and that makes F5 very unique in its position for running AI inferences in the future. All of that of course will accrue to our software business.

Francois Locoh-Donou:

Yes. Thank you, Samik. I, I don’t think it, it was related to a budget flush for -- you know because, you know, the comments we made in resumption were really things we observe in the, the quarter that ended in, in September for us. When we look at next year, no, we do not have visibility into exactly what budgets our customers will have in FY ‘24. We do have a strong pipeline, entering the fiscal year on hardware. And you know that would -- it will come down to what are the close rates on that. In Q4 the close rates that we saw on our pipeline entering the quarter were better than in the prior three quarters of the year. That’s also part of why we talked about stabilization. And green shoots in Q4 is because what we saw in the close rate. So we’re going into the fiscal year with a stronger hardware pipeline. Recent data points on close rates that are positive. But of course, we are cautious, because there’s still a lot of uncertainty out there. Around the macro as you noted. We continue to see customers you know in certain occasions, delaying, delaying deals or having continued budget scrutiny and more approvals. We are seeing that phenomenon continue. And so overall, we’re still cautious going into the year.

Operator:

Our next question comes from the line of Meta Marshall with Morgan Stanley. Please proceed with your question.

Francois Locoh-Donou:

Thank you, Meta. The -- so let me start with the first question, and my comments on pipeline. There are more related to what we’re seeing in the -- on the hardware side of things, where we had a number of customers that A, number one have been sweating their assets, and they’re getting sometimes the utilization levels, where we, we know that at some point in ‘24 they will have to do something. Or number two, customers who have placed orders in FY ‘22 have not been able to receive equipment for these orders, who now have and have started to deploy that capacity and are starting to be ready to order again. So that is accruing to a stronger hardware pipeline. In terms of big you know, kind of multi-cloud software, what we’ve called this transformational software project, we are not yet seeing a you know substantial resumption of these kinds of projects. But then that’s what I was saying earlier is customers are still very cautious on undertaking, you know, big projects like that. And we’re not seeing a different pattern going into the year on those aspects. As it relates to AI and whether it will require productization, we have essentially and so on, on the aspect of being able to run inferences in any environment, we have these capabilities in Distributed Cloud. I think we need to ensure that we harden these capabilities and there is a strong go-to-market effort to be made around that to make customers aware of that in the future as they start deploying AI workloads. As it relates to being able to secure and deliver AI workloads, those capabilities exist today and we are ready to go with that already.

Meta Marshall:

Great. Thank you.

Michael Ng:

Hey, good afternoon. Thank you for the question and for all the comments on, on the outlook. I just had two, both on software. You know, first, I was just wondering if you could talk a little bit about, you know, your visibility into the term business. You know, you called out term as something that would help drive the double-digit software revenue growth in fiscal ‘25, as well as potential growth in fiscal ‘24. And then second, I was just wondering if you could talk a little bit more about this migration from Silverline to DCS. It sounds like it’s a multi-year headwind, you know, something that contributed to the weakness in ARR in fiscal ‘23, but it also seems to be a headwind in fiscal ‘24 and fiscal, fiscal ‘25. So maybe you could just talk about that and you know, how that transition is rolling off and you know, over how many years. Thank you.

Francois Locoh-Donou:

Thank you, Frank. And to your second question, Michael on SaaS and managed services. So, like, if we talk about, you know, FY ‘22 to FY ‘23, you saw that the ARR there was flat to slightly down. There are two reasons for that. One is, yes, the transitions we talked about started in ‘23 and there was about call it roughly, you know, $12 million of ARR that we transitioned out of the business in 2023. The other reason is at the high-end of the bot business, we saw quite a bit of softness, especially in the second-half of the year, as customers had significant budget scrutiny and you know we’re reluctant unless they were under immediate attack, to really implement our more sophisticated solutions. We think over time that will change, but specifically this year with the macro pressures and budget scrutiny, we saw a lot of softness there, both in, you know, new bookings and in some churn in some cases. So that is the FY ‘22 to FY ‘23. So from going into 2024, well, you asked about, you know, is this transition is a multi-year transition. Yes, we expect that the $65 million of, of revenue stream that we are transitioning will work themselves out over the next couple of years, so over FY ‘24 and FY ‘25 they are a headwind to total growth. However, we are quite excited by what’s happening with F5 out of the SaaS portion of our offerings, specifically SaaS on F5 Distributed Cloud. We have launched a WAF offerings, the security offering, you know, about 18 months ago. We are seeing extraordinary traction on that. As I said earlier, we’ve won over 500 customers in that period, all of whom are enterprise customers. And we are seeing very rapid traction on that. We’re also seeing rapid traction on the multi-cloud networking market, where we bring both networking and security capabilities and we’re quite differentiated to anybody in the market. So that has grown fast and we expect that portion of the business to continue to grow fast, and overtime become a, a majority of this SaaS and managed services portfolio.

Francois Locoh-Donou:

[Indiscernible] Michael.

Tim Long:

Thank you. Two, if I could as well. First, Francois, I think you talked about replacing competitor with, in the ADC, both hardware and software, domain. Could you dig into that a little bit more, is that something that you think it is kind of, it’s a one-off or do you think there is a sustainable move there and how is that happening. And then second, just on the, you know, the changes in the transitions in software, it sounds like you know, move into Distributed Cloud services makes a lot of sense. Having looked at some of those businesses and kind of you know, moving on from them. Does that change your view of kind of synergies across product offerings or is it a sign that maybe those businesses didn’t have the same synergy and that’s why you’re not, you know, you’re not going forward with them. Thank you.

Tim Long:

Okay. Thank you.

Ray McDonough:

Great, thanks for taking the questions. Francois, given some of the changes you’re making to your software portfolio, it seems like in a way you’re, you’re simplifying or even converging some of your solutions. So as we think about the roadmap for Distributed Cloud in particular, what can you do to accelerate adoption and make sure you capture the potential voluntary churn that you’ve talked about or, or even how should we think about the priorities around Distributed Cloud next year.

Ray McDonough:

I appreciate that. And if I could snick one more in, maybe for Frank. Certainly appreciate the continued focus on operating margins and EPS growth. But can you help us think through how we should think about cash flow margins in fiscal ‘24. I know you typically don’t guide cash flow. But should we think of cash flow growing in line with operating income, ex-some of the tax headwinds you had in fiscal ‘23, any even directional thoughts would be helpful.

Ray McDonough:

Great. Appreciate it.

James Fish:

Hey guys, thanks for snicking me in. I’ll just make it simple here. You know, you guys talked about in the prepared remarks about subscription renewals performing well. Any more color into specifically what products are seeing those better renewals, but the cross-sell that you’re seeing or any qualitative or quantitative color around net retention rates understanding, you, you have this headwind around specifically with the SaaS and MSP business about $65 million. You know, how should we think about that net retention rate within the term business or the aggregate overall when you kind of exclude even the impact of that SaaS please. Thanks guys.

James Fish:

Makes sense. And just on the go-to-market side, any changes in terms of incentives or approach as we turn to page into this next fiscal year and as we have, you know, transitions now within the overall software transition.

James Fish:

Thanks guys.

Simon Leopold:

Great, thanks for taking the question, I just wanted to get a better sense of where the systems business is stabilizing, in that I assume the September quarter did not have much if any backlog drawdown in it. And so, other than maybe some seasonal movement, I’m just trying to get a sense of if sort of it’s you know $120 million to $130 million per quarter level, sort of, the new normal for systems. And then just quickly on how the software is trending with the Silverline exit. Does that manifest itself gradually throughout the year or is that something that shows up in a particular quarter. Thanks for that.

Francois Locoh-Donou:

And to the second part of your question, in terms of Silverline no, it’s not going to be all in one quarter. You know, it’s going to bleed off over the next couple of years, kind of, every quarter. And it’s going to be time with, you know, when customers are at a point where they have to renew or migrate their subscription that there will be a decision point. And so you’re going to see it I think over the next six to eight quarters.

Operator:

Ladies and gentlemen, this does conclude today’s teleconference. Thank you for your participation. You may disconnect your lines at this time and have a wonderful day.

Suzanne DuLong:

Hello, and welcome. I am 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 October 24, 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 13739739. The telephonic replay will be available through midnight Pacific Time, July 25, 2023. For additional information or follow-up questions, please reach out to me directly at [email protected]. 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.

Frank Pelzer:

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 base 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 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 effective tax rate for the quarter was 16.4%. Our non-GAAP effective 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 per share 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 million 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 million to $350 million. Incorporating our year-to-date results, we have now narrowed our estimates for FY '23 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 million 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?

Operator:

Thank you. We will now be conducting a question-and-answer session. [Operator Instructions] Thank you. Our first question is from Ray McDonough with Guggenheim Partners. Please proceed with your question.

Francois Locoh-Donou:

Hi, Ray. Thank you so much for the question. So the true forwards when we set out our plan at the beginning of the year, we had higher expectations than what we've seen throughout the course of this year. That having been said, it was a strong quarter in a four 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. When I was incredibly encouraged though from the expansion that we saw in some of our second terms, as Francois mentioned, were 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.

Francois Locoh-Donou:

Hi, 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. What hasn't changed for us is this the customers continue to scrutinize spend. 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 looking to the first spend as much as possible and sweating their assets, where they can do that. Those behaviors have not changed. And as a result, even though we saw a 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 a lot of uncertainty, specifically in the financial services sector right after the bank failures. There was uncertainty still about interest rate debt ceiling for -- in the U.S. specifically. And so, spend in financial services almost came to a halt then. That I'm going to call it almost irrationality has come out now. So there is still deal delays and scrutiny. But even though deals are being scrutinized, they are getting approved. So that, specifically for that vertical, I think has changed. And then, I think we've seen in a couple of areas the deals that had been delayed were 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 working to sweat their assets as much as possible, and we're seeing that behavior continue across the board.

Operator:

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

Francois Locoh-Donou:

Hi, Samik. Okay, so let me unpack that. There was a lot in there. So, when I talked about the demand stabilization, it's really the fact that if you look at the first two quarters of the year, things were getting progressively worse in March than they were in January, and they were worse in January than we felt them were in September. But when you back to where we were at the end of June, we didn't feel things have further worsened. And so, things have stabilized. That's really the origin of by my commentary. As it relates specifically to hardware, Samik, as you know, we have -- 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 made -- 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 level that you saw in Q3 in terms of where were 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 gating 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 will 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 ship 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 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.

Francois Locoh-Donou:

So, for us in AI, Samik, we're, of course -- I think like a lot of other companies that if we've got focused in three areas, one that I'd say is generics to other companies, which means we are looking to leverage the new capabilities to enhance our productivity. And we -- as you know, we are focused on earnings growth. We said we want to deliver double-digit earnings growth, which we are now confident we will this year. But continuing to drive that, we want to drive more productivity over time. And these tools would help us through that in certain areas. The other two areas that are really specific to our business, Samik, is one, 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 application traffic at a very granular level, which is an incredible powerful capability. And we're going to enhance 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. We have -- sorry borrowing over 300 million website and being is 40% of the world's web application. 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. So that is still early days and probably harder to define in the short-term, but what we see, Samik 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 explosion 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 opportunity for F5 down the road.

Operator:

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

Francois Locoh-Donou:

Yeah. Simon, I don't think we're -- we can kind of direct you to what is or should be the base run 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, the -- and you look at a longer trend in 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. 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 ignore the short-term disruption, then you just look at a long-term trend of 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 would add though, Simon, that part of what we think 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 F5 model because not all applications are in the same environment, and they want the ability to something to have applications funded by hardware in their private data centers and maybe other applications supported by software or SaaS. And 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 delivery policies and security policies across these consumption models. And so we're going to continue to offer this flexibility and its core to how we intend to continue to drive earnings growth in the business.

Frank Pelzer:

Simon, in terms of specific metrics, more to come. In terms of the delivery approach that Francois was describing, one of the reasons why we have gotten away from trying to 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 to the customer to make that decision for themselves. And so we will see some fluctuation and volatility between what software and what’s hardware. I think when we actually see the SaaS business, particularly around Distributed 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 ratable 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 points -- data points where that expectation and that software revenue will come.

Operator:

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

Francois Locoh-:

Hey, Jim. So let me give you a sense by product in terms of what we're seeing in terms of demand. So we're -- 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 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 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, on a small base is in our distributed cloud opportunity, which is really in security, offering application security in front of us, a lot of applications but deployed as 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 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.

Francois Locoh-Donou:

Sure. So yes, that dynamic, I will 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. That part is part of our renewal base of revenue, which has been, 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 line, slightly better than the revised expectations that we set last quarter.

Operator:

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

Francois Locoh-Donou:

Thank you. And in a way, your two questions are related because it comes down to this flexibility of the model we've built, of offering hardware, software and SaaS. So, to the first part of your question, was there any -- relative to our expectation in terms of the mix, hardware/software. Look, I think we were pleased to see that a couple of the bigger software deals that we have 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 level in terms of new projects and starting these new especially big software transmission 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 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, Meta, we have -- so in the ADC -- traditional ADC market specifically, we believe that we are gaining share, largely because of the investments we've made in next-generation platforms and next-generation software and the flexibility of the model we are delivering. So Meta, we have rolled out rSeries and Vellos platforms this quarter. I think over 70% of the shipments that we made in hardware were on the new rSeries 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 these new platforms and the new software that brings cloud-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 WAF market, that is Web Application Firewall, API security, DDoS and bot protection as a service. This is a market, Meta, 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 quarters to come.

Operator:

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

Frank Pelzer:

Yeah, Alex. It's Frank. I'll start and see if Francois wants to add anything. But the long and short, the 6% to 8% 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 6% 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 -- have been better in Q3 than what we saw in the first half of the year. But it stabilized at a lower -- much lower level than where we were in FY '22. 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 FY '23 in terms of demand. But that intersection between 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 we're hesitant to know exactly what point in '24 we'll see that change in the systems there. On the software side of the equation, we have seen great traction. Obviously, in the renewals as we mentioned, we have seen a challenging new environment so far. That will likely also change. But we are seeing that change likely come more in the form of SaaS revenue, which we'll not necessarily recognize in the same rate in FY '24 as 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. We'll have more to talk about that in the next -- on the next call, but that's the early indication and the way to reconcile some of the comments that we made.

Alexander Henderson:

So 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 these commentary relative to the product side of the equation.

Alexander Henderson:

Okay. Thanks.

Michael Ng:

Hey. Good afternoon. I just have two questions. The first is on this trended software. It's clear you had strength in 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.

Michael Ng:

Great. And I just wanted 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, recognizing the uncertainty on 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.

Francois Locoh-:

If I go on the second part of 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 intend to drive to that.

Operator:

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

Francois Locoh-Donou:

Yes. Can you just repeat the first part -- the beginning of the question?

Francois Locoh-Donou:

Yeah. Thank you. So like -- so in API security, it's a nascent market. There are a few start-ups that are in the mix, but what -- a couple of things about API security. One is it is a big data problem because you have a lot of API -- 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 application security -- 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 3, at the networking layers, maybe Layer 3, Layer 4. But we are seeing increasingly enterprise need not just Layer 3 to Layer 4 networking, but also Layer 7 security to really connect these applications securely and one has to go with the other. And essentially, F5 is now with all of the integrations we've made on our Distributed Cloud, taking from our organic innovation and thinking from our acquisitions, from Shape and Treadstack and Volterra and some capabilities from BIG-IP, 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 going forward. So we're pretty excited about our opportunity in the space.

Operator:

Thank you. This concludes today's call. You may now disconnect.

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, where an archived version of today’s audio will be available through July 24, 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 the call. To access the replay of today’s webcast by phone, dial 877-660-6853 and or 201-612-7415 and use meeting ID 13737373. The telephonic replay will be available through midnight Pacific Time, April 20, 2023. For additional information or follow-up questions, please reach out to me directly at [email protected]. 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 François.

Frank Pelzer:

Thank you, François, and hello, everyone. I will review our Q2 results before I speak to our third quarter outlook and provide additional color on our FY 2023 expectations. We delivered Q2 revenue of $703 million, reflecting 11% growth year-over-year. Global Services revenue of $363 million grew a strong 8% due to the high maintenance renewals and the impacts of the price increase introduced in Q4 of last year. Our revenue remained roughly split between Global Services and product with Global Services representing 52% of total revenue. Product revenue grew 14% year-over-year, reflecting strong system shipments against an easier comparison in the year ago quarter. As François described, our successful redesign efforts enabled systems revenue of $209 million, representing growth of 43% year-over-year. At $132 million, Q2 software revenue was down 13% compared to last year. Let’s take a closer look at our software revenue, which is comprised of subscription and perpetual license sales. Subscription-based revenue, which includes term subscriptions, our SaaS offerings and utility-based revenue totaled $109 million or 83% of Q2’s total software revenue. Within our Q2 subscription business, as François described, near-term subscriptions performed significantly below plan in the quarter. In contrast, and similar to last quarter, software renewals continued to perform largely in line with our expectations. Perpetual license sales of $23 million represented 17% of Q2’s software revenue. Revenue from recurring sources contributed 65% of Q2’s revenue. This includes subscription-based revenue, as well as the maintenance portion of our services revenue. On a regional basis, we saw growth across all theaters, though I’d note that these trends are more reflective of shipments in the quarter than current demand. Revenue from Americas grew 7% year-over-year, representing 54% of total revenue; EMEA grew a strong 22%, representing 27% of revenue; and APAC grew 9%, representing 18% of revenue. Looking at our major verticals. During Q2, enterprise customers represented 67% of product bookings, service providers represented 13% and government customers represented 20%, including 6% from U.S. Federal. I will now share our Q2 operating results. GAAP gross margin was 77.9%. Non-GAAP gross margin was 80.4% in line with our guidance for the quarter. GAAP operating expenses were $441 million. Non-GAAP operating expenses were $374 million, in line with our guided range. Our GAAP operating margin was 15.1%. Our non-GAAP operating margin was 27.2%. Our GAAP effective tax rate for the quarter was 25.1%. Our non-GAAP effective tax rate was 20.8%. Our GAAP net income for the quarter was $81 million or $1.34 per share. Non-GAAP net income was $154 million or $2.53 per share, above the top end of our guided range of $2.36 per share to $2.48 per share. This reflects improved operating margins from strong cost discipline, as well as a benefit to our tax rate in the quarter. I will now turn to cash flow and the balance sheet, which remains very strong. We generated $141 million in cash flow from operations in Q2. Capital expenditures for the quarter were $11 million. DSO for the quarter was 62 days, flat with Q1 and up from historical levels, primarily due to strong service maintenance contract renewals in the quarter and, to a lesser degree, back-end shipping linearity. Cash and investments totaled $760 million at quarter end. We did not repurchase any shares in Q2. We remained out of the market as we analyze the potential impacts of the cost-saving measures we discussed previously, as well as the changes we were seeing in the demand environment and its effects on our outlook. Deferred revenue increased 12% year-over-year to $1.8 billion, up from $1.76 billion in Q1. This increase was largely driven by substantially higher maintenance renewals on our installed base of products sold four-plus years ago. Finally, we ended the quarter with approximately 7,100 employees. This number does not reflect the reductions we announced today. We expect these headcount reductions will result in annualized savings of approximately $130 million. We expect to incur approximately $45 million in severance and benefits costs and other charges related to these actions in FY 2023. I will now share our outlook for Q3. Unless otherwise stated, my guidance comments reference non-GAAP operating metrics. We expect Q3 revenue in the range of $690 million to $710 million, with gross margins of approximately 82%. With the partial quarter impact of our announced cost reductions, we estimate Q3 operating expenses of $348 million to $360 million and our Q3 non-GAAP earnings target is $2.78 per share to $2.90 per share. We expect Q3 share-based compensation expense of approximately $60 million to $62 million. Finally, we plan to repurchase at least $250 million worth of shares during Q3. We remain committed to returning cash to our shareholders and continue to expect to use at least 50% of our annual free cash flow towards share repurchases. I will now speak to our FY 2023 expectations. We expect low-to-mid single-digit revenue growth in FY 2023. Given our first half results and the environment for new software projects, we no longer see a path to 15% to 20% software growth in FY 2023 and are not offering guidance for the second half product revenue mix at this time. Based on current visibility and our earlier than anticipated systems recovery, we expect to see lower systems revenue in Q3 and Q4 than in Q2. We expect that we will continue to substantially work down our systems backlog over the second half of FY 2023. We expect FY 2023 non-GAAP operating margins of approximately 30% and non-GAAP earnings growth in the range of 7% to 11%. Incorporating our year-to-date results, we have narrowed our estimate for our FY 2023 effective tax rate to 21% to 22% for the year. I will now turn the call back over to François. François?

Operator:

Thank you, sir. [Operator Instructions] And our first question comes from the line of Sami Badri with Credit Suisse. Please proceed with your question.

Frank Pelzer:

Yeah. Sure, Sami. So we did not update the mid-single-digit outlook that we did update in Q1 on services. Obviously, we outperformed that in Q2, and for all the dynamics that you highlighted, we continue to think services contribution is going to be strong through the course of the year as customers continue to sweat assets and particularly when we look at some of the aged assets and their decisions around that. And so, we don’t have an update, but I think that mid-single-digit is well intact and we will see what happens. Specifically, we did not give any guidance on mix and product, and the results of looking at that services growth to what the product growth will be in that mix, I will leave that to you to model. But we are not giving any specific guidance to what we think software growth is going to be for the balance of the year and our systems growth for the balance of the year.

François Locoh-Donou:

Thanks, Sami. For a couple of indicators on that. The first is, what we have seen in our second fiscal quarter is, this pullback in spending has been broader and more severe, frankly, across all verticals and all geographies, and so I would say all protocols and geographies are affected at this point. If I had to pull out a couple, I would say, the financial services in the -- especially in the second half of March, where we saw a number of our deals being pulled out, delayed or downside or delayed by multiple quarters. Financial services was impacted prior to the collapse of SVB, but we did see even more caution in the financial services industry after that, and we expect that will persist. The other vertical Sami, that I would call out is service providers, where we had a number of customers that had expectations around their budget, I would say, in our fiscal Q1 or calendar Q4 and when the budgets were settled in the February timeframe, the budgets were a lot less than they expected. And that’s driven by, I think, in some cases, certainly in the MSO sector, cable sector worries about our service provider customers perhaps losing or reducing the growth on the highest margin customers and we are seeing that also in with certain mobile operators around their planned spend on 5G. So that’s -- I would say those are the two verticals that perhaps have been where we have seen perhaps the strongest differential between where they were in Q1 and where they are today.

Operator:

And the next question comes from the line of Ray McDonough with Guggenheim Securities. Please proceed with your question.

Frank Pelzer:

Ray, I will start, and certainly, François, wants to pick up he can. I think we saw a challenge in new business sales in both Q1, as well as Q2. Did it accelerate in Q2? Probably slightly versus our expectation, but not necessarily when you take a look at the raw number. So that’s how I’d answer that one for you. I think in terms of your second question around spend. On the true forwards that we saw, those were slightly below our expectation level. We do keep that in the renewal bucket. And so when we said that it largely performed to our expectation, that was the one piece that did not perform to our expectation where we think that people are being a bit more critical around their consumption and being much closer to what they had planned to consume and not going over and that’s not what we experienced up until this year.

Frank Pelzer:

Yeah. Ray, so we don’t specifically guide to cash flow and I think the dynamics that you mentioned are the similar ones to the ones that we are experiencing. So we did have some unusual cash hits to last year in relation to component costs and other supply chain challenges that we do anticipate are going to work their way out of our model by Q4. You saw some of that happen in the Q2 timeframe, you will see more of that happen in Q3. But we don’t guide to a specific margin percentage, because we don’t guide to cash flow.

Frank Pelzer:

Sure.

Tim Long:

Thank you. I have two as well on software. First, you guys said a few times the renewals came in as expected. It would be helpful if you could give us a little color about what you were expecting there, were you expecting them to be down or up? So any color you can give us on what your kind of expectations were for the renewals business? And then second, similar to a previous question, but if you could talk about kind of the weakness more on the product and solution lens. So how much of this is the core virtually do you see, how much of this is maybe not fully monetizing in NGINX, how much of this is not really able to bundle other software offerings on top of virtual ADCs. So anything you can give us kind of on that, what’s missing when you look back at the acquisitions and what it was supposed to do for the software business, what’s not happening? Thank you.

Frank Pelzer:

And Tim, on the maintenance -- the renewal question, I am going to separate out the maintenance renewals, which have obviously been quite strong on the services side and the software renewals, which are also strong, and the your saying, what are your expectations? When you think about the way we have talked about businesses, STPs [ph] have been the predominant amount of growth that we have seen in our software business and that’s the majority of what comes up for renewal in any given quarter. Those have performed largely to our expectations, and in many cases, growing from the levels that they were when they ended year three. There has been some this year where we have taken a look at years two of the agreement and year three of the agreement, where that true forward amount has not been up to the level of expectations that we had that we modeled from previous years as people are very critical on trying to consume very close to what they have contracted for. And so we are not seeing the same overages that we have before, and we think that’s probably indicative of the same way that cloud providers are seeing their consumption. So when we say the renewal base, the renewal base is up substantially last year as expected as this is the first full year of STP sales when we take a look back three years ago as a comparison.

Operator:

And the next question comes from the line of Samik Chatterjee with JPMorgan. Please proceed with your question.

François Locoh-Donou:

Samik, I missed part of the question, but is it about topline in fiscal 2024?

François Locoh-Donou:

Yeah. So look, Samik, when we look at fiscal 2024, of course, we are not in a position or have the visibility really to guide to the topline for 2024. But I can give you just a few pointers here. It is clear from the -- from where we are at with our ability to ship today that we will ship the vast majority of our backlog in fiscal 2024, either by the end of the third quarter or the end of the fourth quarter, sorry, by the end of fiscal 2023, sorry, by the end of Q3 or at the end of Q4 fiscal 2023. So when you look at that on a normalized backlog level in 2024, clearly, that’s going to represent a headwind to revenue growth in 2024 in the order of 6 points to 8 points of growth given that dynamic. On the other hand, we also see that the -- we are seeing a lot of projects that are delayed and our view is that customers can only sweat their assets for so long. And that, at some point, demand is being pent up and demand is going to pick up. When that is going to happen is a bit of an uncertainty, but it’s reasonable to assume that we would see some of that at some point in 2024. So I can’t give you a position on revenue growth for 2024, but what we can control, of course, is our cost base and you see that we have made an adjustment to our cost base that will give us meaningful expansion of operating margins in 2024 and secure our ability to deliver double-digit earnings growth in fiscal 2024.

François Locoh-Donou:

Well, a couple of things there, Samik. Number one is, our objective has been and continue to be to drive operating leverage in the business and we think from where we are at today at the 30% operating margin for the year. If you look at it in the second half of the year, it’s going to be -- the first half was in the 26%, 27% zone, the second half of the year is going to be meaningfully higher than that when you look at the full year being at 30% and from there our intent is to drive further operating leverage in 2024 and beyond. And we see the opportunity to do that with a combination of getting more efficient in our business and driving productivity, as well as continuing to drive topline growth. We said at our Analyst Day in 2020 that we were going to invest in driving some efficiencies and costs out of the business. We have been doing that. Today, we are announcing some changes to our cost base, but whilst we are doing that, we are also doubling down on investments in automation that will allow us to drive operating leverage going forward. So we see that as an ongoing journey of driving operating leverage, which we will -- you will start to see the benefits of that in the second half of this fiscal year, but that will continue in 2024.

Operator:

Thank you. And the next question comes from the line of Simon Leopold with Raymond James. Please proceed with your questions.

François Locoh-Donou:

Simon, thank you for the question. So let me start with saying, when we looked at our -- we spent quite a bit of time in the first half of our fiscal year looking at the demand signals that we were seeing from our customers. And if you recall, Simon, last year, we have challenges on our revenue in the second half of the year that were driven largely by issues of supply. And at the top, we said, we did not want to reduce our staffing levels, because this was not a demand issue, it was a supply issue. We also said at the time that if we did see a softening in demand, that that would cause us to relook at our cost base and potentially address our staffing levels and that’s exactly what we are doing. This year, we are seeing a softening of demand and whilst we appreciate that, that is driven by macro environment and it is temporary, we are also being quite disciplined about driving our earnings performance, but also ensuring that in this environment. We are operating as lean as we can be and as lean as we should be and that’s what’s driven our approach to reducing our staffing levels. We do feel that with these staffing levels we are well positioned to drive growth and capture the opportunity when demand levels normalize and our customers are ready to spend. In terms of giving you a couple of pointers, Simon, on where we have made some cuts? It’s across the Board. But if I park it in roughly three categories. In G&A, we have looked at increasing productivity and driving some efficiencies and just being able to rationalize the G&A organization for the size of the company we are post these cuts. In sales, we are -- we have looked at realigning or consolidating some territories and we are configuring some of the roles in our go-to-market to have a leaner go-to-market motion and having focus on the territories that will drive the best returns in the near- to medium-term. And then the product organizations, we have looked at all R&D projects that we have underway and really are focusing on the ones that will drive the best returns and where we have made cuts is on those projects that are perhaps more speculative or have longer term returns. And all of those really amount to us focusing on our top priority projects, and really being leaner and positioned for when demand will normalize. I would add that whilst we are doing that, we are doubling down on investment in our software, our hybrid and multi-cloud portfolio, because we are seeing growing evidence from customers from architecture conversations that we are ideally positioned for where their applications are going, where the security challenges are going, which is really about securing and delivering apps not in a single infrastructure environment, but across multiple public clouds, private clouds in the edge and being able to network all these environments together and I think we are in a unique position in that, so we are continuing to make these investments.

Frank Pelzer:

Yeah. Simon, we are not in the -- our normal course is not to update backlog in any one particular quarter. We talk about it at the end of the year. We tried to highlight to people during this particular call that we did expect to be through most of our shippable backlog by the end of the fiscal year, whether that’s Q3 or Q4, I can’t tell you. But we didn’t quantify where we were at the end of Q1 and we are not quantifying where we are at the end of Q2.

François Locoh-Donou:

Yeah.

Meta Marshall:

Great. Thanks. A couple for me, maybe to start with, you mentioned that customers are kind of running their networks at higher utilization of the F5 equipment. Just wondered if you could give a sense of is that matching kind of previous levels that you have seen in prior kind of macro pullbacks or just kind of where we are on kind of how hot they are running their networks versus peaks that we have previously seen if there’s any way to contextualize that maybe as a first question?

Meta Marshall:

Got it. That’s helpful. And then maybe as a follow-up question. Obviously, a lot of your software revenue tied to kind of the cloud transformation projects are now being delayed a little bit with cloud optimization projects. But is there a way to -- are -- is that largely virtual ADC projects, which are being kind of postponed, but security projects are going ahead. I am just trying to get a sense of is this kind of across the Board or are there certain secure or certain projects that are more security attached that are getting higher prioritization. Anything that that would be helpful in terms of what software projects are getting approved versus not?

Meta Marshall:

Great. Helpful color. Thank you.

James Fish:

Hey, guys. Most mine have been asked, but just wanted to follow up. François, you actually made the comment that you expect some of the -- maybe it was Frank, some of the working capital stuff to kind of work itself out by fiscal Q4 and I know you don’t want to talk about backlog specifically, but it sounds like if it’s going to work itself out by fiscal Q4 that we should expect to kind of exit the year at a more normal backlog level now. Is that the right way to kind of think about it at this point?

James Fish:

Okay. And just lastly, I know you called out SaaS being more resilient and that it’s still growing on a year-to-year basis. Just given now that, that’s become a more resilient part and it seems like it should be at this point a material part of the business. Any further color as to what percentage of the total recurring software business is now overall and if it grew actually sequentially?

James Fish:

Okay. Understood. Thanks, guys.

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 [email protected]. 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.

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?

Operator:

[Operator Instructions] Our first question is from Sami Badri with Credit Suisse.

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. .

Operator:

Our next question is from Tim Long with Barclays.

François Locoh-Donou:

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

Alex Henderson :

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

François Locoh-Donou:

So Alex, on the rSeries, there were -- there have been two factors that have sort of gated the ramp and growth of the rSeries over the last several quarters since we launched it. First is what you mentioned, the number of use cases and applications that rSeries could cover relative to the iSeries. And second was our ability to build and ship rSeries, which has been significantly constrained with some of the components. The good news is both of these factors are going away over the next couple of quarters. So on the supply chain factors, we are seeing better component availability and also access to broker markets where we are still constrained. We still have constraints on rSeries. We still had in Q1, and [we're still having] but a lot of the redesigned efforts that we have already done will be complete by the end of our second quarter. And so we are seeing lead times on rSeries will be improving in our second quarter and beyond. And then the second aspect in terms of the application, the number of use case that rSeries can cover will pretty much be at parity with iSeries, if not in the June quarter, in the September quarter. So in both cases, there's a lot of progress. There is a lot of demand for rSeries. And I think you should expect that rSeries will certainly grow into FY '24 to become the vast majority of what we ship in terms of appliances.

Samik Chatterjee :

I guess for the first one, if I can, François, ask you to sort of share a bit more color on in terms of budget scrutiny, which regions as well as customer...

Samik Chatterjee :

Can you hear me now?

Samik Chatterjee :

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

Samik Chatterjee :

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

Operator:

Our next question is from Amit Daryani with Evercore.

François Locoh-Donou:

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

François Locoh-Donou:

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

Meta Marshall :

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

Frank Pelzer :

Meta, in relation to gross margins, particularly product gross margins, our view of that for the year has not changed. And we talked about the supply chain improvements starting to benefit our product gross margins really in the latter half of this year, even all the way up into Q4. But the real benefit that we're going to see is going to be in FY '24 in terms of product gross margin improvement. We still had the purchase price variance and expedite fees that we're working through the components that make up our box builds through this year, and we still have got a few critical components where we are having to go in the broker market. So largely, we will start to see improvement in Q4, but more of it you will see in FY '24.

James Fish :

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

James Fish :

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

Operator:

Our next question is from Simon Leopold with Raymond James.

François Locoh-Donou:

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

François Locoh-Donou:

Yes, Victor. I mean, we saw them, which is why if you look at our software growth in 2021, I think it was around 37%. And if you look at our software growth in 2022, the first three quarters of '22 prior to the change in the environment, our software growth was also close to 40%. So we -- and it came from these three drivers, more deployment of modern applications that we serve with NGINX now with Distributed Cloud Services, more need for security in front of applications that we serve with all security solutions, Shape Distributed Cloud, BIG-IP and more deployments in multi-cloud environments with our large customers.

Thomas Blakey :

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

Thomas Blakey :

Yes. I'm sorry, I'm just focusing on the subscription business with regard to renewals and true-ups. And then as you mentioned -- sorry, Frank, go ahead.

Thomas Blakey :

Okay. And then just on the perpetual side, you've been a little bit above trend line in the last couple of years -- the trend line over the last couple of years, where -- what kind of visibility do you have into this perpetual business line, in the pipeline there? Comments from François, maybe. And maybe if you could juxtapose that with your comments about pause and a slowdown in spending just doesn't really jive with your kind of like beating the last couple of quarters pretty handily from a perpetual license perspective, that would be helpful.

Operator:

Our next question is from Jim Suva with Citigroup.

Frank Pelzer :

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

Frank Pelzer:

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

Fahad Najam :

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

Frank Pelzer:

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

François Locoh-Donou:

Yes, absolutely. So let me take them quickly in order. I would say on NGINX and Shape integrations are largely complete. And so on NGINX, you've already -- so they're complete both from a, if you will, product perspective in terms of capabilities, we have ported from F5 or BIG-IP onto NGINX, so we can offer, for example, security on NGINX. And increasingly, we're offering our customers a single pane of glass to be able to get visibility on both NGINX and BIG-IP deployments. And they're also complete from a go-to-market perspective whereby we have now enabled our mainstream go-to-market, marketing and sales resources to be able to promote and engage customers on NGINX. We've done the large thing on Shape, we're a little behind that, but I would say almost 80% there where we now have the integration complete. Shape is available in BIG-IP. Our customers who have BIG-IP can turn on Shape and tie more capabilities quickly. Shape is also available in our Distributed Cloud platform as a standard anti-bot defense offering. And we've also done a lot of the go-to-market integration. By the way, those integrations from -- when I say from a go-to-market, they are quite critical because they have allowed us to continue to drive better operating leverage from a sales and marketing perspective. So if you look at our sales and marketing expense, I think it was 31% or so of revenue in 2020, and it's 29% in 2022 despite the revenue pressures we had because of supply chain. So you see operating leverage there. And you look at our overall OpEx as a percentage of revenue has gone from roughly 54.5% in 2020, down to 50% to 51% implied in our FY '23 guidance. So the integrations have also enabled us to drive the right synergies and operating leverage. And then in terms of the -- I don't know if you asked about Volterra, of course, is newer. And so we're still going through that, but we've already done a chunk of the integrations by deploying all of our security capabilities onto that platform that we call now Distributed Cloud, and we're getting quite a bit of traction where all of that is going, is that ultimately, we are going to offer our customers a single console and a single pane of glass from which they can manage all their security policies from which they can get visibility to all their deployment with F5, whether it's hardware, software or SaaS and whether it's in legacy or modern environment. And in that regard, we're positioning to be quite a unique player that can cover all these models in a way that's agnostic to the underlying infrastructure.

Ray McDonough :

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

Operator:

Thank you. This concludes today's question-and-answer session. This is the end of today's conference. You may disconnect your lines at this time. Thank you for your participation.

Suzanne DuLong:

Hello, and welcome. I'm Suzanne DuLong, 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 January 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 call by phone, dial (800) 770-2030 or (647) 362-9199 and use meeting ID 3209415. The telephonic replay will be available through midnight Pacific Time, October 26, 2022. For additional information or follow-up questions, please reach out to me directly at [email protected]. Our discussion today will contain forward-looking statements, which include words such as believe, anticipate, expect and target. These forward-looking statements involve uncertainties and risks that may cause our actual results to differ materially from those expressed or implied by these statements. Factors that may affect our results are summarized in the press release announcing our financial results and described in detail in our SEC filings. Please note that F5 has no duty to update any information presented in this call. With that, I will turn the call over to Francois.

Frank Pelzer:

Thank you, Francois, and good afternoon, everyone. I will review our Q4 results before moving on to briefly recap FY '22 results. I will then speak to our FY '23 and first quarter outlook. We delivered fourth quarter revenue of $700 million, reflecting 3% growth year-over-year with 3% product revenue growth and 2% global services growth. Product revenue represented 50% of total revenue in the quarter and was split 49% software, 51% systems. Q4 software revenue grew 13% to $172 million, systems revenue of $178 million was down 5% year-over-year. Rounding out our revenue picture, global service delivered $350 million in revenue. Let's take a closer look at our software growth. Our software revenue is comprised of subscription-based and perpetual license sales. Subscription-based revenue, which includes term subscriptions, our SaaS offerings and utility-based revenue totaled $131 million or 76% of Q4's total software revenue, the remaining 24% or $41 million came from perpetual license sales. Let's talk first about subscriptions and their performance in the quarter, multiyear subscription renewals and our SaaS solutions performed as expected. However, as Francois noted, as the quarter progressed, we began to see increased budget scrutiny from customers and elongating selling cycles, particularly related to new projects and new architectural rollouts. While we had a strong pipeline of new multiyear subscriptions headed into the quarter, these dynamics led to lower close rates on new deals. We believe budget pressures also led to a strong mix of perpetual software sales in Q4 with an increasing number of customers for foreign tech-based consumption models. Revenue from recurring sources, which includes term subscriptions SaaS and utility-based revenue as well as the maintenance portion of our services revenue totaled 67% of revenue in Q4. On a regional basis, Americas delivered 6% revenue growth year-over-year, representing 61% of total revenue. EMEA declined 3%, representing 23% of revenue, and APAC declined 2%, representing 17% of revenue. Enterprise customers represented 66% of product bookings in the quarter. Service providers represented 13% and government customers represented 21%, including 12% from U.S. Federal. I will now share our Q4 operating results. GAAP margin was 78.9%. Non-GAAP gross margin was 81.4%. This was below our guidance of 82% to 83% as a result of the higher systems revenue mix in the quarter and higher costs associated with procuring and expediting critical components in the broker market. GAAP operating expense was $445 million. Non-GAAP operating expense was $379 million, in line with our guided range. Our GAAP operating margin was 15.4%. Our non-GAAP operating margin was 27.3%. Our GAAP effective tax rate for the quarter was 10.4%. Our non-GAAP effective tax rate was 14.1% GAAP net income for the quarter was $89 income was $158 million or $2.62 per share. I will now turn to cash flow and balance sheet. We generated $154 million in cash flow from operations in Q4. Capital expenditures for the quarter were $9 million. DSO for the quarter was 60 days. Similar to last quarter, this is up from historical levels due to the back-end shipping linearity in the quarter resulting from ongoing supply chain challenges. Cash and investments totaled approximately $894 million at quarter end. Deferred revenue increased 14% year-over-year to $1.69 billion, up from $1.64 billion in Q3. This increase was largely driven by subscriptions and SaaS bookings growth and, to a lesser extent, deferred service maintenance. Finally, we ended the quarter with approximately 7,090 employees. I will now briefly recap our FY '22 results. For the year, revenue grew 3% to $2.7 billion. Product revenue of $1.3 billion grew 6% from the prior year and accounted for 49% of total revenue. As Francois noted, we achieved a significant milestone in the year, with software representing 51% of product revenue. Software revenue grew 33% to $665 million for the year, while systems revenue declined 13% to $652 million. Global services grew 2% to $1.4 billion. FY '22 software growth came from both subscriptions and perpetual license growth. Since FY '19, we have driven total software revenue growth at a 41% compounded annual growth rate. Subscription software at a 58% compounded annual growth rate and perpetual license at a 10% annual growth rate. In FY '22, revenue from term-based subscription models, including renewals and inter term expansions or true forwards continue to represent the majority of our software subscription revenue. With the launch of F5 distributed cloud services in February, we have introduced a new growth vector for our software business with a SaaS-based consumption model. We are thrilled with the early customer traction for the platform, but scaling ratable SaaS revenue takes time. We are transitioning all of our previously available SaaS services, including solutions from Shape and Silverline managed services to F5 distributed cloud services, creating a unified delivery platform for customers. We fully expect F5 distributed cloud will be a meaningful contributor to our revenue in the future. We will look to disclose both its revenue contribution and other relevant ratable revenue metrics as the business grows and matures. Our software revenue growth is driving us towards a higher recurring revenue base. In FY '22, 69% of our revenue was recurring, up from 66% in FY '21 and reflecting an 11% compound annual growth rate since FY '19. We closed FY '22 with approximately $231 million in product backlog, the vast majority of which is system space. This is up more than 80% from approximately $125 million in product backlog in FY '21. While backlog orders are cancelable, we continue to see very low to nonexistent cancellation rates. Two years ago, we began disclosing the portion of our revenue derived from security solutions. Francois mentioned, we delivered $1 billion in security revenue in FY '22, representing 37% of total revenue. We estimate our stand-alone security product revenue, which includes solutions sold exclusively for security use cases in either software SaaS or hardware deployment models, grew to approximately $440 million. This reflects a 30% compounded annual growth rate since FY '19. I will now turn to our FY '22 operating performance. GAAP gross margin in FY '22 was 80%. Non-GAAP gross margin was 82.6%. Our GAAP operating margin in FY '22 was 15% and our non-GAAP operating margin was 28.9%. Our GAAP effective tax rate for the year was 16.4%. Our non-GAAP effective tax rate for the year was 18.1%. Our FY '22 annual tax rate was lower than expected primarily due to a dispute benefit from filing our fiscal year 2021 state income tax returns. GAAP net income for FY '22 was $322 million or $5.27 per share. Non-GAAP net income was $623 million or $10.19 per share. I will now share our outlook for FY '23. Unless otherwise stated, my guidance comments reference non-GAAP operating metrics. As Francois noted, we expect to deliver 9% to 11% revenue growth in FY '23. This view incorporates a balance between tailwinds to our systems business from gradually improving component availability during the year and macroeconomic headwinds. It also factors in current customer caution. In FY '23, we expect the dynamics around budget scrutiny and caution around new projects will be similar to what we experienced in Q4. As a result, we expect software growth of 15% to 20% for the year. We expect systems revenue growth in FY '23 with growth weighted towards the second half when supply chain risk related to critical components begins to abate. Finally, we expect low to mid-single-digit revenue growth from our global services. Shifting to our operating model, we expect supply chain pressures to remain acute in the first half of the year and to gradually improve in the second half. This dynamic will impact our FY '23 operating model trends likely outweighing our usual seasonality. Specifically, revenue, gross margin and operating margin expansion are expected to be more weighted in Q3 and Q4 of FY '23. We expect FY '23 gross margins of approximately 81% with the combination of moderating supply chain cost and price realization from our previously announced price increases flowing through as we progress through the year. We expect continued operating expense discipline will result in non-GAAP operating margin in the range of 30% to 31% for the year. We expect our FY '23 effective tax rate will be 21% to 23%. And we expect to deliver non-GAAP EPS growth in the low to mid-teens for the year. As Francois noted, with results in these ranges, we would achieve our Rule of 40 target for FY '23. We are committed to maintaining it and double-digit earnings growth going forward on an annual basis. Our FY '23 outlook incorporates the expectation that we will allocate 50% of our free cash flow for the year to share repurchases, consistent with our balanced approach and the commitment we made at our last Analyst Day. Included in this expectation is that we pay down the $350 million remaining on our term loan related to the Shape acquisition when it matures in January of 2023. I will now speak to our outlook for Q1 FY '23. We expect Q1 revenue in the range of $690 million to $710 million with gross margin of approximately 80%. We estimate Q1 operating expenses of $370 million to $382 million. And our Q1 non-GAAP earnings target is $2.25 to $2.37 per share. We expect Q1 share-based compensation expense of approximately $61 million to $63 million. I will now turn the call back over to Francois. Francois?

Operator:

[Operator Instructions] Take our first question this afternoon from Tim Long of Barclays.

Francois Locoh-Donou:

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

Francois Locoh-Donou:

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

Sami Badri:

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

Frank Pelzer:

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

Alex Henderson:

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

Alex Henderson:

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

Operator:

We take our next question now from Samik Chatterjee at JPMorgan.

Frank Pelzer:

Sure, Samik. So why don't I start with that and certainly Francois can jump in. The assumption is actually that there is an improving gross margin as we work through the quarters, largely because we are not actually dependent on the broker market to get some of these critical components that we have gone through our redesigns and resins and we are now shipping product without the critical components that have plagued us for the past 6 to 8 months. And so -- that work is expected, as I said, to be largely completed by the end of Q2, beginning of Q3. And that is baked in as our assumption into our gross margins and our operating margins for the year.

Samik Chatterjee:

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

Operator:

We go next now to Paul Silverstein at Cowen.

Francois Locoh-Donou:

I would say, first of all, Paul, it was most acute in EMEA and APCJ, where it was the combination of inflation, currency exchange volatility and fulfilling the crisis coming and wanting to really restrained budget. So this is where it was most acute. In terms of the number of customers, it's not hundreds of customers, and it's probably more -- but it is definitely in double-digit number of deals where we saw that. Typically, those are deals that are $1 million-plus deals. And so that just gives you a sense of the impact of these deals being pushed out.

Francois Locoh-Donou:

Yes.

Francois Locoh-Donou:

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

Francois Locoh-Donou:

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

Francois Locoh-Donou:

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

Francois Locoh-Donou:

It's balanced across both.

Meta Marshall:

I just wanted to get a sense of with your customers, what are the biggest inhibitors to kind of the rSeries transition today and then still opting for iSeries? And then should we assume that the vast majority of the gross margin headwinds are primarily due to the broker purchases for the iSeries? Or are they kind of across both I and rSeries?

Operator:

We go next now to James Fish at Piper Sandler.

Frank Pelzer:

And I appreciate the question, Jim. We are not splitting out those components at this point. But I think some of the guidance that Francois said in his discussion point on -- if you take a look at the midpoint of our guidance on software range and more than half of that coming from new business. That will sort of give you some sense for the renewals plus the true forwards plus the SaaS business is less than half of that number. As we think about how that's going to continue to grow. I'm not going to say at the end of FY '23. But clearly, as we take a look out, particularly as the SaaS business matures more and more over the coming years, we expect that contribution to come down such that, that new business contribution to the overall 20% growth rate is not nearly as strong as it has been at the point where we have to where we are today. And so that's the anticipation that we've got in the longer term of the 20-plus percent growth rate. And those are the dynamics that we see compounding upon themselves, particularly as we reach the second or the third or the fourth of renewal cycle within these flexible consumption programs on top of the growth in the SaaS platform that's frankly still nascent in its overall revenue contribution to the company.

Frank Pelzer:

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

Victor Chiu :

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

Victor Chiu :

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

Operator:

We go next now to Amit Daryanani at Evercore.

Frank Pelzer:

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

Frank Pelzer:

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

Jim Suva:

I heard you mention something about second half of fiscal '23 being more back half loaded for demand or, I guess, deliverable. Was that on both the hardware and the software? And was it more from your discussions with your customers or more just you can't get all the components together to complete the various items? Because I'm just kind of wondering on the software side, it seems like it would be a little bit early to say back half loaded for something 9 months from now.

Operator:

And this will conclude today's call. You may now disconnect.

Suzanne DuLong:

Hello and welcome. I am 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 October 24, 2022. Visuals accompanying posted to our IR site at the conclusion of the call. To access the replay of today's call by phone, dial (888) 674-7070 or (416) 764-8692 and use meeting ID 468081. The telephonic replay will be available through midnight Pacific Time, July 26, 2022. For additional information or follow-up questions, please reach out to me directly at [email protected]. Our discussion today will contain forward-looking statements, which include words such as believe, anticipate, expect to target. These forward-looking statements involve uncertainties and risks that may cause our actual results to differ materially from those expressed or implied by these statements. Factors that may affect our results are summarized in the press release announcing our financial results and described in detail in our SEC filings. Please note that F5 has no duty to update any information presented in this call. With that, I will turn the call over to Francois.

Frank Pelzer:

Thank you, Francois, and good afternoon, everyone. I will review our Q3 results before discussing our Q4 outlook. We delivered third quarter revenue of $674 million, reflecting a 4% growth year-over-year with 5% product growth. Product revenue represented 48% of total revenue in the quarter, and software represented 55% of product revenue. This is the second quarter in a row where the majority of our product revenue has come from software. Q3 software revenue grew 38% to $179 million. Systems revenue of $148 million declined 18% year-over-year due to ongoing supply chain challenges and resulting shipment delays. Similar to Q2, we added systems backlog of tens of millions of dollars in Q3. Rounding out our revenue picture, global services delivered $348 million in Q3 revenue, up 2% from the prior year. Taking a closer look at our software revenue, subscription-based revenue contributed 82% of total software revenue in the quarter, a new high. Term-based subscriptions continue to represent over half of our subscription revenue with smaller but growing contributions from Software-as-a-Service and utility consumption models. Revenue from recurring sources, which includes term subscriptions, Software-as-a-Service and utility-based revenue as well as the maintenance portion of our services revenue totaled 72% of revenue in the quarter. This is another milestone for us and is up from 66% in the year ago period. On a regional basis, Americas delivered 5% revenue growth year-over-year, representing 57% of total revenue. EMEA declined 7%, representing 23% of revenue, and APAC grew 15%, representing 19% of revenue. I'll remind you that given current supply chain constraints, our geographic revenue distribution in a quarter is not fully indicative of demand for each given region. Enterprise customers represented 70% of product bookings in the quarter. Service providers represented 18% and government customers represented 12%, including 3% from U.S. Federal. I will now share our Q3 operating results. GAAP gross margin was 80.6%. Non-GAAP gross margin was above our guide at 83.2%. While we continue to experience increased component prices, expedite fees and other sourcing-related costs, our Q3 gross margin reflects some improvement in average selling price on systems in the quarter. We are not ready to say it's a trend, but we are encouraged about the overall direction. GAAP operating expenses were $436 million. Non-GAAP operating expenses were $367 million. This is lower than our guided range as a result of some investments we delayed in anticipation of potential macro headwinds that did not materialize in the quarter and lower international expenses related to the strengthening dollar. Our GAAP operating margin was 15.9%. Our non-GAAP operating margin was 28.8%. Our GAAP effective tax rate for the quarter was 18%. Our non-GAAP effective tax rate was 17.4%, largely driven by a nonrecurring benefit associated with the filing of our federal income tax return during the quarter. GAAP net income for the quarter was $83 million or $1.37 per share. Our better-than-guided gross and operating margin performance and lower tax rate contributed to non-GAAP net income of $155 million or $2.57 per share. I will now turn to cash flow and the balance sheet. We generated $71 million in cash flow from operations in Q3. This is net of more than $30 million of payments to partners related to securing component inventory to support future hardware builds and component expedite fees. Capital expenditures for the quarter were $9 million. DSO for the quarter was 61 days. Similar to last quarter, this is up from historical levels due to back-ended shipping linearity in the quarter resulting from ongoing supply chain challenges. Cash and investments totaled approximately $757 million at quarter end. During the quarter, we repurchased approximately $250 million worth of F5 shares or approximately 1.5 million shares at an average price of $171 per share. Deferred revenue increased 14% year-over-year to $1.64 billion, up from $1.60 billion in Q2, largely driven by subscriptions and SaaS bookings growth and, to a lesser extent, deferred service maintenance. Finally, we ended the quarter with approximately 6,900 employees. I will now share our outlook for the fourth quarter. Unless otherwise stated, please note that my guidance comments reference non-GAAP metrics. We expect Q4 revenue in the range of $680 million to $700 million. Our pipeline indicates Q4 demand that would put our software revenue growth towards the high end of our 35% to 40% target for the year. As Francois discussed, however, we are very cognizant of the broader, more cautious environment. And as a result, we see more risk at the top end of our software growth range than there was a quarter ago. Given the Q3 strength in global services, we now expect global services revenue to grow approximately 1.5% to 2% for the year. We expect Q4 gross margins in a range of 82% to 83%. We are seeing component costs continue to rise and expect that they will be higher still next year. As a result, we implemented an approximately 15% price increase in systems effective July 1. Given our backlog, we expect it will take some quarters for the price increase to manifest into sustainable gross margin improvements. We estimate Q4 operating expenses of $374 million to $386 million, which would put our FY '22 operating margin at approximately 29%, an improvement of 100 to 200 basis points from our prior outlook. Factoring in the tax rate benefit from Q3, we now expect FY '22 effective tax rate will be approximately 19%. Our Q4 earnings target is $2.45 to $2.57 per share. We expect Q4 share-based compensation $61 million to $63 million. Finally, as we announced in the earnings press release, our Board authorized an additional $1 billion for our share repurchase program. This new authorization is incremental to the $272 million remaining in the existing program. As we have over the last two years, we expect to continue to balance share repurchases with other strategic uses of cash. This concludes our prepared remarks today. Operator, would you please open the call to Q&A?

Sami Badri:

First thing, I wanted to just clarify was, I think there was a reference to the backlog increasing or at least adding more revenues to the backlog. Could you clarify if the backlog exiting fiscal 3Q is actually higher than where it was exiting fiscal 2Q '22? So that's my first question. The second question is there's a lot of interest in the investor base around the software growth trajectory of the business. And I know you guys discussed coming in at the higher end of the range at fiscal year '22, but could you characterize or give us indication on what fiscal year '23 is going to look like, just because the growth rates are rather significant?

Francois Locoh-Donou:

And Sami, I'll take the second part of your question. So, obviously, this is not a time where we are guiding for fiscal 2023. Overall, if you look at our -- the performance of the business in software, we guided 35% to 40% of our investor meeting about almost two years ago now in November of 2020. And we have delivered that in the first year in 2021, and this year we are delivering closer to the top end of the range of that guidance. So we feel very, very good about the drivers of software growth in the business that we talked about, including modern applications, the strength we are seeing in security and the adoption of multi-year agreements with F5 driven by digital transformations and automation. And so we will talk more about software growth for 2023 in October. But when you look at 2023, frankly, the factors, I think some of the factors that will affect that, one, of course, like every other company is the macro environment and will that have an effect on our growth rate. Today, frankly, it's too early to say, because we haven't seen a fundamental change in the buying behaviors of our customers across the globe based on the macro at this point. And I think the other factors will be, we, through the pandemic Sami, and this is specific I would say to the BIG-IP part of our business. We have seen continued demand for hardware and we have seen a number of customers that had declared that they would move to software pretty quickly that have actually recommitted to hardware and stayed with hardware longer. So, we are seeing very, very strong resilience and strong demand in hardware, sometimes at the expense of customers that would've moved to software. So if that, kind of mix shift, if you will continue in 2023 that may affect our software growth rate some, but it wouldn't affect the top-line because it would be more of a mix shift factor, if we continue to see that shift in customer behavior.

Francois Locoh-Donou:

I think, Sami, there are two dynamics that -- our service provider business is doing very well, and it's the result of kind of two series of investments that are intercepting, I think the market at the right time. On the software side, we have invested heavily in cloud-native functions that allow service providers who want to build 5G cores to evolve to these more cloud made environments and be able to do that with us. And we have now a number of design wins in this area that are starting to go into production. And this quarter, we had more of these going into production, and so it's turning into revenue. And our expectation is that, that will continue. But we feel well positioned for the cycle of kind of next-generation software deployments with service providers both in the core infrastructure and at the edge. The other dynamic that's going on with service providers is that they continue to increase capacity in their 4G environment for increasing traffic, specifically 5G traffic, and we -- I think, as we shared before, we have continued to make investments in our hardware platforms to prepare for this increased demand for capacity. And as a result, we've been able to get to some price performance points that are really meeting the demands of high-scale, high-capacity service provider deployments, especially in the GI land part of the network for things like carrier-grade firewalls. And that's driving strong demand and execution in the service provider vertical.

James Fish:

Wanted to go off the software question from before. Is there a way to think about how much the unattached software deal flow is either independent or dependent on some of the systems deal flow given you're already selling into some of the largest organizations out there? And also, you mentioned there, Francois, multiyear agreements just now. Is duration actually extending for software?

James Fish:

All right. And then maybe for Frank. I do want to unpack your guide a bit here, essentially the back of The Street for Q4. Is there a way to understand for how much during the year will be a net issue from the supply chain constraints versus that prior, I believe, $60 million to $90 million headwind versus the macro impact you're now including in guidance?

Operator:

Your next question comes from Meta Marshall of Morgan Stanley. Please go ahead.

Francois Locoh-Donou:

Meta, so when we're talking about improvements in our shipments in the second fiscal quarter of 2023, Meta, that's driven by two factors. The first is what we expect to be better component availability from our suppliers based on commitments they've made to us. And generally, from what we see, they are on track with execution against these commitments on some of the most constrained components. So that's factor number one. Factor number two is we have also been doing some design work to design around or redesign around some of the most constrained components, And those design efforts should complete towards the tail end of the calendar year, which would allow us to ship with the new components in the second quarter -- or the second fiscal quarter of '23. So those are the two factors driving that, Meta. As of today, both of those factors are really on track. Now we're talking about things that are happening in the next six to nine months and then looking at the full second half of 2023. So, we -- I'll caveat that by saying, there's still a ton of execution to come and commitments to be delivered by our suppliers. But generally, we're on track. And I would say, we feel incrementally better about that than we did three months ago from what we've seen from our suppliers' commitments and our own load. As it relates to rSeries, we are very happy with the ramp of rSeries. It actually is right now the fastest-renting new platform than we've had. The rent is happening 2x faster than prior new platform introductions. And that's largely due to the benefits of the rSeries platform. So it's an investment we started a few years ago really to bring to our customers several of the elements of the cloud to their on-premises environment. So they're getting a lot of automation benefits from rSeries, the ability to run multiple software tenants on the same platforms. And so for those customers that really want to automate their environments, which is at the heart of a lot of the digital transformation, what they're getting from rSeries is not just the price-performance benefits that you get from a new hardware platform, but also a lot of the cloud-like benefits of automation and multi-tenancy into the platform. So that's a good ramp, and we are -- I think we're pretty excited about what rSeries is going to do for the business, not just this year, but for the next few years.

Tim Long:

Just a few on the software business. First, any update on getting more consistent metrics here, RPO, ARR and the dollar retention? Love to get an update on when we could potentially see those numbers more specifically and then maybe related to it, we're not going to get them now. Frank, could you a little -- talk a little bit about kind of what you're seeing is a nice jump in software? New deals, first true-forwards, how do we look at that aspect of the software growth this quarter? And then maybe the last one is maybe for you, Francois. We're coming up on three years of -- three-year anniversary of some of the really large first-term deals. Could you talk to us a little bit about how you think those renegotiations or renewals would be working and how that can work into the model? Maybe just a little color on the first set of deals, It should be a pivotal time to renew those deals, I would think. And if so, are those deals like some of the other business where it's kind of been running above run rates, so those renewals could potentially be larger than the initial contracts? Thank you.

Francois Locoh-Donou:

Yes. Generally, Tim, on the renewals, the early indicators on the revenue expansion opportunity are really good on these -- on those large multiyear agreements. What we're seeing is continued growth in application usage, and that's a part of what's driving the expansion in some of these opportunities. So, it's early days, as you said, but it's going very well. I would say the other driver -- I would say, both of renewals and new multiyear agreements is security. We had a very strong quarter, again, in security. And what we're seeing is that the portfolio that we've put together that allows our customers to put security capabilities across their environment is really making a difference. So this quarter, we had a very strong quarter on security with BIG-IP and WAF. And in fact, WAF across all of our form factors and BIG-IP, and we had a very strong quarter with NGINX security. This was the second quarter in a row where we had over 100 wins of NGINX with security. We have very strong debut, if you will, for our distributor cloud services WAP offering, which is our SaaS offering on security. And we're bringing all of these security offering over time under a single SaaS console that will allow our customers to push the same policy to all of their environments for protecting their applications. So that, if you will, competitive differentiation, we're seeing the benefit of that both in terms of expansion of existing agreements as well as new agreements that are driven by our security software.

Frank Pelzer:

Yes. So we're not going to split that out in the quarter. I think both of them were quite healthy. When I take a look at where we have been in the past, the true-forward contribution was along our expectations for the growth in new business. That was also in line with our expectations, and it resulted in the 38% software growth, but I'm not going to give a specific split between the two for the call.

Alex Henderson:

So across the presentation, you've made a number of references to buying behavior, specifically said at one point that buying behavior patterns haven't changed. Another point, you said that there's some increase in the number of signatures required. And you've weighed into your guide the expectation of continued softness in the broader economy. But can you talk a little bit about where you are in terms of the pipeline of activity that you're chasing, whether the activity is more robust, less robust than you would expect for this time of year? And particularly whether the deal sizes are bigger, smaller, how the price increase might impact that longevity; and within the backlog, whether there's any concern around cancellations of orders?

Operator:

Your next question comes from Samik Chatterjee of JPMorgan. Please go ahead.

Francois Locoh-Donou:

Samik, just the last part of your question about the 15% price increase, what was your question about that?

Francois Locoh-Donou:

Okay. So let me just start with that part of the question. So Samik, yes, we did have a price increase that took effect on July 1. And we -- as a result of that, we had a number of orders that were pulled into our third quarter by customers wanting to order early to not be affected by that price increase. When we look at the demand signals for Q3, we normalize out these orders that were pulled in. And even if you normalize out for these orders, it was actually a strong -- I would say, strong to very strong demand quarter. In terms of the order trends post the price increase, we are early in the quarter, and the linearity that we're seeing today is not really different than what we would see in the first month of the quarter. To the first part of your question around how we're preparing for what may transpire in the macro, we -- you will see that we are being cautious. So, we're not -- I want to be clear, we're not seeing any change in our demand signals to date. But given everything else that's going on in the macro, we have, out of caution, significantly slowed down hiring in the last month across functions. There were some kind of investment initiatives that we have delayed to see more clearly what's going to transpire in the macro and see if we push forward with these investments or not. So right now, Samik, it's more on the management of our OpEx and OpEx run rate that we have focused our -- if you will, our preparation and readiness. Our incentives for software for our teams are pretty strong, and they're going to continue to remain strong. And hopefully, you've seen that in the results we're having on our software growth rates.

Rod Hall:

I wanted to come back to the comment, I think, Francois, you made it about the back-end loaded nature of the quarter and kind of the DSOs. I guess I was curious about the drivers of the back-end loading. I mean you guys are saying you're not seeing demand impacts, but I wonder what -- how would you characterize the drivers for the back-end-loaded nature of the quarter? Was there a particular type of product you were selling more in the back end of the quarter? Was there a promotion, something like that? And I'm curious also on the DSOs whether you think next quarter those might come back down again.

Francois Locoh-Donou:

Yes. And Rod, on the back-end-loaded quarter, first of all, yes, it was more back ended but on a very, very strong demand quarter. And so I think I mentioned earlier that we saw at the very end of the quarter some order being -- some orders that we felt should have come in Q4 that came in Q3. We attributed some of that to customers are doing ahead of a price increase. I think if you normalize that out that would normalize a little more the linearity of the quarter. The other factor is Europe, which was, in fact, back-end loaded in linearity. We think that to do with the macro and the scrutiny there. And if you normalize out these two factors, there was probably also an element that we started to see around more customers, I want to say outside of Europe that had more approval cycles in their orders. And so, it may have pushed some orders that we may have expected in the second month but happened in the third month of the quarter.

Francois Locoh-Donou:

Yes. That phenomenon around the sort of orders very late in the quarter to avoid the price increase would have been more about systems than for software, where I think we had a more kind of normal linearity.

Amit Daryanani:

I have two as well. I guess maybe to start with on the software side, right, even see at the higher end of the 35% to 40% growth rate this year, is there anything you would call out that's more onetime in nature that you think helped you on software growth in fiscal '22, ELAs or big deals or something? And if you do end up in a slower macro environment in '23, does that help or have your software business over time?

Francois Locoh-Donou:

Yes. And then the second part of your question, Amit, about -- so the question is whether if we are in a recession in 2023, does that help or hurt our software business, well, I will just give you some thoughts on how I think about this. On the one hand, I think one thing we've seen in past recessions is people hunker down and not start new things but continue to do the things that they've been doing. And so what that would mean is for our customers that are on hardware, it's likely that some of these customers would decide to just continue to stay in the hardware train rather than start a whole new architecture, a new project if they haven't done that already. And if you look at it that way, that would favor our hardware business and less our software business for where there's this BIG-IP opportunity between hardware and systems. On the other hand, the vast majority of our software business is subscriptions, and we think there are a number of customers that would prefer to move to this OpEx model in that environment rather than new large CapEx outlays. And that would favor more of our software business. But if you step back from it, I think the way we look at it is we have now built a business model that we think is actually quite resilient because we can meet our customers where they are at with hardware form factors, software form factors, a term subscription or perpetual and even SaaS and managed services form factors. And so if we have customers that want to add security capabilities to their environment but they want to start with a lower expense on a pay-as-you-go model, our SaaS offerings are going to get traction very rapidly. They already are, and that would favor that in 2023. So overall, we feel that we've got the resilience in the model to be able to meet customers in the economic model that makes most sense for them in a recessionary environment.

Frank Pelzer:

So yes, let me start with that and let Francois. So, we were giving an absolute in terms of revenue dollar value for when Q1 would be the low point in our systems revenue. And that is truly a result of the components that are needed to ship when we see those schedules comings in. As Francois mentioned, the volatility associated with decommits has gone down from what we have experienced in recent quarters. That having been said, the commitments that we have, will show that, that will be the low point of what we can actually produce to that volume. And so that's why on a dollar basis, we expect Q1 to be the low point.

Frank Pelzer:

And Amit, I will just -- I will reconfirm what Francois said last quarter. Q1 will be a low point. We will see a build in Q2 from there as some of the redesigns and components become more available. We expect Q3 to be higher yet still because of -- we're able to ramp production even more on the new platforms. And then ultimately, by Q4, we may actually start to begin to bring down backlog because of availability. But we do expect it to take a linear up curve on the revenue for systems, next year.

Jim Suva:

And I just have one question. Francois, in your prepared comments, you mentioned additional signatures and a little bit more time to get deals to be completely approved. I'm wondering, does this also allow the CTOs more time or more contemplation to do virtual instances, more software, VM type of production orders from you? Or is it kind of the cadence of what they're looking at kind of as you expect? I'm just kind of wondering what the elongated closing time, does it actually allow them to kind of take a step back and look at the whiteboard a little bit more about the solutions that they're buying from you?

Operator:

Ladies and gentlemen, due to time constraints, we will take our last question from Simon Leopold of Raymond James. Please go ahead.

Frank Pelzer:

Let me start and I'll let Francois pick up on the back half of your question. So as you know, we -- as a policy, don't really guide to specific mixes within the components of our product revenue. I did say last quarter that we expect either Q4 or Q1 to be the low point of our systems revenue purely due to supplier commitments and what we could actually ship. And so, I'm not going to address are we going to be down sequentially quarter-over-quarter in terms of dollar revenue. But that directionally, I was saying last quarter and still feel that Q4 and Q1 were the low points. We're saying now specifically Q1 may be lower than Q4. I wasn't saying specifically what Q3 -- what Q4 is going to be in relation to Q3. The supply -- so on the supply chain dynamics, you are correct. We are seeing a bit of a stabilization on most of the components. But we do have what we call the Golden Screw component to building boxes, meaning that you have to have everything obviously to do it. And there are still a few components associated with our builds that are constrained and continue to be constrained. And so if for whatever reason, those are freed up, which is not our expectation, we could do better than these, but that's not the expectation that we want to set for you. There's still -- know broadly, the supply chain is getting better for most components. There are still a few in our specific builds that are constrained. We talked about fiscal Q2 being better, not because those suppliers are able to ship us more but more because of the redesign efforts that will likely go into effect in the back half of our fiscal Q1. That will help us with the improvements in build in Q2.

Operator:

Ladies and gentlemen, this concludes your conference call for this afternoon. We would like to thank you all for participating and ask that you please disconnect your lines.

Suzanne DuLong:

Hello and welcome. I am 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 call will be available through July 24, 2022. Today’s live discussion is supported by slides, which are viewable on the webcast and will be posted to our IR site at the conclusion of today’s discussion. To access a replay of today’s call by phone, please dial 800-585-8367 or 416-621-4642 and use meeting ID 7769889. The telephonic replay will be available through midnight, Pacific Time, April 27, 2022. For additional information or follow-up questions, please reach out to me directly at [email protected]. Our discussion today will contain forward-looking statements, which include words such as believe, anticipate, expect and target. These forward-looking statements involve uncertainties and risks that may cause our actual results to differ materially from those expressed or implied by these statements. Factors that may affect our results are summarized in the press release announcing our financial results and described in detail in our SEC filings. Please note that F5 has no duty to update any information presented in this call. With that, I will turn the call over to Francois.

Frank Pelzer:

Thank you, Francois and good afternoon everyone. I will review our Q2 results before discussing our second half outlook. We delivered second quarter revenue of $634 million, above the midpoint of our guidance range and reflecting a 2% decline year-over-year. Software revenue grew 40% to $152 million. Systems revenue declined 27% to $146 million. We delivered a 4% product revenue decline year-over-year, with product revenue representing 47% of total revenue in the quarter and software contributing 51% of product revenue. Rounding out our revenue picture, Global Services delivered $337 million in revenue. This is flat compared to last year and represented 53% of total revenue. Taking a closer look at our software revenue, subscription-based revenue represented 75% of total software revenue in the quarter. This is down a bit from the 80% mix, where it had been in the last couple of quarters, but we do not see this as indicative of a trend. Rather, it reflects some activation timing variability for a couple of large multiyear subscription agreements as well as a small number of larger deals in the quarter where customers preferred a CapEx model. As a reminder, a significant component of our subscription business is term-based licenses that are not recognized ratably, and as such, we expect some quarter-to-quarter variability. Revenue from recurring sources, which includes term subscriptions as a service and utility-based revenue as well as the maintenance portion of our services revenue totaled 69% of revenue in the quarter. This is up from 64% in the year ago period. On a regional basis, Americas delivered 4% revenue growth year-over-year, representing 57% of total revenue. EMEA declined 9%, representing 25% of revenue, and APAC declined 6%, representing 19% of revenue. In the quarter, we saw some signs of softness in EMEA. We believe this is in part related to the macro and global political concerns in the region. Enterprise customers represented 65% of product bookings in the quarter. Service providers represented 15% and government customers represented 20%, including 7% from U.S. Federal. I will now share our Q2 operating results. GAAP gross margin was 80.1%. Non-GAAP gross margin was 82.9%. We continue to experience increased component prices, expedite fees and other sourcing-related costs. GAAP operating expenses were $433 million. Non-GAAP operating expenses were $358 million. Our GAAP operating margin in Q2 was 11.8%. Our non-GAAP operating margin was 26.5%. Our GAAP effective tax rate for the quarter was 22.7%. Our non-GAAP effective tax rate was 21.3%. GAAP net income for the quarter was $56 million or $0.92 per share. Non-GAAP net income was $131 million or $2.13 per share. I will now turn to the balance sheet. We generated $127 million in cash flow from operations in Q2. Capital expenditures for the quarter was $5 million. DSO for the quarter was 59 days. Cash and investments totaled approximately $922 million at quarter end. During the quarter, we repurchased approximately $125 million worth of F5 shares or approximately 610,000 shares at an average price of $205. Deferred revenue increased 17% year-over-year to $1.60 billion, up from $1.58 billion in Q1. The growth in total deferred was largely driven by subscriptions and SaaS bookings growth and, to a lesser extent, deferred service maintenance. Finally, we ended the quarter with approximately 6,700 employees, up approximately 150 from Q1. Francois shared our updated fiscal year 2022 revenue outlook in his remarks. I will recap the details of the second half outlook with you now. Unless otherwise stated, please note that my guidance comments reference non-GAAP operating metrics. I will begin with our revised view for fiscal 2022. Given persistent and dynamic supply chain pressures, which are limiting our systems revenue recovery near-term, we expect to deliver fiscal year 2022 revenue growth within the range of 1.5% to 4% for the year. This compares to our prior expectations of 4.5% to 8% growth. We continue to expect to deliver close to the top end of our 35% to 40% software revenue growth target for the year. We expect Global Services growth of approximately 1% to 1.5% for the year, reflecting the lower expected range of system sales. Because we believe the current supply chain challenges are temporary and do not reflect the underlying growth of the business, we do not intend to adjust our operating model near term. We believe doing so would risk compromising our ability to deliver future revenue growth. As a result, we are likely to see operating margin pressure over the next several quarters. We expect non-GAAP operating margin in the range of 27% to 28% for FY ‘22. We would expect to regain the Rule of 40 operating benchmark as we return to full manufacturing capacity. We continue to expect our full fiscal year effective tax rate will be in the range of 20% to 21% with some fluctuations quarter-to-quarter. We remain committed to repurchasing 500 million in shares during the fiscal year. I will now move to our third quarter expectations. We expect Q3 revenue in the range of $660 million to $680 million. Given component costs and the costs related to actions we are taking to mitigate supply chain pressures, we expect Q3 gross margins of approximately 82%. We estimate Q3 operating expenses of $368 million to $380 million. Our Q3 earnings target is $2.18 to $2.30 per share. We expect Q3 share-based compensation expense of approximately $63 million to $65 million. With that, I will turn the call back over to Francois. Francois?

Operator:

Sure. Thanks, sir and thank you. [Operator Instructions] Our first question comes from the line of Samik Chatterjee from JPMorgan. Please ask your question.

Francois Locoh-Donou:

Samik, it’s Francois. Thank you for the question. Let me start on the pricing. We have been generally philosophically quite cautious about pricing with our customers. That being said, we have seen, as you know, significant price increases in – sorry, significant cost increases. And we did affect the price increase in the last few months that was in the high single digits. And we will continue to review our cost and kind of refine our models and look at whether we need to do anything else in coming months. But we’re going to continuously review that in line with what we’re seeing from a component perspective. But we’ve already taken a first action in that area. As it relates to when things do get better, so based on conversations with our suppliers, Samik, all of this is really about the semiconductor supply chain. And it’s really a handful of strategic suppliers that we have. And we do have deep and broad conversations with them on a very regular basis, including executive to executive conversations to really address the challenges that they and us are facing. And based on these conversations, we expect them to have improvements in their capacity in the fourth calendar quarter of the year, which should translate to improvement in our revenue in the first calendar quarter of 2023, which would be our second fiscal quarter. We expect these improvements from them based upon their expectations of additional fab capacity. And what we’ve seen in terms of their consistent milestones around increasing that capacity. But we’re not sitting on our hands and waiting for just the suppliers to make improvements. We are also driving aggressive actions on our side to drive improvement. So what are we doing? First is we are continuing to shift demand to rSeries, which is our next-generation platform because we expect that platform to be less constrained than our iSeries platform. And from the field perspective in terms of customers taking on the rSeries platform, we are seeing, actually, excellent traction on this front because the value proposition of the platform, the price performance of the platform is just excellent. So we’re aggressively shifting demand to rSeries. We are increasing the velocity of qualifying alternative sources of supply for both platforms actually, so redesign and qualifying additional suppliers on these platforms to alleviate the supply shortages. And of course, we continue to make aggressive advanced purchases with our suppliers. We have been doing that for several quarters. But we continue to do that very aggressively and providing them a lot of visibility into our forecast for future quarters. So with these actions, as I said, we expect better supply in our fourth calendar quarter that would translate into the first calendar quarter of 2023 for improvement into our hardware revenue.

Francois Locoh-Donou:

Thank you, Samik.

James Fish:

Hi, guys. Good afternoon. Kind of a loaded question here, two parts, of course. The big question we’re getting after hours is really around that software number. And Francois, while 40% growth is strong, it was against an easier compare than last quarter. Is there any way to quantify how much of that shift towards either the CapEx purchases over software as well as how much got delayed to a future period on the software line occurred? And then on the system side, what should we – what should make us believe that we aren’t in for another hardware cut here over the next quarter or two as this is the second quarter in a row of cutting hardware and really, I think, giving us a sense around where backlog is versus the last quarter would be helpful for that.

Frank Pelzer:

Yes. Jim, so on the software number, obviously, we do not sort of guide and a mix on any given quarter. And if you go back in time to the first half of – well, if you go back to Analyst Day in November of 2020 and we talked about software guidance in that 35% to 40% range. And after the second – the first quarter, we had 70%. In the second quarter, we had 20%. And there was a lot of question marks around would we ever be able to make that 35% to 40% range, and we ended up at 37% for the year. We talked about it at the beginning of this year that there was going to be less volatility and variability in that number. I think last quarter, it was 47%. This quarter, it was 40%. But there’s no dynamic to speak of, a mix shift or any other factor. It was an easier comp. But we do think about this number of growth in terms of an annual basis certainly not on a quarterly basis. We are quite happy with where we’ve ended in the first half and continue to expect perform in the second half to be near the top end of our 35% to 40% range.

Francois Locoh-Donou:

Thanks, Jim.

Amit Daryanani:

Thanks for taking my question. I guess I have question and a quick clarification, hopefully. The question I really have is on the operating margin structure. So if I look at the full year guide, you’re talking about 27%, 28% operating margin, which is down kind of like 400 basis points year-over-year, even though there is some revenue growth in the model on a year-over-year basis. So I’m just wondering like what sort of revenue run rate do you think you need to get back to the 32%, 33% kind of operating margin range on a quarterly basis. And alternatively, what do you need to see from a macro basis to perhaps say, I need to get more aggressive in optimizing my cost structure. I’d just love to just understand how you think of OpEx as you go forward? And then is there anything you would call out in terms of why is software implied to decelerate in the back half of the year, fiscal year versus the front half? Is there something in the renewals that’s happened there or just anything you would call out there would be helpful?

Francois Locoh-Donou:

And then your second part of your question was about software growth?

Francois Locoh-Donou:

Yes. No, I think that’s what Frank was talking to this a moment ago, that when you look back a bit, we guided to 35% to 40% growth, first of all, for our Horizon 2 going back at – in 2020. And we delivered 37% growth in fiscal 2021. We guided again to 35% to 40% growth this year. And in fact, we said we would get to the top end, near the top end of that range. And we’re on track to achieve that. We’ve always said, Amit that we weren’t looking at this on a quarter-to-quarter basis but more on an annual basis, in part because our software business is not just a ratable SaaS model that it does include term subscriptions. And therefore, there would be some variability quarter-to-quarter. We did say that we would see less variability quarter-to-quarter this year than we did last year, and we’re also on track to deliver against that. So there isn’t a different dynamic, if you will, in terms of the software business than what we have seen in the past. The renewals that you just referred to, the trends on these renewals are very, very encouraging as well as the true forward and the expansions on the agreements that we signed in the past. So we are generally very pleased with the software drivers we’re seeing.

Operator:

You are next, Alex Henderson of Needham. Your line is open.

Francois Locoh-Donou:

Yes. So let me start there. What we saw in our second fiscal quarter there, and I would say really kind of starting in February and beyond, is a slowdown of demand in Europe. We think – and it’s kind of accelerated a little bit into the last month of the quarter, which was in March. We think it is attributed to macroeconomic conditions, of course, the Ukraine-Russia war, even though our business in Russia is very small. So there is no really direct impact territorially. But in terms of the whole sentiment in Europe around inflation and potentially the economy slowing down, we think that has caused some customers to be a little more cautious, to scrutinize spend a little more and potentially to delay some orders that they would otherwise make. Now in the big scheme of things, we’re not talking about multiple tens of millions of dollars here. It’s effectively a smaller effect than that, but it was noticeable enough in our trends that we felt that we should point it out. In part because we don’t yet know how this will play out in Europe in coming quarters and whether – with the continuance of the conflict and more inflation, whether this will continue or – and to what extent. We also had a very strong demand in the Americas, in the enterprise space as well as for service providers overall. So that contrast a little bit with Europe.

Alex Henderson:

Is Europe more biased to systems and that’s – and less to software? Is that part of it? And is there any change in your supply chain – in your pipeline in Europe in April that would suggest continued erosion in the conditions there? And then I’ll cede the floor. Thanks.

Francois Locoh-Donou:

And Alex, just your question about April, I think the pipeline for EMEA for Q3 actually looks better than what we saw in Q2. But we are cautious because of the macro environment in Europe directly.

Francois Locoh-Donou:

Absolutely.

Unidentified Analyst:

This is Ryan on for Sami. Thanks for taking the question. So basically, our first question is for customers who historically want system, whether they were all parts into the software given the constraints we’re seeing for the past quarter? And I have a follow-up.

Unidentified Analyst:

Got it. I appreciate the color on that. So, my follow-up is, so does the reduction in the guidance imply that 2023 could be a much bigger revenue year, or is this demand that is essentially of late given the extent of database?

Unidentified Analyst:

Got it. I appreciate the color. Thanks so much.

Operator:

Your next question comes from the line of Meta Marshall of Morgan Stanley. Your line is open.

Francois Locoh-Donou:

Let me start with the last part. Yes, the answer is yes. We made the decision to make our rSeries and a software that runs on iSeries that was compatible with iSeries several quarters ago and it’s serving us well today, because it’s shortly the qualification cycles of the rSeries relative to what it would have been in prior cycles. And so the qualification of rSeries with customers and also the demand is very strong, and we get the value proposition for this platform. This next generation platform plays well to our customers’ ability in terms of having both traditional and modern applications served by these platforms. In terms of the transition timeline, like we have always said it’s takes roughly six quarters to make that full transition. And so our expectation is we are going to continue to run rSeries. And by the time that we exit our fiscal 2023, we expect to be almost near 100% of serving the demand of our customers primarily with rSeries. And that will ramp through the next five quarters, six quarters. Your second question was about iSeries and rSeries constraints. So, right now, they both are constrained by semiconductor components. But we are shifting more of the demand to rSeries because we expect rSeries to be less constrained because it’s a newer platform going into the new year, because there are less parts effectively on rSeries that have these constraints than on iSeries. So, that’s why we are aggressively shifting the demand to rSeries. But we are also doing some work, of course, on iSeries to be able to continue to meet demand in the next few quarters for customers that really need to be on that platform for a number of reasons.

Francois Locoh-Donou:

Yes. rSeries is calendar Q4. iSeries, we should see some improvements in also calendar Q4 in terms of the supply we get there. However, going into the new calendar year, we will be continuing to shift to rSeries. So, rSeries will progressively become the majority of the – both the demand and the revenue and shipments.

Operator:

The next question is from Simon Leopold of Raymond James. Please ask your question.

Francois Locoh-Donou:

I think Victor, over the long-term we will continue to see customers rebalancing their environment to these multi-cloud environments. I think our belief system, which frankly, has been, I believe for the last several years is that, ultimately, the applications will land on the best infrastructure environment for the application. And in a lot of cases, that will be public cloud. In some cases, that will be a private cloud. And in a lot of cases, that will continue to be a traditional private data center in – with hardware environment. I don’t think that the current supply chain challenges will fundamentally alter that future destination and that future distribution of applications. And so – and we also can see it from the customer behavior that we are seeing today. I think for customers that really need capacity for their applications and can’t get hardware, the best way – the best plan B, if you will, for that is to move to F5’s software on virtual machine. But to do that, of course, customers need to also have the servers available. And those also have elongated lead times in a number of cases. And – but moving to a cloud, a public cloud, is an entirely different kind of architectural consideration. And it takes planning. It takes quite a bit of time. And so we don’t think that the supply chain challenges are particularly accelerating a move to the public cloud. But generally, we think the destination for all of our customers is multi-cloud. Most of our customers are already in multi-cloud environments. And we intend to – and we have designed our portfolio to serve them for these multi-cloud environments.

Francois Locoh-Donou:

I think customers who – maybe for greenfield environment, Victor, where customers are just deploying new workloads if they could do a virtualized environment and they have either the servers in-house available or they could use F5 software in the public cloud, which maybe thousands of our customers do that today, that would be a way to get to where they want to be faster. That’s – I would say that’s a minority of situations today. But it’s a possibility for customers that are not sort of building greenfield environments.

Operator:

Our next question comes from the line of Jim Suva of Citigroup. Please ask your question.

Frank Pelzer:

Yes. Jim, why don’t I start and then if Francois has got anything to add, by all means, please do. So, Francois sort of laid it out in a couple of questions ago on where we see the hardware side of the business over the next, call it, three quarters to four quarters to five quarters. And we think that largely the operating margin is going to ramp back up along with that shipment of hardware back to where we get to our Rule of 40. But in the immediacy of the – certainly, over the next couple of quarters, we are going to be below that 37% – or the 27% to 28% mark that we had set. And a lot of that is largely due to the step-down in our gross margins that are impacting as well as the less revenue coming from our systems business. And so those combinations are putting pressure on the operating margin in the near-term, but we do expect to get back to our Rule of 40 operating plan when we work our way through some of these supply chain constraints.

Frank Pelzer:

Yes.

Rod Hall:

Yes. Hi guys. Thanks for the question. I just – I wanted to come back to the full year guide change. I am calculating at midpoint, about $91 million of reduction there. And I guess it’s due to these ongoing supply chain challenges. But then I am curious what the duration of that change is. In other words, are you expecting most of that to happen sooner here? And then do you think your supply comes in better as we get to September or do you have visibility all the way to the end of the fiscal year and that encompasses this $91 million. Can you just kind of give us an idea on timing there? Thanks.

Francois Locoh-Donou:

‘22, 2022.

Francois Locoh-Donou:

Q1 of ‘23, Q4 of ‘22.

Rod Hall:

Okay. And then I also wanted to just check in with you regarding the – back on the demand side of things. Do you – are customers indicating to you that’s temporary and I also noticed your DSOs have jumped up to 59 days. I assume that’s due to supply, but are people now starting to order further out, or why are we seeing that jump in the DSOs? I guess two questions in there, really. Sorry about that.

Francois Locoh-Donou:

Yes. And well, in terms of customer behavior, we have seen both. So, some of our customers are – who have – I guess who are planning ahead and have the means to plan ahead and order ahead, we have started to see their behavior move to ordering well ahead to take into account the extended lead times. But at the same time, we also see other customers who are pushing out and delaying orders in part to create leverage and say, “Hey, I will place the next order once you have shipped the order that I placed a few months back.” And so when we net out those two behaviors, we landed about the same place, which is demand is kind of where we expected it to be and it continues to be strong. What we are not seeing is lost demand due to supply chain delays. And that’s been the trend for the last several quarters, including this last quarter.

Frank Pelzer:

Absolutely. Rod, thank you.

Unidentified Analyst:

Hey. This is Sebastien on for Jason. Thanks for taking the question. I just have one clarification and an opening question. So, just in terms of the supply chain issues, last quarter, you mentioned about $60 million in revenue being pushed out of fiscal year 2022 for the specialized networking chips. I just want to make sure those lead times haven’t changed at all and that’s still the expectation. And it’s really like the standard components and those lead times that have been pushed out further than expected and pushing revenue into fiscal year ‘23. Is that correct?

Unidentified Analyst:

Got it. Okay. That’s helpful. And then as a follow-up, maybe a bit more open ended for you, Francois. In terms of – as you guys shift more of your revenue to software, subscription, managed services, is your relationship with the partner channel, the VARs, the MSPs, is that changing at all? Are you becoming less reliant on them to generate revenue, or are you still sort of – as you have been historically reliant on that channel to drive revenue growth?

Unidentified Analyst:

Got it. Thank you. That’s all I have.

Suzanne DuLong:

Hello, and welcome. I’m 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, where an archived version of today’s call will be available through April 26, 2022. Today’s live discussion is supported by slides, which are viewable on the webcast and will be posted to our IR site at the conclusion of today’s discussion. For access the replay of today’s call by phone, dial 800-585-8367 or 416-621-4642 and use meeting ID 687-9935. The telephonic replay will be available through midnight Pacific Time, January 26, 2022. For additional information or follow-up questions, please reach out to me directly at [email protected]. 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.

Frank Pelzer:

Thank you, François, and good afternoon, everyone. I’ll review our Q1 results before providing our Q2 outlook and updated fiscal year 2022 guidance. As François outlined, our team delivered another very strong Q1. First quarter revenue of $687 million is up 10% year-over-year and above the top end of our guidance range. Please note, as I review our revenue mix, I will be referring to non-GAAP revenue measures for the year ago period. Q1 product revenue of $343 million is up 19% year-over-year, representing 50% of total revenue. Q1 software revenue grew 47% to $163 million representing 47% of product revenue, up from 38% in the year ago period. Systems revenue of $180 million is up 1% compared to Q1 last year. Rounding out our revenue picture, we see continued strength from our global services with $344 million in Q1 revenue. This is up 2% compared to last year and represents 50% of revenue in Q1. Taking a closer look at our software revenue, subscription-based revenue represented 81% of total software revenue, up from 77% in the year ago period. Subscription-based revenue includes a ratably recognized as-a-service offerings and our solutions sold as term-based licenses. Revenue from recurring sources, which includes term subscriptions as a service and utility-based revenue as well as the maintenance portion of our services revenue totaled 68% of revenue in the quarter. On a regional basis, in Q1, Americas delivered 17% revenue growth year-over-year, representing 59% of total revenue. EMEA was flat year-over-year, representing 24% of revenue and APAC delivered 2% growth, accounting for 18% of revenue. The strength in Q1 spanned customer verticals as well. Enterprise customers represented 71% of product bookings in the quarter, service providers represented 15%, and government customers represented 14%, including 4% from U.S. Federal. I will now share our Q1 operating results. GAAP gross margin was 80.3%. Non-GAAP gross margin was 83%. Along with our increased component prices, we anticipate continued pressures related to our supply chain in the next several quarters. We expect these pressures will result in some increased costs related to expedite fees and sourcing of long lead time components. GAAP operating expenses were $438 million. Non-GAAP operating expenses were $345 million. Our GAAP operating margin in Q1 was 16.6%. Non-GAAP operating margin was 32.7%. Our GAAP effective tax rate for the quarter was 16.3%. Our non-GAAP effective tax rate was 19.5%. GAAP net income for the quarter was $93.6 million or $1.51 per share. Non-GAAP net income was $179 million or $2.89 per share. I will now turn to the balance sheet. We generated $90 million in cash flow from operations in Q1. We tend to see cash flow dip in Q1 as a result of the timing of cash receipts and billings amongst other factors. Q1’s cash flow is below our recent range because of two primary factors. First, we had strong multi-year subscription sales in the quarter. As a reminder, our multi-year subscriptions are generally sold on three-year terms. We built only one-third of the contracted signing with the remainder going to unbilled assets. Second, during the quarter, we also had some significant prepayments with our contract manufacturer associated with the components for future builds. DSO for the quarter remained strong at 55 days. Cash and investments totaled approximately $936 million at quarter end. During the quarter, we repurchased approximately $125 million worth of F5 shares or approximately 539,000 shares at an average price of $232. Capital expenditures for the quarter were $11 million. Deferred revenue increased 16% year-over-year to $1.576 billion, up from $1.359 billion. The growth in total deferred was largely driven by subscription and SaaS bookings and to a lesser extent, deferred service maintenance. Finally, we ended the quarter with approximately 6,550 employees up approximately 90 from Q4. This includes employees added with the Threat Stack acquisition, which closed in the quarter. François shared our Q2 revenue outlook and our updated fiscal year 2022 outlook in his remarks. I’ll recap our full Q2 guidance and fiscal year 2022 updates with you now. Unless otherwise stated, please note that my guidance comments reference non-GAAP metrics. Let me start with Q2. We expect Q2 revenue in the range of $610 million to $650 million as a result of supply chain related systems production constraints. Taking into account continued component cost increases, and the costs related to actions we are taking to mitigate supply chain pressures, we expect Q2 gross margins to approximate 82% to 82.5%. As François discussed, because we believe the current supply chain challenges are transitory and do not reflect the underlying growth trajectory of the business, we do not intend to adjust our operating model. We believe doing so with risk compromising our ability to deliver future revenue growth. As a result, we are likely to see operating margin pressure in Q2 and for the next several quarters. I’ll remind you that, historically, Q2 is our seasonal low for operating margins as a result of annual payroll tax and retirement benefit resets. That said, we estimate Q2 operating expenses of $357 million to $371 million. We anticipate our full fiscal year effective tax rate will be in the range of 20% to 21%, including the impact of our 19.5% Q1 tax rate with some fluctuations quarter-to-quarter. Our Q2 earnings target is $1.75 to $2.15 per share. We expect Q2 share-based compensation expense of approximately $65 million to $67 million. Let me now review our updated fiscal year 2022 outlook. We expect fiscal year 2022 revenue growth in the range of 4.5% to 8%, reflecting a reduction of $30 million to $90 million to our prior fiscal year 2022 revenue guidance. The higher end of this range provides for the potential of some additional supplier decommits. It does not, however, assume another step function deterioration from the level of decommit we have seen recently. We continue to be very confident in our software revenue growth range of 35% to 40% and expect to be closer to the top end of the range for the year. We also anticipate global services revenue growth of 1% to 2% for the year. Like other vendors, we have seen component costs and expedite fees escalate over the last year. As a result, in December, we announced we would be implementing a price increase of approximately 8% to our iSeries appliance platform effective February 1. We expect this pricing change will begin to positively impact gross margins in the second half of our fiscal year. We expect non-GAAP operating margin in the range of 29% to 31% for fiscal 2022 with Q2 representing the low point for the year, and operating margins are improving in Q3 and Q4. We remain committed to regaining our target Rule of 40 operating benchmark, where the combination of our revenue growth and non-GAAP operating margins total 40. We also remain committed to repurchasing $500 million in shares during fiscal year. With that, I will turn the call back over to François. François?

Operator:

[Operator Instructions] For our first question we have James Fish from Piper Sander. James, your line is open.

François Locoh-Donou:

Hey, Jim. It’s François, and I’ll take your first question. I – so let me just start from the last point of your question, then I’ll come back to the supply issue. On the demand side, Jim, you know that last year, our backlog continued to grow. I think we exited last year with a backlog that was at the highest level it’s ever been. In Q1, if you’re referring specifically to hardware, you saw that our hardware revenue was pretty much flat, but our backlog continued to grow in our first fiscal quarter. In fact, it grew by more than 10%. So based upon the demand we saw in Q1 and the pipeline we see in Q2, we feel very, very good about our demand and the health of the demand. And so the issue that we’re facing to be very clear is not a demand issue. It absolutely is a supply issue. And the revision we’ve just done to our annual guidance is 100% linked to the supply issue. Now to the first part of your question about what we’ve been doing to mitigate the issues and why are we facing this issue now. So we’ve been talking about for several quarters that our – the issue with our supply chain has deteriorated steadily. And last year, we were not able to ship the demand, which is why our backlog grew so much during the year. Things have been getting worse. And at the beginning of our fiscal year, when we were doing the planning for this year, we actually took into account the number of decommits that we were getting from various suppliers and a situation that was already very tight on a number of components. Over the last 30 days, though, we have seen a step function decline in the state of component availability from a number of suppliers. And that’s what’s caused us to relook at the view for the year and see that we wouldn’t be able to even ship the systems that we have planned to ship for the full year. To just give you a sense, Jim, the number of decommits, so we’re now seeing over 400 decommits per quarter. And we were running about 30% less than that even just a month ago. So we are – the situation is quite unprecedented. We are doing a number of things to mitigate these supply issues, working with our suppliers, of course, on escalations and allocations of supply to F5. We will be working on shifting some of our demand to – we’ve introduced new hardware platforms that are just starting to ship recently, and utilize more readily available components. So we’ll be working to shift some of the demand we have to these newer hardware platforms. And we have a number of mitigation elements in place to improve the situation but the supply chain is absolutely tight. The other thing that has changed in the last 30 days relative to where we were before is that we have been going to not just our suppliers but also when we couldn’t get the supply, we have been going to secondary markets, so on the open market through brokers to get part of our supply. And that avenue has dried up really in the last several weeks because I think everybody is in the same situation and going through that. So those are some of the changes that have happened in the supply recently.

François Locoh-Donou:

Thanks, Jim. Let me just make sure. So we don’t see any risk to orders being canceled. The demand we have is very real. Our lead times, unfortunately, have gotten progressively worse over the last five, six quarters, but we haven’t seen any change in – any increase in order cancellation, and we don’t expect to see that going forward. In terms of the timing of improvement, Jim, I want to clarify because we – there are two issues really at play here, and I want to make sure I give you visibility into both issues. So let me talk first about our fiscal year. So the $30 million to $90 million reduction to our revenue for the full fiscal year, that is linked to a struggle to get specialized networking chipsets that come from the big chip manufacturers and are kind of specialized chipset. The lack of supplier role is really what’s driving that $30 million to $90 million reduction. And we don’t expect to see – part of why we’re pointing to that reduction is that given the level of decommits we have in deliveries and the visibility that we have now from our suppliers. We don’t expect this situation with specialized networking chipset to get better until the very end of calendar 2022, which is when the new fab capacity will start flowing into parts to F5, and we will start to be able to ramp up our levels of shipments. So that’s the situation that is affecting the full year. As it relate specifically to our second quarter in Q2, we have an additional challenge, which is more standard electronic components, where we have had a significant decommit in the last few weeks that is affecting only Q2, because we expect to be able to qualify alternative parts relatively quickly and make those shipments in Q3 and Q4. So the second issue has a much shorter time frame to be resolved. The first issue is the bigger issue around the specialized networking chipset that will take several quarters before we see meaningful improvement there.

Sami Badri:

Hi, thank you. First, François, and maybe, Frank, you could also help us as well. Can you just kind of unpack the growth algorithm of software and just how we got to this point, because you essentially exceeded expectations on a very strong comp prior year? Could you just unpack what exactly it was that got you to this result? So that’s the first question. The second question is, as I hear you describe the degree and the magnitude of the supply chain constraints, it almost sounds so strong that it would almost compel the customer to change architecture because of the degree of the effect that what’s happening, right, like it service, for example, what they had in mind. So how come – what’s going on when you guys are saying the delays and essentially, what sounds like a systemic problem is not compelling customers to, say, adopt more software type architectures or solutions and sticking to specifically hardware? And then, thank you, that would be great.

Sami Badri:

Got it. Thank you.

Amit Daryanani:

Thank you for taking my question. I have two as well. First off, I’m hoping maybe you just help me reconcile the March quarter and fiscal year guidance. François, I sort of heard you talk about the two different component challenges that you have, but your March quarter guide, I think if I take it at midpoint implies in the first half, you’ll grow 3.7% and so. Then to you to hitch a full year guide at almost invites that you have to grow high single-digits in the back half of the year, June and September. So, am I doing this correctly? And I guess why the confidence that growth will snap back so quickly in the June, September quarter for you folks?

Amit Daryanani:

Got it. Perfect. And then I guess the second one and this almost seems silly to ask given all the hard questions you have. But on the software side, and François, you talked a fair bit about this, you did 47% growth on probably one of the more difficult compares. I think it was 70% last year. And your guidance on right down the full year would imply that your software growth will decelerate as you compare start to get easier. That seems a little counterintuitive. And I guess there’s a need to be conservative given the supplies and issues you have, but I’d love to understand why do being software decelerates after everything you talked about that business?

Amit Daryanani:

Fair enough and best of luck. Thanks for the time.

Operator:

For our next question, we have Alex Henderson from Needham. Alex, your line is open.

François Locoh-Donou:

Hi Alex, So, I would – first, I would say, Alex, our – we know we are going through an extraordinary situation as it relates to supply. Everybody along the value chain is feeling that and you’re seeing different type of behaviors. In some case, you are seeing some suppliers in the semiconductor space who are taking advantage of that to some extent [indiscernible] prices. And that, we believe, is a short-term approach that may have some benefits. But in the long-term, it’s detrimental to relationships. And so the way we look at it is our customers and our shareholders are going to be happy if we continue to have great long-term relationships with our customers and continue to be with them as they evolve their architectures. And so as we think about how do we balance the cost pressures with price increases. We are looking at it through the lens of also maintaining strong relationships with our customers for the longer term. So what always, from our perspective, we’re always going to have that balance in how we approach things. In terms of the way our customers are seeing things in our conversations, – of course, they want to get their products as fast as possible. In the case of F5, we are not seeing them – as I said before, we’re not seeing order cancellations. We’re not seeing them double ordering solutions because F5 solutions is unique, and you can’t replace them like-for-like for something else. And frankly, also because so far, we have managed to keep our lead times that are much better than what they’re getting from other vendors. So, we are getting increasing pressure, of course, from customers to try and supply to them faster. But we’re not seeing a dramatic change in their behavior towards F5 from what we saw through last year.

François Locoh-Donou:

Alex, I would not say that we are intentionally shifting away from the service provider space. We had a very strong -- through the last five, six quarters, we have very strong demand in the enterprise that has been broad-based. And so when you look at the mix overall service provider as a mix has come down. However, our service provider business itself has actually been growing very healthily over the last several quarters, including this last quarter. And also with what we’re seeing coming in the 4G to 5G transition, we see strong opportunities both in hardware and software with good service providers, with some potentially important deals to come over the next few quarters. And so no, we are actually investing into the service provider space, both for our existing platforms and Volterra that is also potentially a platform of very strong interest with our providers. We are starting to see more and more deals in the IoT space with service providers, oftentimes requiring scale to tens of millions of devices, which for that scale is served to hardware. So, we continue to invest in our service provider segment. I understand how you drew that perspective from the mix. Service provider has been only at 15% for the last few quarters, but it is growing in line with the rest of the business with very strong prospects to come.

Alex Henderson:

Thanks.

Operator:

For our next question, we have Rod Hall from Goldman Sachs. Rod, your line is open.

Frank Pelzer:

Rod, it’s in the ballpark for the system side. What François was referencing was the systems piece of the backlog, which, as we said in our K was the vast majority of that $125 million, but I just want to make sure you understand the net inflations…

François Locoh-Donou:

Rod, it’s a great question. So, I first want to remind you, Rod, that the – where there is an opportunity to substitute, if you will. Hardware for software is really in our big IT platform. But the drivers of software growth are across the entire portfolio. So that’s the first thing you got to remember. Second, when you say, "Hey, why is there not more a substitution in the IP of hardware for software, but it’s the first reason is because hardware demand is not weak. So that the hardware – the behavior of our customers as it relates to hardware hasn’t changed. The hardware demand continues to be strong. We saw broad-based demand in the enterprise on systems, security use cases continue to drive systems demand and we see security existing security customers even expand their F5 security footprints in hardware. And generally, application growth, traditional application growth continues, and therefore, our hardware demand to support those applications continues to be very strong. So there hasn’t been a change from a demand perspective – the issue we have is the supply issue. So that’s the second reason you’re not seeing a big substitution effect. Now you could ask, well, okay, but if our lead times get much worse, will that encourage more customers to change their demand from hardware to software? And on the margins, we think there may be a slight element of that, which is part of what’s causing us to say, "Hey, maybe we’re closer to the top of the range, but – to the top of the range on software, but we think that’s a marginal effect because when customers look to say, "Hey, I’m going to go to a software-first environment. First of all, F5 is not the only consideration that they have. There are other vendors that are part of their environment, that drive that architectural decision. And second, I think our lead times would have to really extend well beyond six months for just a lead time factor to cause our customers to really change and look at software. Now, with all of that being said, with the supply challenges that we’re having, our teams when working with customers, if a customer is on the margin and we need to go one way or the other. I think, of course, we’ll encourage them to move to software because they can get there much faster. But we don’t look to that as a thing that’s going to shift multiple tens of millions of dollars from one consumption factor to the other.