F5 (TICKER: FFIV) F5 Inc Ffiv Q4 2023 Earnings Call Transcript

F5, Inc. (NASDAQ:FFIV) Q4 2023 Earnings Conference Call October 24, 2023 4:30 PM ET Company Participants Suzanne DuLong - Vice President, Investor Relations Francois Locoh-Donou - President and Chief Executive Officer Frank Pelzer - Executive Vice President and Chief Financial Officer Conference Call Participants Amit Daryanani - Evercore ISI Alex Henderson - Needham & Company Samik Chatterjee - JPMorgan Meta Marshall - Morgan Stanley Michael Ng - Goldman Sachs Tim Long - Barclays Ray McDonough - Guggenheim James Fish - Piper Sandler Simon Leopold - Raymond James Operator Good afternoon, and welcome to the F5, Inc. Fourth Quarter Fiscal 2023 Financial Results Conference Call. [Operator Instructions] Also, today's 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 A copy of today's press release is available on our website at f5.com, where an archived version of today's audio will be available through January 28, 2024. The slide deck accompanying today's discussion is viewable on the webcast and will be posted to our IR site at the conclusion of our call. To access the replay of today's webcast by phone, dial 877-660-6853 or 201-612-7415 and use meeting ID 13741762. The telephonic replay will be available through midnight Pacific Time, October 25, 2023. For additional information or follow-up questions, please reach out to me directly at s.dulong@f5.com. Our discussion today will contain forward-looking statements, which include words such as believe, anticipate, expect and target. These forward-looking statements involve uncertainties and risks that may cause our actual results to differ materially from those expressed or implied by these statements. We have summarized factors that may affect our results in the press release announcing our financial results and in detail in our SEC filings. In addition, we will reference non-GAAP metrics during today's discussion. Please see our full GAAP to non-GAAP reconciliation in today's press release and in the appendix of our earnings slide deck. Please note that F5 has no duty to update any information presented in this call. With that, I will turn the call over to Francois. Francois Locoh-Donou Thank you, Suzanne, and hello, everyone. Thank you for joining us. In my remarks today, I will speak to our Q4 and FY `23 highlights, as well as our expectations for FY `24. Frank will then review the details of our Q4 and FY 23 results and provide some additional color about our outlook. We delivered a solid Q4, in an environment that showed some additional signs of stabilization. We saw strength from our enterprise vertical, including technology and financial services customers, offset by softness from service providers. The result was Q4 revenue near the high-end of our guidance range. Our continued operating discipline helped us deliver earnings per share, well above the high end of our range. Our global services team delivered robust 9% revenue growth, driven by strong maintenance renewals and reflecting the benefit of price increases announced last year. In addition, software revenue grew 11%, aided by 27% growth in subscription software. Software revenue from renewals, which have performed well all year ticked up in Q4 over Q3. And while new subscriptions remain down year-over-year, we saw some improvement compared to the first half. Strength in global services and software offset a systems decline of 25%, which reflects a lower level of backlog related shipments than we had for the first three quarters of the year. Stepping back and looking at fiscal year 2023, we adjusted to the environmental challenges we faced, resolving supply chain pressures and largely returning to normalized delivery times. We took decisive actions to adjust our operating model to the realities of the demand environment, driving meaningful improvement to our operating margins and delivering 15% EPS growth. We also returned 58% of our annual free-cash flow to shareholders by our share repurchases. Highlights from FY `23 include. First, subscription renewals performed largely to plan for the year. In today's tough IT spend environment, this is a strong signal, that customers are getting the value and return they expect from our software solutions. Second, F5 Distributed Cloud Services SaaS offerings are gaining traction with both new and existing customers. In fact, 29% of Distributed Cloud SaaS customers are new to F5. In total, we now have more than 500 customers for our SaaS services on Distributed Cloud, an increase of more than 200% since Q4 of last year. Third, we are having very good success, displacing a traditional ADC competitor, in both software and hardware form factors. And finally, we delivered meaningful operating improvements, driving our non-GAAP operating margin up 130 basis points from FY `22. As we look ahead, we enter FY `24 in an environment that seems to be stabilizing. In fact, from a demand perspective, we saw encouraging early signs with enterprise customers in Q4, but it is too soon to say if what we are seeing is a durable trend. As we contemplate our outlook for FY `24, we consider a number of factors. At the macro level, we expect continued application and API growth, fueled by automation efforts and new use cases, including Generative AI. We also expect customer spending caution persist into FY `24, but it's stable. And finally, we believe the tension between application and API growth and customers' ability to sweat assets will reach a tipping point, causing them to reinvest in their application infrastructure, likely beginning sometime in FY `24. At the F5 level we also consider. First, we have an approximately $180 million revenue headwind from FY `23's backlog fulfillment primarily in systems. Second, we expect flat to modest total software revenue growth in FY `24, as a result of a number of dynamics, including continued subscription renewal strength and steady Distributed Cloud SaaS revenue growth. These positive trends will be offset by a series of transitions we are executing in our SaaS and managed services offerings. And third, we expect our global services revenue will return to low-single-digit growth as we lap price increases. As a result of these factors, we expect our FY `24 revenue will be flat to down low-single-digits from FY `23, inclusive of the 6% headwind related to FY `23 backlog shipments. We also expect to return to mid-single-digit revenue growth in FY `25. Whether we achieve the lower high end of our revenue range, we are committed to driving continued strong profitability and we will continue to manage our operating model with discipline. We expect to deliver FY `24 non-GAAP operating margin in a range of 33% to 34%. We are also targeting FY `24 non-GAAP EPS growth of 5% to 7%, reflecting growth of at least 10% on a tax neutral basis compared to FY `23. 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. F5 is the only Company that can deliver, secure and optimize any app and API anywhere. Our security and delivery solutions, offer a custom fit for each app and API. Modern apps and APIs require different solutions than legacy apps. We have the right solutions for both. In addition, to delivering the right tools for the right app or API, our combination of deployable software and hardware and SaaS and managed service offerings, means we are the only vendor that can serve every app and API across all environments in a datacenter, public cloud and at the edge. We are the only Company who can do this today. And going-forward, further integration and convergence of our solutions will make it much easier for our customers to secure and deliver their apps, across all infrastructure environments. The power of our converged portfolio is resonating with customers who are able to deploy the solutions they need today, with the knowledge that F5 will be with them on every step of their multi cloud journey. Before I pass the call to Frank, I will speak to some customer highlights from each of our product families. Our F5 BIG-IP family serves traditional applications, either on-premises, co-located or in cloud environments. BIG-IP's data plane performance, automation capabilities and seamless integration into public cloud environments continues to differentiate the platform, and we continue to win against competitors. 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 80% of Q4 systems bookings. In one example of a BIG-IP wins from Q4, we displaced a competitor and a North American healthcare customer. The opportunity arose as a result of the incumbent provider's inability to handle a mission critical upgrade to the customer's physician portal. The customer selected F5 BIG-IP based on its advanced application delivery capabilities, secure access management, our partnership with their healthcare records platform and confidence in our roadmap. In addition to providing the mission critical functionality that customer needed urgently, we replaced all of the competitor's use cases with the customer, simplifying their application environment and future proofing their datacenters. F5 NGINX, delivered a very strong Q4. 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 and as those applications scale, we are seeing our NGINX opportunity scale as well. In addition, customers are also leveraging NGINX for app layer security for containers. As an example, in Q4 when the e-commerce division of a global technology customer needed to comply with new data security standards, they selected NGINX App Protect to implement app layer security to the containers processing consumer's credit card data. We have invested both organically and inorganically to build our F5 Distributed Cloud Services, a portfolio of SaaS and managed services. Apart from the offering transitions I mentioned, we are really excited about the future for Distributed Cloud. We are intercepting two exciting emerging growth categories, web app and API protection or WAAP and secure multi cloud networking or secure MCN, that will drive future growth for Distributed Cloud Services. In one WAAP win for the quarter, we are helping an EMEA-based banking customer evolve from its traditional WAAP security posture to a more comprehensive WAAP solution that encompasses web application firewall, as well as API protection, bot defense and Layer 7 DDoS Protection. This customer approached us when they came under attack by a malicious foreign actor that their existing WAF could not handle. Against multiple competitors, we successfully demonstrated the superiority of our WAF offering, including our ability to protect major payment companies APIs. Early traction for our secure multi-cloud networking offerings includes a Q4 win with a large retailer In Latin America, that also offers a range of financial services to its customers. As part of its digital transformation efforts, the customer needed a solution to enable them to grow and manage their expanding body of cloud native applications. They also plan to migrate their large existing footprint of virtual machines and on-premises appliances to the cloud. After a thorough proof-of-concept, the customer selected our secure multi cloud networking solution, because of our ability to use the customer edge to make the move 100% transparent, to both internal users and consumers. We are also seeing cross portfolio traction with customers who are operating in hybrid environments, choosing to deploy F5 across multiple form factors. In a win that highlights the synergies of our product families, during Q4 we secured a win with an APAC based financial services provider. The customer launched a multifaceted modernization project, designed to add and consolidate applications, and enable scalability to handle exponential traffic growth. They also needed help, stopping a barrage of constant automated attacks. In a competitive bid, our combination of BIG-IP and F5 Distributed Cloud Bot Defense won out. The combination enables the customer to manage unpredictable traffic growth, customized services for each application and enhance their security posture, with our ML based AI engine. These real life use cases, offer a view to how we are enabling customers to secure, deliver, optimize and manage their applications and APIs and how we simplify the challenges of operating in a complex hybrid multi cloud world. Now, I will turn the call to Frank. Frank? Frank Pelzer Thank you, Francois And good afternoon everyone. I will review our Q4 and FY `23 results, before I elaborate on the outlook Francois shared. We delivered Q4 revenue of $707 million, reflecting 1% growth year-over-year, with a mix of 54% global services and 46% product revenue. Global services revenue of $382 million grew a strong 9% due to continued high maintenance renewals as well as the price increases, we introduced last year. Product revenue totaled $325 million, down 7% year-on-year. Systems revenue of $134 million declined 25% year-over-year, reflecting a lower level of backlog related shipments that we had in prior quarters and demand that showed some signs of stabilization, albeit at lower levels than we have seen historically. In contrast, software revenue grew 11% over the year ago period, to a new high of $191 million. Subscription based revenue grew 27% year-over-year to $166 million, another record-high, representing 87% of Q4 total software revenue. Perpetuals and software license sales of $25 million represented 13% of Q4 software revenue. Revenue from recurring sources contributed 76% of Q4's revenue another all-time high. Recurring revenue includes subscription based revenue as well as the maintenance portion of our services revenue. On a regional basis, revenue from Americas was down 6% year-over-year, representing 57% of total revenue. EMEA grew 16%, representing 26% of revenue, and APAC grew 4%, representing 17% of revenue. Looking at our major verticals, during Q4 enterprise customers represented 72% of product bookings. Service providers represent 9% and government customers represented 19%, including 7% from U.S. Federal. Our Q4 operating results were strong, reflecting operating discipline and a full quarter benefit from the cost reductions announced in April. GAAP gross margin was 80.1%, non-GAAP gross margin was 82.7%, an improvement of 125 basis points from Q4 of FY `22. GAAP operating expenses were $394 million, non-GAAP operating expenses were $345 million. Q4 non-GAAP operating expenses as a percent of revenue was below 49%, resuming pre-2019 acquisition levels. Our GAAP operating margin was 24.3%, our non-GAAP operating margin was 33.9%, representing an improvement of more than 600 basis points from Q4 of FY `22. Our GAAP effective tax rate for the quarter was 13%, our non-GAAP effective tax rate was 14% below our initial expectations for the year, as a result of IRS guidance issued during the quarter, relating to foreign tax credits. Our GAAP net income for the quarter was $152 million or $2.55 per share. Our non-GAAP net income was $209 million or $3.50 per share, well-above the top-end of our guidance range of $3.15 to $3.27 per share. This reflects the combined impact of our gross margin improvements and operating expense discipline, as well as the Q4 tax benefit. I will now turn to cash flow and the balance sheet, which also remain very strong. We generated $190 million in cash flow from operations in Q4 driven by our improved profitability. Capital expenditures for the quarter were $15 million. DSO for the quarter was 58 days. Cash and investments totaled approximately $808 million at quarter end. Deferred revenue increased 5% year-over-year to $1.78 billion. We repurchased $60 million worth of shares in Q4. For the year, we used 58% of our approximately $600 million of free cash flow for share repurchases. I note that in each of the past three years, we have met or exceeded our share repurchase commitments. Finally, we ended the quarter with approximately 6,500 employees. I will now recap our FY `23 results. For the year, revenue grew 4% to $2.8 billion. Global services revenue grew 7% to $1.5 billion, representing 53% of total revenue for the year. Product revenue grew 1% to $1.3 billion, representing 47% of total revenue. For the second year in a row software represented roughly 50% of product revenue. Software revenue was flat compared to last year at $664 million. This was down from our initial expectation of 15% to 20% growth as a result of customers delaying large transformational projects. As Francois noted, software renewals performed largely as planned. We delivered $671 million in systems revenue during the year, representing 3% growth. I would now like to provide some additional information regarding software revenue. We said we intended to provide additional software revenue details as the SaaS business scale. As we said last October, we had several SaaS and managed service transitions planned. We started these transitions in FY' 23 and they will continue through FY `24 and FY `25, leading to some short-term revenue variability that is not necessarily indicative of potential future performance. We believe that providing visibility to our SaaS and managed service revenue, and to the transitions that are underway, provides greater clarity on both our FY `24 revenue expectations and our expectation of returning to mid-single-digit revenue growth in FY `25. Today, I will speak the three components of our FY `23 software revenue. The first, term subscriptions, the second SaaS and managed services and the third perpetual licenses. We intend to continue report the SaaS and managed service portion of our revenue on an annual basis going forward. In FY `23, revenue from term based subscriptions comprised a BIG-IP and NGINX subscriptions, contributed $353 million to software revenue, up 9% year-over-year. Under ASC 606, sales of term-based subscriptions are recognized largely upfront as software revenue. The remainder is deferred and recognized as service revenue over the term of the subscription. The majority of our term-based subscriptions are contracted for three years. Term subscriptions included both new, renewal and true forward or expansion revenue, for both annual and multi-year subscriptions of deployable software. New revenue includes new customers, as well as new use cases or offerings sold to existing customers. In FY `23 renewal and true forward or expansion revenue experienced healthy year-over-year growth, offsetting the weakness in new term subscription software projects. Renewals performing largely to plan in FY `23 is encouraging for several reasons. First, given the current levels of customer spending scrutiny, strong renewals are a signal that customers are getting the value they demand. Second, our renewals motion is still relatively new and it is great to see confirmation that it is working as intended. The second component of our software revenue, SaaS and managed services contributed $203 million in revenue in FY `23, up 2% year-over-year. SaaS and managed service is comprised of our F5 Distributed Cloud SaaS offerings. Revenue from managed services including our legacy F5 Silverline offering in our anti bot and anti-fraud offerings as well as revenue from legacy SaaS offerings. SaaS and managed service sales are recognized ratably as product revenue over the term of the subscription. At the end of FY `23, our SaaS and managed services ARR was $198 million, down approximately 2% year-over-year. There were four primary contributors to this performance. First, we are seeing solid early momentum from our F5 Distributed Cloud Service SaaS offerings. Second in FY' 23 our most advanced anti-bot and anti-fraud managed service solutions underperformed relative to our plan, as a result of customer spending caution and budget scrutiny. Third in FY `23, we began migrating customers from our legacy Silverline managed service offerings, to our F5 Distributed Cloud SaaS offering. And fourth, we began executing the planned retirement of legacy SaaS offerings from companies we acquired. Both the Silverline customer migrations, and the retirement of legacy SaaS offerings resulted in planned revenue churn. The third component of our software revenue is perpetual licenses, which contributed $108 million in software revenue, down year-over-year after unusually strong FY `22. In FY `23 71% of our revenue was recurring, up from 69% in FY `22. Several years ago, we began breaking out our security related revenue annually. This year our total security revenue which includes standalone security, attach security and security related to maintenance revenue was approximately $1.1 billion or 40% of total revenue. Our standalone security product revenue grew 5% to approximately $475 million. We are seeing good traction with the lower end anti bot offering delivered through Distributed Cloud services as well as from security on NGINX. Our FY `23 security revenue growth was affected by customer spending caution, including stalled transformational projects and the underperformance of advanced anti bot anti-fraud solution as I mentioned previously. During the year, we overcame supply chain challenges and successfully returned our lead times to normal levels. As a result, our FY `23 product backlog returned to pre-supply chain challenge levels and we closed the year with approximately $53 million in product backlog. I will now turn to our FY `23 operating performance. GAAP gross margin in FY `23 was 78.9%. Non GAAP gross margin was 81.5%, down 110 basis points from FY `22, as a result of higher supply chain costs in FY `23. Our GAAP operating margin for FY `23 was 16.8% and our non-GAAP operating margin was 30.2%, up 130 basis points from FY `22, as a result of our previously announced cost reductions. Our GAAP effective tax rate for the year was 18.7%. Our non-GAAP effective tax rate for the year was 18.3%. Our FY `23 annual tax rate was lower-than expected, primarily due to IRS guidance issued during the fourth quarter related to foreign tax credits. GAAP net income for FY `23 was $395 million or $6.55 per share. Non-GAAP net income was $705 million or $11.70 per share, representing growth of 14.8% over FY `22. Francois, outlined our annual and longer term outlook at the start of the call, I'll recap that with some additional color. I will also provide our outlook for Q1. With the exception of revenue, my guidance comments reference non-GAAP metrics. In our FY `24 outlook, we've made the following assumptions. We expect customer spending caution will continue into FY `24, but we also expect customers will begin to reinvest at some point in the year. We expect our global services revenue will return to low-single-digit growth as we lap price increases. We have approximately $180 million revenue headwind in systems from FY `23's backlog fulfillment. We expect to continue to take share in the traditional ADC space with BIG-IP in both hardware and software form factors. Within our software revenue, we expect continued strength from our term subscription renewals and continued growth from our F5 Distributed Cloud SaaS offerings. As I've discussed previously, we will have some planned revenue churn as we work through the SaaS and managed service transitions I discussed. We expect these transitions will be largely complete in FY `25. In FY `23 and in ARR associated with the transitions is approximately $65 million, a little more than half of which is associated with offerings we intend to transition onto Distributed Cloud over the next two years. The net of these assumptions, combined with the current demand levels leads us to expect FY `24 revenue in the range of flat to down low-single-digits from FY `23. Excluding the $180 million or 6% headwind from our FY `23 backlog reduction, our guidance range would reflect low to mid-single-digit revenue growth in FY `24. Whether we achieve the bottom or top end of this range, largely depends on when customers resume more normal levels of spending. We expect some continued quarter-to-quarter variability, as a result of upfront revenue recognition related to our term subscription offerings. Regardless of our revenue performance, we remain committed to driving strong profitability. From an operating perspective, we expect gross margin will improve in fiscal year `24 to the range of 82% to 83%, this is primarily the result of supply chain related cost pressures, working their way out of our model. We expect our continued operating expense discipline will result in FY `24 non-GAAP operating margin in the range of 33% to 34% for the year. On a percent of revenue basis, this would put our operating expenses roughly in line with 2018 levels, at roughly 49% of revenue. We expect our FY `24 effective tax rate will be 21% to 23%. In FY `24 we expect to deliver 5% to 7% non-GAAP earnings growth, which translates to at least 10% year-over-year growth on a tax-neutral basis. Finally, we expect to use at least 50% of our annual free cash flow for share repurchases, consistent with the approach we have discussed previously. As of the end of FY `23, we had $922 million remaining on our previously announced authorized share repurchase program. We also want to take the opportunity to speak to our expectations beyond FY `24, as we believe it will help signal how we intend to run the business longer term. As Francois noted we expect mid-single-digit revenue growth in FY `25. We expect to drive additional gross margin improvements, and to deliver gross margins between 83% and 84%. We expect to grow our operating expenses slower than revenue, resulting in an operating margin of at least 35%. We will continue to prioritize profitability, adjusting our operating model if needed to enable us to deliver at least 10% compounded annual non-GAAP EPS growth. Finally, we intend to continue to use at least 50% of our annual free cash flow towards share repurchases. I'll conclude with our expectations for Q1 of FY `24. We expect Q1 revenue in the range of $675 million to $695 million. We expect gross margins in the range of 82% to 83%. We estimate Q1 operating expenses of $332 million to $344 million. We are targeting Q1 non-GAAP EPS in the range of $2.97 to $3.09 per share. We expect Q1 share-based compensation expense of approximately $58 million to $60 million. I will now turn the call back over to Francois. Francois? Francois Locoh-Donou Thank you, Frank. Before we open the call to questions, I want to address our view on F5's AI opportunity. At the highest level, we believe customer's use of AI will accelerate the growth of applications and APIs and the corresponding need to deploy, manage and secure them, which is what we do best. We also believe AI inference, the process of using a train model to make predictions on never seen before data will become increasingly distributed. Organizations will need to support it anywhere from datacenters to manufacturing floors to public clouds. We believe every application and API will soon require inference just as they require security and traffic management. With our rich history of delivering innovative ML based security solutions, including bot defense, protection against denial of service attacks and anti-fraud and our role in the flow of application traffic, we are uniquely positioned to secure AI workloads, wherever they reside and to empower our customers to run AI wherever they need it. In conclusion, we are leveraging our incumbency and our position in the flow of 40% of the world Internet traffic, to deliver hybrid, multi-cloud solutions that dramatically simplify application and API deployment, security and management for our customers. We are also significantly reducing our customer's total cost of ownership. We are uniting and automating all of our customer's apps and APIs across their datacenters, cloud and edge environment. We are encouraged both by the early signs of stability we saw in the second half of `23, and with the residence our converging portfolio is having with customers. We have an install base of 20,000 customers, all of whom have an acute and significant multi-cloud challenge. Other than F5, there is no one company that can address this challenge. With F5 Distributed Cloud services, we have created a platform to drive SaaS growth in the future. In closing, I'll reiterate the three pillars of our long-term operating model, which will enable us to drive double-digit earnings on a compound annual growth rate. Number one, delivering sustained mid-single-digit revenue growth, supported by our differentiated positioning in attractive end markets, along with our durable high margin global services business. Number two, driving non-GAAP operating margin expansion, which we will achieve through gross margin improvement and operating discipline. And number three, returning cash to shareholders, via share repurchases, using at least 50% of our annual free-cash-flow. Operator, please open the call to questions. Question-and-Answer Session Operator Thank you. Ladies and gentlemen, at this time we will be conducting a question-and-answer session. [Operator Instructions] Our first question comes from the line of Amit Daryanani with Evercore. Please proceed with your question. Amit Daryanani Yep. Good afternoon. Thanks for taking my question. You know, I guess, Francois maybe to start with, you talked about software growth being flat to have been up modestly, but that included some of the headwinds around the business transition is taking place on the managed services side. I didn't appreciate this, but is the headwind from this transition $65 million or is it half that number? And maybe just flush out how much that is and what are the transitions that you're doing? Francois Locoh-Donou Hi, Amit. So in, in total, so we talked about it roughly $200 million in SaaS and managed services. In that $200 million there is about $65 million of revenue stream, that essentially are going to go away. Now, but that's more than half of that is revenue streams coming from a legacy managed services platform Silverline, that we are retiring. But we intend to migrate the customers over to Distributed Cloud. So we would expect you know a portion, if not a significant portion of that, you know of that revenue stream to go on to Distributed Cloud over time. The other a little less than half of that $65 million are offerings that we are retiring completely that, you know, when we looked at our portfolio and looked at the offerings we wanted to rationalize, that we felt were underperforming. We decided to retire these offerings completely to, you know, focus on the products that are going forward and successful rationalize our cost and improve our efficiency. Amit Daryanani Got it, that is really helpful to get -- understanding the split on the $65 million. And then you know, I think, Francois you in your comments you sort of talked about, you're seeing encouraging signs from enterprise customers in September quarter. Can you just perhaps talk about what are these signs, is it just the assets are running at high utilization, you can't sweat them anymore. And is there any sort geo vertical, we're just trying see these initial positive signs that you may have from customer demand. Francois Locoh-Donou Amit there, I wouldn't say there is a particular geography where we are -- where, that's really different than others. I would say, North America has been probably more solid and stable than our Asia and European markets. If we look at verticals in terms of where we're seeing stabilization, I think the enterprise market, we're seeing more stabilization. The service provider market has been soft. That's for a number of factors service providers continue to sweat assets, and, and be really ruthless in their prioritization, the 4G to 5G transition is a little slower than anticipated. So service providers in general have been soft than we're kind of expecting that to continue. What we were encouraged by, especially, in the second-half of the year, but specifically in Q4 is in the enterprise space specifically, we saw some customers that had been sweating their assets, and got to kind of at the end of that cycle and started demanding hardware again or ordering hardware again. So we did see a rebound in hardware orders in the fourth fiscal quarter. Coming from A, we think some customers having sweated their assets, but also, you know, it took a long time for us to ship equipment to a number of our customers in 2023. And in Q4 we saw some of these customers that finally had received their hardware and had been able to deploy that to start ordering again. So we were encouraged by those trends. Amit Daryanani Got it. Thank you very much. Operator Our next question comes from the line of Alex Henderson with Needham. Please proceed with your question. Alex Henderson Great, thanks so much. Looking back at your prior longer term expectations, I think you had talked about growth rate in software in excess of 20%, and high to mid-single declines in systems. Can you give us an update on what do you think those percentages might look like in longer term once you get through the wobble in FY `24? Francois Locoh-Donou Yes. So, Alex, we're -- so today we're talking -- so I don't want to talk about what's beyond FY `25, I'm going to talk about FY `24 and `25. Beyond FY `25, I think our view of our end markets haven't really changed. And so you know in the future that opportunity to return to 20%-plus growth in software, is there based on the end markets that we are targeting. But let's talk about FY `24 and FY `25. So FY `24 we've talked about growth in software being you know flat to modest. And that, if you take the three components of software that we've, we just talked about, we expect, you know, frankly, the perpetual base of the business to be roughly flattish. We have a similar view on the SaaS and managed services part of the business based on the transitions we're going through. And potentially, you know in the term subscription part of the business is where potentially we would see some modest growth. Going into 2025 from a revenue perspective, we don't necessarily expect growth from perpetual or the SaaS and managed services business because of the transitions that we're going through. But we have strong visibility into our -- the renewals and expansion in our term subscription business. The expansions which are very strong from what we're seeing and we expect that to continue and be amplified in 2025. So in 2025, we would expect you know software growth to return to double-digit, really powered by our term subscription business. Alex Henderson I see. Just if I can follow-up on, you talked about your backlog having been normalized, but you've also had orders out for components that were driven off of the tight supply environment. When do you expect the full normalization of the component costs, you know, in your cost of goods sold, is that already achieved or is that going to be something that's going to feather in over the next year maybe, year and a half? Frank Pelzer Alex, it's Frank. So largely most of that has been achieved but there is still some of the purchase price variances that are coming through in FY `24. By FY `25 we expect that to be fully out in a normalized level. Alex Henderson Could you give some sense of what the `24 variance would be? Frank Pelzer Alex, I think it's probably in the range of 25 to 50 basis points of where we'll see improvement just based off of that, in comparison to expectations for gross margins in FY `25. Alex Henderson Great. Thank you so much. Operator Our next question comes from the line of Samik Chatterjee with JPMorgan. Please proceed with your question. Samik Chatterjee Hey, thanks for taking my question. I guess Francois just relative to your fiscal `25 outlook for mid-single-digit, I'm just curious if you've changed your view about what the long-term trajectory in systems demand looks like, particularly as you mentioned, you've seen orders pick up a bit. And maybe you can also talk about, when you talked about AI demand, do you expect -- how do you expect it to play out between systems, related to sort of software within your portfolio? And I have a quick follow-up. Thank you. Francois Locoh-Donou Samik. Thank you. These -- so over a long period of time I think we, you know, we think that the hardware business would be more of a you know low-single, low-single-digit decline or overtime. However, that is a statement you know that is based on a normal, first a normalization of the hardware business, and we're not there today. And that's been as you know, the demand was much softer in 2023. And so we actually expect our hardware business to rebound in 2024, and we saw some signs of that already in this fourth quarter. And you know the -- I'm giving you more of a long-term trend kind of beyond 2025. But you know I think at least for 2024, we expect to rebound in the hardware business. In terms of where AI will play in our business, so the way to think about it Samik is, we -- the portfolio that we're putting together, which is hardware, software and SaaS, we expect, you know, that will enable our customers to secure and deliver their API and their applications in any environment. AI workloads are going to be modern applications, some of which may run on-prem but we think a, a lot of them will run in software environment, and so it's likely that supporting AI workloads will accrue more to our software business over time. And in addition to that, we think we have a very unique position in that with our distributed cloud capabilities, we are able to run inferences really in any cloud environment and beyond. So we can run inferences in any public cloud, we can run it at the edge, we can run it in our own cloud. And increasingly, we're hearing from customers that they will want to run these inferences on manufacturing floors or on the retail branches for retail customers or and vehicles for some far as use cases. And we have the ability to run and secure and deliver these inferences in any environment. You know, whether it's in the cloud or in any one of these far edge environments and that makes F5 very unique in its position for running AI inferences in the future. All of that of course will accrue to our software business. Samik Chatterjee Go it, got it. A quick follow-up Francois, you mentioned the green shoots you're seeing in terms of enterprises spending and the recovery there. I think one of the pushbacks we've seen from investors on that front has largely been the expectation that there might be a pickup here in the back end of the year just from a budget flush perspective from the enterprises, and you might sort of see a pull back again, as we enter into next year and more sort of budget cuts. Any insight you know, that you're already getting from your customers about how budgets look for next year or in relation to whether would this sort of pickup, if anything to do with the more temporary flush of budgets before the year end? Thank you. Francois Locoh-Donou Yes. Thank you, Samik. I, I don't think it, it was related to a budget flush for -- you know because, you know, the comments we made in resumption were really things we observe in the, the quarter that ended in, in September for us. When we look at next year, no, we do not have visibility into exactly what budgets our customers will have in FY `24. We do have a strong pipeline, entering the fiscal year on hardware. And you know that would -- it will come down to what are the close rates on that. In Q4 the close rates that we saw on our pipeline entering the quarter were better than in the prior three quarters of the year. That's also part of why we talked about stabilization. And green shoots in Q4 is because what we saw in the close rate. So we're going into the fiscal year with a stronger hardware pipeline. Recent data points on close rates that are positive. But of course, we are cautious, because there's still a lot of uncertainty out there. Around the macro as you noted. We continue to see customers you know in certain occasions, delaying, delaying deals or having continued budget scrutiny and more approvals. We are seeing that phenomenon continue. And so overall, we're still cautious going into the year. Samik Chatterjee Yes. Thank you. Thanks for taking my questions. Operator Our next question comes from the line of Meta Marshall with Morgan Stanley. Please proceed with your question. Meta Marshall Great, thanks. Maybe building on Samik's question to start. You know, as you look at your pipeline, is your view that a lot of this is, okay, we've sweated assets as much as we can, or the utilization of the appliances is too high or you know, are we starting to see kind of growth in multi-cloud projects again? Just trying to get a sense of as you look at your pipeline, is it kind of traditional applications are expanding our use cases? And then maybe as a second question, You know, you mentioned kind of having plays as AI and inference cases grow, you know, is that going to require productization of any kind of suites of products today or just kind of tailoring to kind of have AI ready solution? Thanks. Francois Locoh-Donou Thank you, Meta. The -- so let me start with the first question, and my comments on pipeline. There are more related to what we're seeing in the -- on the hardware side of things, where we had a number of customers that A, number one have been sweating their assets, and they're getting sometimes the utilization levels, where we, we know that at some point in `24 they will have to do something. Or number two, customers who have placed orders in FY `22 have not been able to receive equipment for these orders, who now have and have started to deploy that capacity and are starting to be ready to order again. So that is accruing to a stronger hardware pipeline. In terms of big you know, kind of multi-cloud software, what we've called this transformational software project, we are not yet seeing a you know substantial resumption of these kinds of projects. But then that's what I was saying earlier is customers are still very cautious on undertaking, you know, big projects like that. And we're not seeing a different pattern going into the year on those aspects. As it relates to AI and whether it will require productization, we have essentially and so on, on the aspect of being able to run inferences in any environment, we have these capabilities in Distributed Cloud. I think we need to ensure that we harden these capabilities and there is a strong go-to-market effort to be made around that to make customers aware of that in the future as they start deploying AI workloads. As it relates to being able to secure and deliver AI workloads, those capabilities exist today and we are ready to go with that already. Frank Pelzer Meta, I just wanted to add that, you know, last year we talked about in our outlook, particularly, in software that, we were a little less than 50% of our outlook at the time was coming from the renewals and the trueforwards portion of our term subscription agreements, and that's and our SaaS based revenue. And that's a little more than half was going to come from new, this year as we take a look at that same formula and we look out over 60% of you know what we expect in that flat to modest software growth is coming from, both the renewables pieces of the SaaS and managed service business, plus the renewables true forwards of our term subscription business. So we tried to take into account the fact that we don't see these transformational projects on the horizon as we thought about the guidance. Meta Marshall Great. Thank you. Operator Our next question comes from the line of Michael Ng with Goldman Sachs. Please proceed with your question. Michael Ng Hey, good afternoon. Thank you for the question and for all the comments on, on the outlook. I just had two, both on software. You know, first, I was just wondering if you could talk a little bit about, you know, your visibility into the term business. You know, you called out term as something that would help drive the double-digit software revenue growth in fiscal `25, as well as potential growth in fiscal `24. And then second, I was just wondering if you could talk a little bit more about this migration from Silverline to DCS. It sounds like it's a multi-year headwind, you know, something that contributed to the weakness in ARR in fiscal `23, but it also seems to be a headwind in fiscal `24 and fiscal, fiscal `25. So maybe you could just talk about that and you know, how that transition is rolling off and you know, over how many years. Thank you. Frank Pelzer Sure, Michael. Let me start with the first question and then I'll let Francois jump in on the second on the Silverline side. So on the, first on the term subscription, particularly the, you know, the trueforwards and the expansions that we have seen, with the second terms coming on and we've had probably about seven or eight quarters now of run rate, and are getting much more comfortable with the early signs that you know, where massive expansions continue. And so getting very, very strong utilization from the -- from that base of deployed, flexible consumption programs, and this specifically covers right now BIG-IP and the NGINX portfolio within our business, as I mentioned in the prepared remarks. And that's giving us a lot of comfort, both in FY `24 and more importantly, in FY `25. FY `25, we've got our, you know, a bigger pool of expansion revenue than we do in FY `24 and `24 is growing on top of `23, so all of these continue to compile upon themselves. As I just mentioned to me Meta that, you know more than 60% of the outlook that we've got within our software revenue is coming, you know, from that cohort that we feel pretty good about seeing which is the term renewals, as well as true forwards plus SaaS and managed service renewal piece that we've got in the revenue stream. So both of those, you know, we feel very confident about, and it's probably the highest visibility that we've got within the revenue stream. Francois Locoh-Donou Thank you, Frank. And to your second question, Michael on SaaS and managed services. So, like, if we talk about, you know, FY `22 to FY `23, you saw that the ARR there was flat to slightly down. There are two reasons for that. One is, yes, the transitions we talked about started in `23 and there was about call it roughly, you know, $12 million of ARR that we transitioned out of the business in 2023. The other reason is at the high-end of the bot business, we saw quite a bit of softness, especially in the second-half of the year, as customers had significant budget scrutiny and you know we're reluctant unless they were under immediate attack, to really implement our more sophisticated solutions. We think over time that will change, but specifically this year with the macro pressures and budget scrutiny, we saw a lot of softness there, both in, you know, new bookings and in some churn in some cases. So that is the FY `22 to FY `23. So from going into 2024, well, you asked about, you know, is this transition is a multi-year transition. Yes, we expect that the $65 million of, of revenue stream that we are transitioning will work themselves out over the next couple of years, so over FY `24 and FY `25 they are a headwind to total growth. However, we are quite excited by what's happening with F5 out of the SaaS portion of our offerings, specifically SaaS on F5 Distributed Cloud. We have launched a WAF offerings, the security offering, you know, about 18 months ago. We are seeing extraordinary traction on that. As I said earlier, we've won over 500 customers in that period, all of whom are enterprise customers. And we are seeing very rapid traction on that. We're also seeing rapid traction on the multi-cloud networking market, where we bring both networking and security capabilities and we're quite differentiated to anybody in the market. So that has grown fast and we expect that portion of the business to continue to grow fast, and overtime become a, a majority of this SaaS and managed services portfolio. Michael Ng Thank you, Frank. Thank you, Francois. Very helpful. Francois Locoh-Donou [Indiscernible] Michael. Operator Our next question comes from the line of Tim Long with Barclays. Please proceed with your question. Tim Long Thank you. Two, if I could as well. First, Francois, I think you talked about replacing competitor with, in the ADC, both hardware and software, domain. Could you dig into that a little bit more, is that something that you think it is kind of, it's a one-off or do you think there is a sustainable move there and how is that happening. And then second, just on the, you know, the changes in the transitions in software, it sounds like you know, move into Distributed Cloud services makes a lot of sense. Having looked at some of those businesses and kind of you know, moving on from them. Does that change your view of kind of synergies across product offerings or is it a sign that maybe those businesses didn't have the same synergy and that's why you're not, you know, you're not going forward with them. Thank you. Francois Locoh-Donou Thanks, Tim. Maybe let me start with the second part. No, it's not about synergies. So there are two aspects of that, Tim in terms of the transitions we're talking about the $65 million of transition. One is a legacy platform that we have, you know that -- on which we have built managed services offering. We have now built a with the F5 Distributed Cloud in much more modern platform with an architecture that's differentiated, and that's gaining rapid traction and we want to transition our customers through this modern platform. And that was always the plan to do that. However, you know, we have to first of all, build a platform and build all the security capabilities on the platform, to be able to start this transition. So we're very excited that we were able to do all this work on the Volterra platform over the last couple of years, and we're able to start this transition in 2023. The second part of the revenue stream that is being retired is not about synergies, it's new offerings that we had launched recently, that we hope to do well in the market. But given the macro environment and what we've seen as the early traction on these offerings, we've made some decisions as you know, in April to rationalize our portfolio and focus on the most attractive investment, and we decided to not go forward with these products. So that's the second part of your question. On the -- I should say that the last thing I'd say about that is, in terms of the synergies between elements of the portfolio, no -- we are actually very encouraged on what we're seeing. We're seeing actually a number of customers, who already have BIG-IP adopt Distributed Cloud. You know so for a set of applications they have BIG-IP on-prem or in the cloud, so hardware or software, and then they want to have software-as-a-service for in -- other applications in their state. And they really want to have the consistency of you know security engine, security policies across all these environments and we're able to do that with BIG-IP, as well as our SaaS and managed services. NGINX also had a very strong quarter in Q4, and that was driven in-part by the security capabilities that we ported from BIG-IP onto NGNIX and that same security stack is now in use in Distributed Cloud. So the synergies, especially in terms of security across our portfolio are, are playing out, and we expect that they will accelerate actually over the next couple of years, as we, we do more and more conversion between the SaaS and deployable products. Now, for the first part of your question, in terms of the ADC competitors, look Tim, here it's -- we have over the last four years, you know, we made a decision to continue to invest in the future of the ADC franchise, and specifically, building the next generation hardware form factors for our ADC franchise and the next generation software form factors that together bring to on-prem deployments, the benefit of the cloud, such as, you know, multi-tenancy rapid upgrades, seamless upgrades, and make it way easier for customers to operationalize ADCs, and have a better total cost of ownership. Those investments are paying out in the market in terms of us gaining share and being able to displace our traditional competitors in, you know, even in situations where they are incumbent, and take share from them. And we think that, you know, that's not a one-off. Our expectation is, that will continue, and, you know, we're pretty excited because, this year we're introducing the next generation software platform on BIG-IP that we think is also even more differentiated than what we've had in the market. So I expect that will continue and it's you know, hopefully a pay-off for the investment we've made over the last four years. Tim Long Okay. Thank you. Operator Our next question comes from the line of Ray McDonough with Guggenheim. Please proceed with your question. Ray McDonough Great, thanks for taking the questions. Francois, given some of the changes you're making to your software portfolio, it seems like in a way you're, you're simplifying or even converging some of your solutions. So as we think about the roadmap for Distributed Cloud in particular, what can you do to accelerate adoption and make sure you capture the potential voluntary churn that you've talked about or, or even how should we think about the priorities around Distributed Cloud next year. Francois Locoh-Donou Thank you. The -- look our goal is to make it ridiculously easy for our customers to secure and deliver their applications. And Distributed Cloud is getting a lot of traction because it does that for, for our customers. So when you look at the priorities next year, of course, it's scaling the platform, so it's available in, you know, more markets in more environments and continue to add services to the platform. We have the two -- I would say first two sets of services WAF and multi cloud networking. We have a backlog of other services that we want to add to the platform that our customers will want to add. We've recently added CDN capabilities on the platform, you know, after the [Acqui hire] (ph) of Lilac a few months back and we're starting to get customers adopting our CDN because it's convenient for them to like catch back to load balancing and, and security in some cases. So the first priorities are, you know, scaling the platform and adding services. As far as go-to-market, frankly, the priority is going into customers that are already F5 customers, that have our hardware or software, but want a SaaS solution to make it easier to front -- to use F5 to front a bunch of applications for which they don't want to manage the lifecycle of deployable products. And if you look at the 500 customers or so that are on Distributed Cloud today, over two-thirds of them are actually existing BIG-IP customers. So about a third of them are net new customers that had never bought anything from F5 and two-thirds of them are existing BIG-IP customers. And we think actually with both net new and with existing customers there is a lot of growth and that's where the focus is. And the focus is going to continue to be with large enterprise customers where F5 has a strong presence. Ray McDonough I appreciate that. And if I could snick one more in, maybe for Frank. Certainly appreciate the continued focus on operating margins and EPS growth. But can you help us think through how we should think about cash flow margins in fiscal `24. I know you typically don't guide cash flow. But should we think of cash flow growing in line with operating income, ex-some of the tax headwinds you had in fiscal `23, any even directional thoughts would be helpful. Frank Pelzer Yes. Ray, as you described, I think, that's roughly correct. You know, cash flow is one of the hardest things for us to, to predict, but those dynamics are it should narrow a bit that net income growth with, you know, with some exceptions to the two tax impacts. Some of the restructuring expense we had last year that we don't have this year that are real cash, but split out for non-GAAP purposes. So there is a few ins and outs, but it should be roughly, roughly close to that. Ray McDonough Great. Appreciate it. Operator Our next question comes from the line of James Fish with Piper Sandler. Please proceed with your question. James Fish Hey guys, thanks for snicking me in. I'll just make it simple here. You know, you guys talked about in the prepared remarks about subscription renewals performing well. Any more color into specifically what products are seeing those better renewals, but the cross-sell that you're seeing or any qualitative or quantitative color around net retention rates understanding, you, you have this headwind around specifically with the SaaS and MSP business about $65 million. You know, how should we think about that net retention rate within the term business or the aggregate overall when you kind of exclude even the impact of that SaaS please. Thanks guys. Frank Pelzer Sure. Fish I'll start and then Francois wants to add anything that would be great. So you know, within our term subscription business, which is generally our BIG-IP software, as well as NGINX and that's the expansion rates that we've seen. It's not the easiest like task in the world to convert that term into an ARR type of business, because of all the moving parts, but when we've tried to do that and try to convert and look at what would you know an expansion rate would be or net revenue retention rate. It's north of what you would think of as the industry norm of 120% let me just put it that way. And that combination of where it is, plus our SaaS managed service our net revenue retention rate is still north of that 120%. So that combination you know, is what gives us a lot of visibility and firmness in our expectation of those pieces of the business that will continue to do well. James Fish Makes sense. And just on the go-to-market side, any changes in terms of incentives or approach as we turn to page into this next fiscal year and as we have, you know, transitions now within the overall software transition. Frank Pelzer The incentive plans between the two years are largely the same Fish. There is always going to be a couple of tweaks here and there as we're looking and seeing what was successful the year before and not but nothing major. James Fish Thanks guys. Operator Our last question comes from the line of Simon Leopold with Raymond James. Please proceed with your question. Simon Leopold Great, thanks for taking the question, I just wanted to get a better sense of where the systems business is stabilizing, in that I assume the September quarter did not have much if any backlog drawdown in it. And so, other than maybe some seasonal movement, I'm just trying to get a sense of if sort of it's you know $120 million to $130 million per quarter level, sort of, the new normal for systems. And then just quickly on how the software is trending with the Silverline exit. Does that manifest itself gradually throughout the year or is that something that shows up in a particular quarter. Thanks for that. Frank Pelzer So I'll start with the first one and then Francois, I don't know if you want to take the second. But in terms of, what we've, what we've said I think in both the prepared remarks and some of the answers, we did both -- we do believe that we hit a trough in FY `23 in terms of systems bookings. And, you know, what we're equating that to the term demand. Now the offset or the balance of that is that, there was FY `22 bookings they were delivered in FY `23. And so the shipments that they actually received, which is the revenue that we recognized that came in in FY `23 and started to be utilized. Now, as that utilization started to increase and more capacity was needed, we started to see that come through in Q4, which was our best systems bookings quarter of the year. It looks like on a revenue basis, that wasn't necessarily the case, but from a demand perspective, our bookings perspective, that was the case. There will still continue to be fluctuations. There's probably a bit of leveling or even improvement that we've seen in the enterprise side. On the SP as Francois mentioned service providers have been hesitant and we expect that to continue on. And in Q1, in particular, you know, we've got a federal government that isn't necessarily functional right now, and we'll see what that means as an impact to, you know, bookings for systems in Q1 and we're trying to take that into account, as we, you know looked at the guidance and the expectations. We do expect as we've talked about many times in the past, there is that four to six-quarter long and the dynamics that I just talked about explains why sometimes that takes four to six quarters particularly in a supply-chain restrained environment. So we do expect at some point we're in the that we will pick up in bookings from that Q4 level and then return back to a higher-level. I can't say normalized level, because it's tough to know when exactly that will, will take place. But our outlook and our expectation is not that we are going to do $180 million less with systems bookings, our SaaS systems revenue. Our bookings will improve, but the revenue will be down from last year because of that $180 million of headwind. Francois Locoh-Donou And to the second part of your question, in terms of Silverline no, it's not going to be all in one quarter. You know, it's going to bleed off over the next couple of years, kind of, every quarter. And it's going to be time with, you know, when customers are at a point where they have to renew or migrate their subscription that there will be a decision point. And so you're going to see it I think over the next six to eight quarters. Simon Leopold Thank you. Operator Ladies and gentlemen, this does conclude today's teleconference. Thank you for your participation. You may disconnect your lines at this time and have a wonderful day.