F5 (TICKER: FFIV) F5 Inc Ffiv Q3 2023 Earnings Call Transcript

F5, Inc. (NASDAQ:FFIV) Q3 2023 Earnings Conference Call July 24, 2023 4:30 PM ET Company Participants Suzanne DuLong - VP, IR Francois Locoh-Donou - President & CEO Frank Pelzer - EVP & CFO Conference Call Participants Ray McDonough - Guggenheim Securities Samik Chatterjee - JPMorgan Simon Leopold - Raymond James James Fish - Piper Sandler Meta Marshall - Morgan Stanley Alexander Henderson - Needham & Company Michael Ng - Goldman Sachs Sebastien Naji - William Blair Operator Good afternoon, and welcome to the F5, Inc. Third Quarter Fiscal 2023 Financial Results Conference Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will [Technical Difficulty] presentation. [Operator Instructions] Also, conference is being recorded. If anyone has any objections, please disconnect at this time. I will now turn the call over to Ms. Suzanne DuLong. Ma'am, you may begin. 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 A copy of today's press release is available on our website at f5.com, where an archived version of today's audio will be available through October 24, 2023.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 s.dulong@f5.com. Our discussion today will contain forward-looking statements, which include words such as believe, anticipate, expect and target. These forward-looking statements involve uncertainties and risks that may cause our actual results to differ materially from those expressed or implied by these statements. We have summarized factors that may affect our results in the press release announcing our financial results and in detail in our SEC filings. In addition, we will reference non-GAAP metrics during today's discussion. Please see our full GAAP to non-GAAP reconciliation in today's press release and in the appendix of our earnings slide deck. Please note that F5 has no duty to update any information presented in this call. With that, I will turn the call over to Francois. Francois Locoh-Donou Thank you, Suzanne, and hello, everyone. Thank you for joining us today. In my remarks today, I will speak to the quarter's results and the current customer spending environment. I will then highlight some notable customer wins from the quarter, including some emerging areas where we are seeing good early traction. Overall, customer caution persists, with customers continuing to sweat assets amidst tight budgets and lingering macroeconomic uncertainty. Despite the tough environment, our team is executing well and we delivered third quarter revenue at the midpoint of our guidance range, with earnings per share well above the high-end of our range. From a demand perspective, we are seeing some early signs of stabilization. Q3 demand played out slightly above our beginning of quarter forecast, which was up from Q1 and Q2 this year, though still off from FY '22 levels. Our global services team delivered strong 8% growth, driven by a continuation of customer trends from the first half of the year, including strong maintenance renewals and price realization. With customers sweating existing assets, we also continue to see higher maintenance attach rates on all the deployments. Our product revenue grew 1%, with systems revenue growing 5% and software revenue declining 3% year-over-year. While systems revenue is benefiting from supply chain normalization and our efforts to substantially work down backlog, systems demand remains constrained. In contrast, we are seeing some positive signs in software demand. Total software revenue was down 3% year-over-year, against a strong Q3 2022 compare. However, total software grew 32% sequentially. And within software, our subscription software revenue grew 4% year-over-year to a record high of $152 million. This reflects strong growth in our software renewals and interim expansions or true forwards, as well as some stabilization in new term subscriptions from the first half. Moving from revenue to our operating results. We are also demonstrating operating discipline and driving operating leverage. Our Q3 non-GAAP gross margins of 82.5% improved more than 200 basis points from Q2. This was slightly ahead of our guidance and reflects the combination of expected supply chain easing and price realization, as well as some of the ancillary supply chain costs like broker and expedite fees. Finally, working their way out of our inventory as planned. In addition, our Q3 non-GAAP operating margins of 33.2% improved 600 basis points from Q2 and more than 400 basis points from Q3 FY '22. As a result of these improvements as well as some tax favorability, we significantly overachieved our non-GAAP EPS expectations in the quarter and now expect to deliver double-digit non-GAAP earnings per share growth for FY 2023. We believe our growth opportunity is fundamentally linked to the continued growth of applications and APIs and the need to secure, deliver and optimize those apps and APIs. As part of our efforts to capture that growth, we continue to drive innovation, advances and integration across our product families, including F5 BIG-IP, F5 NGINX and F5 Distributed Cloud Services. I will call out some customer highlights from each product family from the quarter. Our BIG-IP family, which serves traditional applications either on-premises, collocated or in-cloud environments, continues to take share from competitors who have failed to invest in innovation. From a hardware perspective, the value proposition with our next-generation platforms is resonating with customers with our rSeries and VELOS platforms, representing more than 70% of Q3 systems bookings. On the software side, BIG-IP's data point performance, automation capabilities and lower total cost of ownership continues to differentiate our offering and drove multiple wins in the quarter, including wins at a major American airline, a multi-national automobile manufacturer and a major UK retail and commercial bank. We also saw strong demand for F5 NGINX in the quarter. NGINX serves modern, container-native and micro-services based applications and APIs. We continue to see large enterprises adopt NGINX for their cloud and Kubernetes workloads. We have repeatedly demonstrated that when applications are built with NGINX from the ground-up, and those apps grow. We grow with them. We saw this in several NGINX growth opportunities in the quarter, including a multi-million dollar term-based subscription renewal that grew by an extraordinary 10x from initial inception. The customer, which provides a large collaboration platform is streamlining deployments in both public and private clouds using F5 NGINX as their single platform for load balancing, cashing and telemetry. Over the last several years, we have invested both organically and inorganically to build a portfolio of SaaS and managed services called F5 Distributed Cloud Services. Since launching distributed cloud in February of '22, we have been expanding our offerings and building momentum for multiple security use cases. A good example of this is a win with a global financial services industry application provider that wanted to standardize its web application firewall and API protection or WAP policies and deployments in APAC and EMEA to reduce time to delivery. Their existing this application (ph) security and complex policy tuning was a challenge as was managing apps and APIs across distributed environments with a small team. Today, F5 Distributed Cloud Services is protecting their apps and APIs with WAP and multi-cloud networking, reducing their time to delivery from months to minutes. It is early days still, but we also are seeing encouraging signs that our distributed cloud services are intercepting the markets, specifically in two emerging categories, API security and multi-cloud networking. On API security, with the growth of modern applications using containers and composed of distributed microservices, the number of API endpoints is exploding. CISOs tell us they struggle to know-how many APIs they have, where they all are, who is connecting to them and to what extent, they are secured. Doing so, requires robust API discovery and protection capabilities like those we offer in our distributed cloud API security service. When a North American service provider experienced a serious cyber security incident, which caused them to lose their entire virtualization infrastructure at multiple datacenters, they turn to us for urgent help. F5 distributed cloud services, superior features, functionality and value beat a competitive offering and we worked with the customer to emergency onboard the platform, including advanced WAP both defense and API security. Once deployed, the customer immediately started migrating sites restoring their services. We are also seeing strong early traction in our distributed cloud multi-cloud networking offerings launched just this past March. 85% of respondents cited in our 2023 State of Application Strategy Report said they already are managing multi-cloud environments, securely connecting applications between on-premises, multi-cloud and edge environments at-scale is a tough task for any organization. Our secure multi-cloud networking solutions changed the game. Our ability to package networking, security, and distribution of applications and APIs is unique. Until now, customers have been forced to manage and secure these layers in isolation, often leading to operational complexity, network latency and weak security. Our multi-cloud networking solutions reduce operational complexity for our customers and make it possible for them to securely connect distributed networks and applications across public clouds, on-premises data centers and edge locations. Customers are beginning to understand the power of our secure multi-cloud networks, ability to provide end-to-end visibility, control and security across all of their applications. This empowers them to move workloads to the cloud between clouds and even through the edge, while maintaining end-to-end visibility and consistent security policy. F5 distributed cloud uniquely unifies the visibility, control and security for every application and API, so that applications can be delivered without constraint and with the security today's threat environment demands. Early traction for our secure multi-cloud networking offerings includes a win with one of the world's largest independent providers of insurance claims management systems. F5's multi-cloud networking now enables their global SaaS offerings. The customer first deployed our distributed cloud WAP in February of 2022, to protect a business critical public-cloud workload. In early '23, the customer was abruptly asked to leave a datacenter forcing them to lift and shift workloads to the public cloud in just two weeks. They used F5 Distributed Cloud for this emergency lift and shift. In fact, the project went so smoothly that they opted to expedite moving their global data centers to public clouds. Now, the customer has standardized on F5 Distributed Cloud for their secure multi-cloud networking needs, spanning across multiple clouds and protecting external and internal applications and APIs. These are just some of the customer challenges we help tackle in Q3. While we are not in a position to predict with precision when customer spending patterns will return to more normal levels, F5 is well-placed to benefit when they do. We are encouraged both by the early signs of stability in Q3 and with the resonance our application and API-focused approach is having with customers. We are making it possible for our customers to secure, deliver and optimize their applications and APIs with a consistent approach, no matter what environment they're deployed in, datacenter, collocated, private cloud or public cloud. And this is a critical capability and differentiator in today's hybrid multi-cloud network world. Now, I will turn the call to Frank. Frank? 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? Francois Locoh-Donou Thank you, Frank. Customers made F5 the standard for securing, delivering and optimizing traditional applications. Now, with compelling and differentiated solutions for modern applications and APIs as well as those mission critical traditional apps, we are being architected into new areas and use cases across our portfolio. Our holistic application and API focused approach enables new found consistency across environments and across hardware, software and SaaS deployment models, which reduces risk, lowest operating cost and delivers better digital experiences. In closing, I ask that you take away three things from this call. Number one, we are seeing some early and encouraging signs of demand stabilizing. Number two, we are seeing demonstrable proof points that the differentiated solutions portfolio we are creating through a combination of organic and inorganic innovation and technology integration is well-aligned with how application architectures are evolving. And number three, we are delivering on the operating discipline we committed to, and expect to produce additional leverage in FY 2024. Operator, please open the call to questions. Question-and-Answer Session 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. Ray McDonough Great. Thanks for taking the questions. Maybe first for Frank. How did the true forward portion of renewals performed this quarter relative to the last and assuming it is improved, which it seems like it has, do you think we're at the tipping point where customers simply need to add capacity, which will continue to drive relative strength and renewals going forward, or is it too early to tell whether or not that's bottomed? 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. Ray McDonough That makes sense. And maybe if, I could a follow-up for Francois. You mentioned you're obviously seeing signs of macro stabilization here? Can you unpack that a little bit more? I mean, how broad-based is a stabilization maybe from a vertical perspective? And from a product perspective, are you seeing each vertical kind of stabilize, or is there kind of give and takes between where the spending is kind of more firm than others? 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. Ray McDonough Great. Thanks for the color. I appreciate it. Operator Thank you. Our next question is from Samik Chatterjee with J.P. Morgan. Please proceed with your question. Samik Chatterjee Yeah. Hi. Thanks for taking my question. And Francois, if I can sort of go back to the comments about the stabilization of demand and dig into that a bit more. I mean you didn't comment about the stabilization in a quarter when we saw systems revenue declined significantly, as you sort of walk -- have walked through the backlog. So I'm just wondering when we interpret those comments related to both hardware and software, is that -- should we be interpreting this as sort of a more normalized mix based on what you're seeing in the macro and that sort of as we think about fiscal '24 means that you're sort of looking at a $700 million or $2.8 billion annualized sort of number as being at least where the floor is where you track be if the macro remains the same? Is that the way to the went to sort of interpret the demand stabilization comment? 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. Samik Chatterjee Got it. And Francois, a question that I'm getting a lot from investors really is about AI and their investors are expecting inflection again in terms of application growth because of AI use cases. It's really more about your application security capabilities. How do you think they positioned to navigate sort of that inflection and application growth and how do you think about the challenges in managing that growth as well at the same time? 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. Samik Chatterjee Got it. Great. Thank you. Thanks for taking my questions. Operator Thank you. Our next question is from Simon Leopold with Raymond James. Please proceed with your question. Simon Leopold Thanks for taking the question. I was looking at really where the systems revenue had been prior to the pandemic. And wondering how you would think about the idea that a normal revenue run rate might be in that sort of $170 million and $180 million a quarter. Clearly, a lot has changed. Gilbert, since I guess late-2019. Could you maybe help us think about sort of the puts and takes to even if we don't know the timing to sort of get a better sense of what should be the sort of base run rate for hardware? 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. Simon Leopold That's helpful. And just maybe as a follow-up, in terms of the software trajectory, what sort of signals might you suggest we look for in terms of sort of things getting better and things getting back on normal apart from just sort of the macro? What kind of advice would you give to the analysts? 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. Simon Leopold Thank you very much. Operator Thank you. Our next question is from James Fish with Piper Sandler. Please proceed with your question. James Fish Hey, guys. Following up on a few of the questions asked here already. But what are you seeing demand wise or demand stabilization between the product side, meaning on the ADC side versus security? And really asking also, what percentage of your customers are actually using products from both as we're trying to understand what penetration opportunity you guys have left? 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. James Fish Makes sense. And Frank, maybe for you. You guys keep mentioning expansion opportunities and expansion rates being pretty strong. I know you're not quantitatively giving them, but can you qualitatively kind of give us some color around what you saw versus the first half of the year with net retention rates, be it on recurring revenue or just the recurring software piece? And also trying to understand how much of growth is being constrained by the transition to recurring sources, particularly the SaaS side of things, as you collect more revenue over time but less upfront. Thanks, guys. 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. James Fish Thanks, Frank. Operator Thank you. Our next question is from Meta Marshall with Morgan Stanley. Please proceed with your question. Meta Marshall Great. Thanks. Maybe first question, was there any difference in the mix that you ended up seeing in the quarter versus expectation? I guess I'm just asking because the backlog seems to have been exhausted. But yes, the systems number was maybe a little bit lighter than expected. So just are more customers kind of opting now for virtual editions as they move back towards kind of thinking about hybrid cloud? And then I have a second question just on -- you made a point of talking about the share gain opportunities. Just what has been the best entry point or targeted sales program to kind of identify and go after some of those customers? Thanks. 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. Meta Marshall Great. Thank you. Operator Thank you. Our next question is from Alex Henderson with Needham & Company. Please proceed with your question. Alexander Henderson Great. Thanks. So last year, you had a pretty steep decline in your systems business. You cited the supply chain, and now you're up low-single digits and you're suggesting that your backlog has already been resolved, that really doesn't imply a particularly strong headwind as we go forward of 6% to 8%. So can you reconcile why that headwind of 6% to 8% would be there given you haven't really produced meaningful strong top line growth in that business? And then conversely, you're citing a 6% to 8% headwind going forward. Your comps on the software side were extremely difficult over the last year but now have gotten quite easy with declines in the September quarter last year and are setting up for pretty easy comps over the next year. So if I look at the software side of it, is it reasonable to think that we're going to now see a meaningful shift to software growth, and therefore, it's still possible to produce revenue growth on the product side as we go into 2024? I know you don't want to give guidance, but you have given guidance on 6% to 8% headwind. And so what should we be thinking about as the offset to that in these easy software comps? 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. Francois Locoh-Donou Thank you, Frank. I would just add so that it's absolutely clear. When we talk about, Alex, the 6 to 8 point headwind, it's not demand headwind. We -- in fact, we expect demand next year in hardware to be higher than this year. But it is a shipment headwind that's impacting recognized revenue. So wanted to be clear about that. 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. Francois Locoh- Well, look, Alex, we're not ready to guide for 2024. We're -- what we've said about the 6 to 8 point headwind on total revenue is no different than we said last quarter. And it is simply math that we say, look, we want to make sure that one knows that the -- this year, given that we're shipping all of our backlog, we're shipping the equivalent of 6 to 8 points more of revenue than the demand we've had for -- from hardware. We're not ready to guide for where revenue would be in 2024, but it's clear that, that 6- to 8-point headwind is going to challenge growth for next year. That being said, I also want to be clear, we have been on a march of double-digit earnings growth, and we want to remain on that march. You saw that we took a number of actions to drive earnings growth this year, and we're confident we'll achieve double-digit earnings growth. We had said from 2022 when we started with the supply chain challenges that we expected to work through these challenges in our model and start showing the improvements in the back half of 2023. And you're seeing this quarter gross margin made a step improvement as they -- we started to work out through these expensive components, and we have been quite disciplined around price realization with the price increases that we drove last year. And you saw also that operating margins made a 600 basis point jump sequentially. And we expect to continue this operating leverage next year. So this is the -- our plan on continuing to drive earnings growth. Alexander Henderson Okay. Thanks. Operator Thank you. Our next question is from Michael Ng with Goldman Sachs. Please proceed with your question. 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. Frank Pelzer Sure, Michael. Thanks for the question. Yes, we did see an improvement in the new business activity, though it was still down from where we were a year ago. And so it was a positive sign to see, again, as Francois mentioned earlier, some of the irrationality come out of the buying behavior. Still many more deal approval levels than what we would have seen a year ago, but the deals are actually getting approved. So we're really happy to see that come through. And we're obviously not guiding to a mix on software versus hardware sequentially. But we do have a lot of faith in the software business. Obviously, last quarter was a challenging quarter. This quarter came back closer to the expectations that we have for the business. And we'll talk more about the actual outcome next quarter. 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. Frank Pelzer Absolutely. So yeah, Michael, when we made those comments, obviously, we had had an outlook of 7% to 11%. We're higher now on EPS for where we're going to be in FY '23. We're really happy about that. Some of that is coming from the tax benefit. And so when we take a look at our pretax income for FY '24, it's certainly our aspiration to be double-digit. How the things like tax and share repurchase and stock price as those share repurchases come into play, it's just too early to give any specific guidance further than that on FY '24. But we're really, really happy with the progress that we made, the leverage that we're seeing, particularly in our gross margins and operating margins. It's exactly what we thought was going to happen, and more to come on FY '24. 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. Michael Ng Thanks, Frank. Thanks, Francois. Operator Due to time constraints, our last question is from Sebastien Naji with William Blair. Please proceed with your question. Sebastien Naji Hi. Thanks for squeezing me in, guys. Can you maybe just talk a little bit about how competition for F5 has changed, particularly as you enter some of these new markets like API security, multi-cloud networking? And then maybe expand a little bit on some of the key points of differentiation as long to take share a few comments here. Francois Locoh-Donou Yes. Can you just repeat the first part -- the beginning of the question? Sebastien Naji Yeah. Just maybe could you talk a little bit about how competition has changed as you entered some of these new markets around API security, multi-cloud networking, et cetera? 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. Sebastien Naji Great. Thank you. That's very helpful. Operator Thank you. This concludes today's call. You may now disconnect.