F5 Inc. is hosting a Third Quarter Fiscal 2023 Financial Results Conference Call. During the call, 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 make prepared remarks and answer questions during the Q&A session. A copy of today's press release and the slide deck accompanying the discussion are available on the F5 website, and a replay of the webcast can be accessed by phone. The call contains forward-looking statements, and non-GAAP metrics will be referenced.

F5 reported third quarter revenue at the midpoint of their guidance range and earnings per share well above the high-end of their range. Despite customers continuing to exercise caution with tight budgets and lingering macroeconomic uncertainty, F5's global services team experienced 8% growth due to strong maintenance renewals and price realization. Systems revenue grew 5%, while software revenue declined 3% year-over-year, but grew 32% sequentially.

F5 Networks reported record high subscription software revenue of $152 million, which was a 4% year-over-year growth. The company also demonstrated operating discipline and drove operating leverage, with non-GAAP gross margins of 82.5% and non-GAAP operating margins of 33.2% both improving significantly from the previous quarter. F5 Networks also expects to deliver double-digit non-GAAP earnings per share growth for FY 2023. The company's BIG-IP family continues to take share from competitors, with its rSeries and VELOS platforms representing more than 70% of Q3 systems bookings.

F5 Distributed Cloud Services is a portfolio of SaaS and managed services that has been expanding their offerings and building momentum for multiple security use cases. In the quarter, BIG-IP's data point performance, automation capabilities and lower total cost of ownership drove multiple wins, including a multi-million dollar term-based subscription renewal that grew by 10x. F5 NGINX was also in strong demand for cloud and Kubernetes workloads. A global financial services industry application provider also used F5 Distributed Cloud Services to standardize its web application firewall and API protection policies and deployments, reducing their time to delivery from months to minutes.

F5 distributed cloud services are showing encouraging signs in the markets for API security and multi-cloud networking. Their API security service offers robust API discovery and protection capabilities, which allowed a North American service provider to quickly respond to a cyber security incident. F5's secure multi-cloud networking solutions are also gaining traction, as they are able to package networking, security, and distribution of applications and APIs in a way that has not been done before. This helps to reduce operational complexity, network latency, and weak security.

F5's multi-cloud networking solutions reduce operational complexity and enable customers to securely connect distributed networks and applications across public clouds, on-premises data centers, and edge locations. One customer was able to move their workloads to the public cloud in two weeks with F5's Distributed Cloud WAP. They have since standardized on F5's Distributed Cloud for their secure multi-cloud networking needs, and F5 is well-positioned to benefit when customer spending patterns return to normal.

In Q3, F5 Networks reported revenue of $703 million, with global services representing 53% of total revenue. Global services revenue grew 8%, due to maintenance renewals and price increases, while product revenue grew 1%. Systems revenue grew 5%, and software revenue decreased 3%. Subscription base revenue was a new high, totaling $152 million and making up 87% of software revenue. Perpetual license sales totaled $22 million, making up the remaining 13%. Recurring revenue contributed 75% of Q3's revenue, a new all-time high.

In Q3, revenue from Americas grew 3%, EMEA grew 16%, and APAC declined 6%. Enterprise customers represented 66% of product bookings, service providers represented 13%, and government customers represented 21%, including 8% from U.S. Federal. GAAP gross margin was 79.8% and non-GAAP gross margin was 82.5%. GAAP operating expenses were $457 million and non-GAAP operating expenses were $346 million. GAAP operating margin was 14.7% and non-GAAP operating margin was 33.2%. GAAP net income was $89 million and non-GAAP net income was $194 million. Cash flow from operations was $165 million and capital expenditures were $15 million.

In the third quarter, DSO decreased from 62 days to 56 days, cash and investments totaled $696 million, and deferred revenue increased 9% year-over-year to $1.79 billion. The company also repurchased $250 million worth of shares and reduced headcount. For the fourth quarter, they expect revenue between $690 million and $710 million with gross margins of 83%, operating expenses between $338 million and $350 million, a non-GAAP earnings of $3.15 to $3.27 per share, and share-based compensation expense of $55 million to $57 million. They also plan to use at least 50% of their annual free cash flow towards share repurchases.

In this paragraph, Francois Locoh-Donou explains that the true forward portion of renewals performed below expectations this year, but there are signs of demand stabilizing. He encourages listeners to take away three key points from the call: that demand is stabilizing, the portfolio of solutions is well-aligned with application architectures, and the company is delivering on its operating discipline. He then opens the call for questions.

The quarter saw an increase in demand compared to the first two quarters of the year, but it was still lower than pre-pandemic levels. Customers continue to be cautious with their spending, delaying or pushing out deals and looking to spend as little as possible. However, the demand did not worsen this quarter and appears to have stabilized, suggesting that the worst may be over.

Francois commented on the stabilization of demand, noting that while systems revenue declined significantly in the quarter, the backlog suggests that it is a more normalized mix based on the macro environment. He suggested that if the macro remains the same, the annualized revenue should be around $700 million or $2.8 billion.

Francois Locoh-Donou explains that demand has stabilized since the beginning of the year, but hardware demand has been soft due to the macro environment and customers needing to digest shipments. The backlog has decreased significantly, and demand for hardware is expected to be even lower in Q4. In the long term, demand is expected to return in 2024, but it is too early to tell when exactly that will happen.

Francois Locoh-Donou explains that F5 Networks is using AI to increase productivity and double-digit earnings growth. They have also used AI in their security products, such as Shape Security, to profile application traffic. Going forward, they plan to enhance these capabilities with new machine-learning models.

F5 is expecting to move more towards AI-enabled security and has access to a lot of data from 40% of the world's websites. They will also see opportunities in new workloads that are API-first and distributed, leading to an opportunity in API and API security. Prior to the pandemic, F5's systems revenue was in the range of $170-180 million per quarter.

Francois Locoh-Donou explains that the trajectory of the hardware in terms of the number of units should be declining in the mid-single digit percentage, and this is seen in the long-term trend of the number of hardware units deployed. He adds that F5 provides customers with flexibility to have applications funded by hardware in their private data centers and other applications supported by software or SaaS.

Frank Pelzer explains that customers value consistency and flexibility when it comes to delivery and security policies, and that the company intends to continue to drive earnings growth through this approach. He notes that the software trajectory will be volatile but that, as the SaaS business grows, this volatility will decrease and more metrics will be available to provide forward-looking data points.

Francois Locoh- gave an overview of the demand for their products, with hardware being the softest in the ADC space. Security products have been more resilient, while NGINX and the distributed cloud opportunity have seen strong growth. Expansion opportunities and net retention rates have been strong in the first half of the year.

Francois Locoh-Donou explains that the majority of their software revenue is still from term-based subscription, but net retention rates have been strong. New business activity was challenged in the quarter, but still in line with revised expectations. Meta Marshall then asks if there is any difference in the mix of customers opting for virtual editions versus hybrid cloud, and if there are any share gain opportunities.

Francois Locoh-Donou explains that the company was pleased to see some of the bigger software deals that they had anticipated come through, and that hardware shipments had returned to normal lead times. He also states that the company is gaining share in the traditional ADC market due to investments in next-generation platforms and software, and the flexibility of the model they are delivering. Over 70% of hardware shipments were on the new rSeries platform, which has seen a strong adoption rate.

F5 has seen a rapid adoption of their new platforms and software, which has allowed them to take market share from their competitors in the ADC space. They are also aggressively attacking the WAF market with their distributed cloud offering, which is differentiated in API security and bot defense. F5 is seeing growth in these areas and is expecting to continue to gain share in the coming quarters. Alexander Henderson's question is about the systems business, which saw a steep decline last year due to supply chain issues. F5 is now up low-single digits and they suggest that the backlog has been resolved, which does not imply a strong 6-8% headwind going forward.

Frank Pelzer discussed the 6-8% headwind on the hardware side of the business due to lower demand in FY'23, and said that it is uncertain when that will change in FY'24. On the software side, the comps have gotten easier with declines in the September quarter last year, and there is potential for revenue growth in the future. Renewals have been challenging so far, but that is likely to change.

Francois Locoh-Donou and Frank stated that while demand for hardware is expected to be higher in FY '24 than this year, the 6-8 point headwind on total revenue will challenge growth. They clarified that the headwind is due to shipments of backlog, not demand, and they are not yet ready to guide for 2024. However, they remain committed to double-digit earnings growth.

Frank Pelzer reported that while new business activity was still down from the year before, there had been an improvement and the irrationality of buying behavior had decreased. He also mentioned that the gross margin had improved due to the price increases, and that operating margins had increased by 600 basis points. He expressed confidence in the software business and in achieving double-digit earnings growth.

Frank Pelzer and Francois Locoh-Donou discussed their expectations for double-digit earnings growth for fiscal '24 and 300 basis points of margin expansion in FY '24. They are pleased with the progress they have made, particularly in gross and operating margins. They expect operating margins in 2024 to be around 33%.

F5 is differentiating itself in the API security and multi-cloud networking markets by having the capabilities to both discover and protect against API attacks. This is an emerging market, and customers are increasingly using multiple clouds. F5's ability to detect threats and mitigate attacks gives them a competitive advantage over players that do not have the same capabilities.

F5 is the only company that can provide secure application and API connections across multiple cloud environments. This is an exciting market opportunity for the company, as enterprises need not just Layer 3-4 networking, but also Layer 7 security to connect applications and APIs securely across clouds. F5 has integrated Shape, Treadstack, Volterra, and BIG-IP capabilities to provide this service.

This summary was generated with AI and may contain some inaccuracies.