F5 (TICKER: FFIV) F5 Inc Ffiv Q4 2022 Earnings Call Transcript

F5, Inc. (NASDAQ:FFIV) Q4 2022 Results Conference Call October 25, 2022 4:30 PM ET Company Participants Suzanne DuLong - Head of IR Francois Locoh-Donou - President and CEO Frank Pelzer - Executive Vice President and CFO Conference Call Participants Tim Long - Barclays Sami Badri - Credit Suisse Alex Henderson - Needham Samik Chatterjee - JPMorgan Paul Silverstein - Cowen Meta Marshall - Morgan Stanley James Fish - Piper Sandler Victor Chiu - Raymond James Jim Suva - Citigroup Operator Good afternoon ladies and gentlemen and welcome to the F5, Inc Fourth Quarter Fiscal 2022 Financial Results Conference Call. At this time, all participants are in a listen-only mode. And please be advised that this call is being recorded. After the prepared remarks there will be a question and answer session. [Operator Instructions] And finally, if anyone has any objections, please disconnect at this time. And now at this time, I'd like to turn the call over to Ms. Suzanne DuLong, Vice President, Investor Relations. Please go ahead, ma'am. 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 A copy of today's press release is available on our website at f5.com, where an archived version of today's audio will be available through January 24, 2023.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 s.dulong@f5.com. Our discussion today will contain forward-looking statements, which include words such as believe, anticipate, expect and target. These forward-looking statements involve uncertainties and risks that may cause our actual results to differ materially from those expressed or implied by these statements. Factors that may affect our results are summarized in the press release announcing our financial results and described in detail in our SEC filings. Please note that F5 has no duty to update any information presented in this call. With that, I will turn the call over to Francois. Francois Locoh-Donou Thank you, Suzanne, and hello, everyone. Thank you for joining us today. I will speak first to our fourth quarter results before discussing fiscal year '22 and our outlook for fiscal year '23. Against the backdrop of a rapidly changing environment, our team delivered fourth quarter revenue at the top end of our guidance and earnings per share above the high end of our guided range. related to new projects and new architectural rollouts. These dynamics were especially evident in our Q4 software revenue. While we had a strong pipeline for new multiyear subscriptions headed into the quarter, customers' macro concerns led to lower close rates and lower software growth than we expected. We had some customers pause large-scale digital transformation projects in favor of business as usual. We also had customers resized projects with more conservative initial usage estimates. And we saw foreign exchange headwinds contribute to budget and spending challenges with customers in both EMEA and APAC, including customers who delayed projects with the hope that currency would stabilize. Conversely, Q4 marked a significant improvement in our systems revenue versus prior quarters, thanks to better availability of several critical components in the broker market. These scarce components came at higher costs, which are reflected in our Q4 product gross margins. However, our priority was and will remain fulfilling customer demand for systems which stayed strong throughout the year. We were able to partially offset higher product costs and continued operating discipline and a favorable tax rate enabled us to outperform our Q4 earnings per share target in the quarter. When I step back and look at FY '22 as a whole, I readily acknowledge that the year did not look the way we envisioned when we began it. Despite supply chain challenges and growing customer caution beginning in Q4, we saw persistent customer demand and our sales teams drove record-breaking bookings for the year. In addition, we achieved several important milestones. First, with portfolio and consumption model diversification, we drove our product mix to 51-49 software hardware, a noteworthy accomplishment in our transformation journey and very different from where we were just 5 years ago when software represented less than 15% of our product revenue; second, with the expansion of our application security portfolio and increasing demand for securing applications and APIs, we have grown our security business to $1 billion in revenue. Security-related revenue now represented 37% of our FY '22 total revenue; third, 69% of our total revenue was recurring in FY '22 with a double-digit 3-year compound annual growth rate. Over time, higher levels of recurring revenue will continue to add predictability and stability to our model. Finally, we launched three significant new platforms during the year, leveraging customer-focused innovation across the continuum of deployment models. These launches included expanding and unifying our SaaS offerings through F5 distributed cloud services as well as our next-generation rSeries and VELOS systems. These milestones are representative of how significantly we have evolved F5 over the last five years. F5 is stronger and better balanced with a more resilient revenue base and an operating model capable of delivering significant leverage. Over the next year, our business is likely to benefit from tailwinds to our systems business as a result of improving component availability. It's also likely to bear some weight from macroeconomic headwinds. In the balance, we expect to deliver FY '23 revenue growth of 9% to 11%. We also expect the combination of revenue growth and operating leverage will enable us to deliver non-GAAP earnings growth in the low to mid-teens, which means we also expect to deliver on our Rule of 40 benchmark in FY '23. Further, we are committed to operating the business to maintain the Rule of 40 and double-digit earnings growth on an annual basis going forward. Frank will speak to our outlook in greater detail in his remarks. Before I pass the call to him though, I will talk to several of the reasons why we believe we will deliver strong revenue and earnings growth this year. First, hybrid IT is here to stay. Our multi-cloud infrastructure-agnostic approach means we can create a more unified experience across customers, disparate environments. We are enhancing automation and driving operational efficiencies and corresponding cost efficiencies. Our ability to create a more seamless application environment for our customers is already an advantage. It is likely to become even more so as customers look to reduce operating costs and complexity; second, demand for security use cases is likely to remain resilient. Customers rely on our security solutions, including DDoS protection, advanced vulnerability defense with web application firewall and bought fraud abuse and API protection to protect them across what feels like an ever-increasing attack surface. With the February launch of our SaaS-based F5 distributed cloud services, we are now an attacker in a rapidly growing segment of the overall security market; third, we expect the combination of a resilient systems business and gradually improving component supply will contribute to drive systems revenue growth in fiscal year '23. Beyond 2023, with customers embracing hybrid IT, we expect hardware demand will prove more resilient and longer lived than expected just a few years ago. Near term, we also see the opportunity to take share from traditional hardware competitors undergoing structural change; fourth, our breadth of form factors and consumption models makes us an ideal partner for customers who are likely to be prioritizing their investments, optimizing costs and may want to shift from one consumption model to another, whether hardware, software, SaaS or managed service, perpetual license or subscription via an OpEx or CapEx budget approach, we are flexible. In an environment of shifting priorities, removing friction and enabling customers to consume how and when they want is a distinct advantage. And finally, we are a trusted and operationalized partner of the largest enterprises, service providers and government entities around the world. In good times and especially when faced with adversity, organizations tend to rely heavily on the partners they know and trust. We have worked for decades to earn that trust. Our customers count on us on our deep understanding of how to protect and optimize their application and on our continuous innovation. It's these factors, among others, including our very sticky installed base and our growing base of recurring revenue, which helped give us confidence in our outlook for next year. Before I conclude, I will highlight two interesting customer use cases from Q4. The first is an example of a multiyear subscription renewal with a sizable expansion. In this case, a customer, a global retailer had a goal of automatically flexing its capacity into its public cloud environments as spiky traffic demands warranted. The customer augmented its existing on-premise big IP hardware with scalable virtualized big IP software in the public cloud. With our deep automation capabilities, we fully automated the deployment and configuration of the F5 stack, enabling them to burst capacity as needed. Automation also simplified how their developers consume infrastructure and best-of-breed cloud services. In an example of an F5 distributed cloud services SaaS win in the quarter, we worked with a global transport company based in South America that needed to protect its multi-cloud applications, but did not want the complexity or inefficiency of disparate cloud native services. The customer selected five distributed cloud services as a one-stop comprehensive security solution including web application firewall, advanced bought Defense, API security and DDoS. With F5, the customer gained more consistent security across its multi-cloud environments, improved protection against bots and is now more self-sufficient for its security and traffic management with a single platform to support expansion to other regions. In both of these use case examples, F5 delivered automated multi-cloud solutions that dramatically simplified our customers' operations and improve their ability to scale their businesses. And we did so with the form factor and consumption model that best fit their needs. Now I will turn the call to Frank. Frank? 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? Francois Locoh-Donou Thank you, Frank. To reiterate a few key points. We believe we are positioned to deliver FY '23 revenue and earnings growth, we are well aligned with our customers' most pressing application challenges, including easing the complexity of protecting increasingly distributed applications and managing and scaling complex hybrid IT environments. With a $1 billion and growing security business and an increasing mix of SaaS-based solutions, we are well positioned for the future. Our innovation and successful transformation efforts to date have substantially expanded our portfolio, driving balance in our hardware software mix. As a result, we have a stronger business model and increased confidence in our ability to deliver sustained revenue and earnings growth. In the balance of what we see are likely both tailwinds resulting from improving component availability and macroeconomic headwinds in FY '23, we expect to deliver meaningful top line growth and double-digit earnings growth. In FY '23 and beyond, we expect to continue to exercise operating discipline, driving to the rule of 40 and double-digit growth on a sustainable basis annually. This concludes our prepared remarks today. Operator, would you please open the call to Q&A? Question-and-Answer Session Operator [Operator Instructions] Take our first question this afternoon from Tim Long of Barclays. Tim Long A few here, if I could. Number one, all related to software here. About three years ago, I think, is when you started with a pretty large term deals and there was a few really big quarters there. Just curious on those handful of deals that really contributed a lot back then. They should come up for a three-year renewal. Could you just talk a little bit about those deals in aggregate? Were they renewed? Were they renewed larger, what kind of upside can we see to them? Or were those deals lost or pushed out? And then I have more follow-ups. 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. Tim Long And then you updated the security number there, which is helpful. Also at that Analyst Day a few years ago, you gave a $100 million revenue number into the cloud vertical. I'm hoping you could give us some kind of update on how business to the cloud vertical has transpired over the year? 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. Operator We go next now to Sami Badri at Credit Suisse. 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? Francois Locoh-Donou Yes. Sam, I'll take the first part, and I think Frank will take the second part. So on my commentary on hardware. Let me just comment on three segments quickly. Let me start with the ADC segment. So in the ADC segment, we have been taking share from our traditional competitors throughout 2022 and before. And we feel that this is happening for a couple of reasons. Number one, we have continued to invest in our hardware franchise, and have brought new features and capabilities that help customers automate their environment. And as a result, when customers are really trying to create these hybrid cloud implementations where they have to have hardware on-prem, but they also need to have applications in public cloud, they can go to F5 as a partner that can help them balance the load between public cloud and on-prem environment. A good example of that, I'll give you we have a customer, a global retailer that really needed to deal with spiky traffic on their website in the peak retail season. They're using F5 on-prem for hardware, and they're using our virtual edition in the public cloud. And they are bursting into the public cloud with our virtual edition where necessary, but built with automation that allows them to go from one to the other. So the investments we've made there have really created a unique proposition for our ADC business, and we're seeing more and more customers want to move to these automated hybrid cloud environment. The second element driving hardware is security. We continue to grow our security hardware business across application security, encryption, decryption and protection against ransomware. And then we've also seen strong performance and resilience in the service provider market for hardware, driven by 5G traffic where we have seen augmentation of capacity on both 4G and now 5G infrastructure. So these are the drivers really on the hardware business. Of course, we have been challenged to ship all of that demand, as you have seen with the backlog in 2022, but we expect that to steadily increase through 2023. Frank? 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. Operator We'll go next now to Alex Henderson of Needham. 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? Francois Locoh-Donou Alex, so when we look to 2023 and our guidance for software specifically, what -- our assumption is that what we have seen in terms of the renewal of existing multiyear subscriptions, that the healthy renewal rate that we're seeing on these projects continues. And we've seen that throughout '22 and from the utilization that we see in these projects from customers. We don't expect a materially different behavior from customers on renewal rates. We are, on the other hand, assuming that we will see more projects delayed or that they will be resized and size down by customers and that there will continue to be way more scrutiny on especially these big multiyear projects than they were in the last year. And so that will affect the new business in terms of new multiyear subscription agreements. And so we don't expect -- we're not planning on year-over-year growth coming from these large new projects in 2023. And for reference, Alex, when you look at our total software business, the new business still represents over half of our total software business. And so we have still a meaningful dependency on this new business, and that's the part that will be affected in 2023 with this macro environment. Now if you go beyond 2023, we actually expect that the rate of these new projects will come back up. We expect to continue to have a healthy rate of renewals and expansion. And over time, we also expect our SaaS and managed services business to scale and grow. And so with these factors, we still consider as a long-term growth rate for our software, a 20%-plus growth rate to be the right target for us. 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? Francois Locoh-Donou Yes, Alex. We expect that the transition between iSeries and rSeries will accelerate in 2023, and especially in the back half of 2023. I don't have the exact mix for you here, but I think, Alex, you should be assuming that exiting 2023, the large majority of what we will ship will be rSeries rather than iSeries. Operator We take our next question now from Samik Chatterjee at JPMorgan. Samik Chatterjee I guess for the first one, I'm just still trying to understand your guidance on the systems revenue for fiscal '23 a bit. You had a big step-up here in the systems revenue from buying components from the broker market. I just wanted to understand if you're embedding that you can sort of continue on that path and essentially 4Q is sort of where you build on top of by going into the broker markets and buying from there to satisfy sort of demand from your customers? Or if you were to do that, is there more downside to the gross margin expectations that you outlined in terms of premium costs for that? And I have a follow-up. 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. Francois Locoh-Donou Yes. Samik, I think the general -- let me just to answer that. The general -- what we've seen in the supply chain just over the last 90 days is generally, we've seen more stability than we had in the prior quarters. And by that, I mean, we're seeing less decommits than we have seen before, although decommits continue to happen. Our -- we are hearing from suppliers that they're starting to get a lot more capacity at fabs on their supply. And generally, specifically to us, we have seen also more progress made by our suppliers on extending capacity. So these aspects give us more confidence in hardware going into 2023. But I would say, as Frank pointed, we -- probably the biggest factor for us is the engineering work that we've done inside of F5 to design around the most constrained components. Part of that has already delivered and more will deliver in the next 3 to 6 months. And that's why we feel we should have a very strong back half of the year on hardware. 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. Francois Locoh-Donou Yes, Samik, I think the general trend -- at a macro level, I think, over time, there will be more customers that are buying subscriptions and buying SaaS services than there are today. I think that's the general macro trend in the industry, and I think we will follow that trend. The good news for F5 is that we have positioned our portfolio to be able to serve all these consumption models, right, perpetual license, subscription or SaaS and also to be able to serve customers in hardware or in software or in Software-as-a-Service. And so where we feel this is an advantage is that there are a number of customers who buy -- there's different behaviors by customer segment. And there's different behavior at a different point in time. Already in the quarter, we have seen some customers that have OpEx pressure and still want to move forward with a project, but they want that project to be capitalized. And so these are customers that would have gone to an OpEx subscription model. And because we are able to offer a CapEx project, they are able to move forward with the project, but they would not have been able to move forward otherwise. And so I think in a year of constrained budget in 2023, we are going to see more of that of potentially some customers going to CapEx, others that were on CapEx moving to OpEx and the flexibility that we offer, we believe, is actually a strong advantage. Over time, I think the trend that I described at the beginning is still the trend. But the flexibility that F5 provides is quite a strong advantage. Operator We go next now to Paul Silverstein at Cowen. Paul Silverstein Francois, Frank, I apologize if this has already been asked. I'm actually going back and forth between two different calls. But going back to your comments about the softness, the delays, the downsizing, et cetera. Can you quantify for us how many customers, how many projects you're talking about? Is this widespread? Or is this a handful, several handfuls of very large projects that you're referring to in terms of just how pervasive the weakness that you're referencing. 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. Paul Silverstein First was I hear you say it was most acute in EMEA and Asia Pac. Was that the comment? Francois Locoh-Donou Yes. Paul Silverstein Was there any appreciable weakness in North America, U.S. in particular? 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. Paul Silverstein And your concern about North America in terms of looking forward, that's just being prudent? Or there's signs based on your conversations with North American customers that would caution you about the future outlook? 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. Paul Silverstein And just to tie to sub Francois, my last one here. Juniper tonight announced, simultaneously with you. They referenced a little bit of the macro that you're referencing, but not meaningful either in the quarter in their guidance. And I'm just wondering, at the risk of asking one for question, is it something specific to your product market that would account for the discrepancy between what you appear to be experiencing and what they appear to be experiencing? Or I mean, it sounds more widespread or more generic its sounds more FX plus perhaps the Russian impact on Europe in terms of why it's worse outside of North America or meaningfully different. But any thoughts you can share? 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. Paul Silverstein Is it balanced across both? Or is it mostly Europe? Francois Locoh-Donou It's balanced across both. Operator We'll go next now to Meta Marshall at Morgan Stanley. 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? Francois Locoh-Donou Thank you, Meta. The -- so the biggest headwinds to transitioning to rSeries are two -- really only two. One is qualification of the product. So for customers that don't operate rSeries today, they have to go through a qualification cycle but we have done some things to make that cycle as short as possible. And the second issue is component availability and our ability to ship to demand on rSeries. Those are the two gates, Meta. Now I should say what we are seeing so far is that the ramp to our series in terms of demand is the fastest ramp that we have ever seen in a transition from one generation to the next. And we expect that to continue because of the capabilities in rSeries. Of course, price performance is one, but the ability to operate in this more automated environment, that customers want to have when they want to balance traffic between on-prem and cloud or private cloud and public cloud environments. So that's why we're seeing a fast ramp to rSeries. And then as it relates to broker buys affecting gross margin, that is true both on the iSeries and rSeries. Operator We go next now to James Fish at Piper Sandler. James Fish I just wanted to circle back to Alex's question from earlier a little bit. Appreciate the color on the perpetual versus term and SaaS. But is there a way to think about how each of these three buckets finished the year in aggregate, and as we're thinking about this 15% to 20% growth, you had mentioned that still over half the business in software is on new. But roughly where should we finish then for new business versus renewals in fiscal '23 for software? 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. James Fish And maybe just to switch gears off of software and top line stuff. But on the free cash flow side, that conversion rate continues to come down. And I get it's something you have talked about around unbilled receivables given the term transition and some of the inventory purchases. But at what point does that free cash flow conversion rate begin to inflect higher and start normalizing a little bit more? And is there a way to kind of normalize the cash flow for those higher inventory purchases going on? 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. Operator We'll go next now to Simon Leopold of Raymond James. 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? Francois Locoh-Donou Yes. Yes, that's a correct assumption. And to the question, was it driven by FX Yes. FX, of course, had a large impact on that. But of course, if you are specifically, I would say, in the world of hardware, if you're a customer purchasing in euro or yen and we've done a price increase, there's two price increase that have increased hardware a little over 20%. And on top of that, you've had significant devaluation of your currency. Your budget does not buy you as much as it did. In software, that is a little less pronounced because there hasn't been as much of a price increase in software. But despite that, we saw these deal delays in software, primarily internationally. And I would say it's a combination of inflation, currency devaluation and just macroeconomic environment and people preparing for a tough economic environment and changing their approach to spend. 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? Francois Locoh-Donou That's correct. Operator We go next now to Amit Daryanani at Evercore. Unidentified Analyst This is Lauren on for Amit. So two for me. Can we first kind of start on backlog and kind of how you're thinking about maybe a potential work down in fiscal '23 and kind of your comfort around maintaining gross margins at around 80%. And then the second, the EPS guide for the full year is low to mid-teens growth, but the Q1 guide implies about down 12%. So how are you thinking about kind of the ramp as we go throughout the year? 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. Francois Locoh-Donou Well, the second question is -- the first one is 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. Operator And due to time constraints, we will take our last question this afternoon from Jim Suva of Citigroup. 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. Frank Pelzer Yes, Jim, the guidance was purely about the ability to ship systems and the rework that we are doing and the component availability for those new builds. And so that's our expectation is that Q3 and Q4 are going to be a much stronger systems revenue quarters than Q1 and Q2 for us. Operator And this will conclude today's call. You may now disconnect.