Good afternoon, everyone. I'm Samik Chatterjee. I cover the hardware and networking companies at J.P. Morgan. I have the pleasure of hosting F5 for the next fireside chat. With me here on the stage are François Locoh-Donou, the CEO, and Frank Pelzer, Chief Financial Officer. Thank you both for taking the time to attend the conference. François, I'll start off with you. And I'm asking most of my companies to make this sort of 12-month projection of what they think spending as well as their end markets look like 12 months from now. We all know where we are today with sort of the enterprise spending being a bit more challenged, but just give us how you're thinking about the next 12 months playing out. Where do you think we will be in terms of spending from enterprises?
Also, I know the other sort of customer verticals are less relevant, but how do you see them playing out over the next 12 months?
Thank you for having us, Samik. Before I begin, let me just, if you don't mind, quickly, read this safe harbor and put that on the record. Please note that our discussion today may contain forward-looking statements, which involve uncertainties and risks. Our actual results may differ materially from those expressed or implied by these statements. Please see our SEC filings for more information on these risk factors. Okay, so enterprise spending. So, you know, look, if I just compare... You're asking me about 12 months from now, I'm gonna start from 12 months ago. 12 months ago, you know, we saw spending obviously decrease significantly. All significant projects were curtailed.
There was a lot of surprises in our own customers and sponsors of projects, because at the last minute they thought a project was approved, and a CFO would come and say, "Actually, it's not approved anymore." If I compare it to where we are today, what we see is I would say two categories of customers today. A category that continues to be very frugal on spending, very cautious on their spend, and for the most part, looking to sweat their assets as much as they can. But we're also seeing a category of customers who have gone through that for the last 18 months and feel that they can no longer wait in their spending, and so they're moving forward with their project.
If you ask me about where we're gonna be 12 months from now, from now, I think we will have more customers move in the latter category of, you know, we can't wait, we have to spend, we have to extend capacity, we have to modernize our infrastructure, or we have to deal with new security threats. And so I think you will see spending steadily resume and move towards the second category. In the case of F5, we feel that we're going to be very well positioned as spending resume, because most enterprises, whether they're in my first or my second category, actually have growing complexity that they need to deal with, and that complexity is coming from their applications being deployed increasingly in hybrid and public cloud environments.
This hybrid multi-cloud environment creates a lot of need to connect apps together, to secure these apps together, and doing that today is dauntingly complex, and we've built a portfolio to make that a lot easier.
Got it. Okay. We definitely want to, as we sort of progress through this discussion, talk AI a bit, but before we get into the demand drivers from customers through AI, wanted to ask you more in terms of how you think about adopting AI internally in the organization. What are some of the improvements you can think of that it can bring, and what could be more tangible for investors to track on that front as well?
So we are rapidly moving to embed AI in a number of functions at F5. We do think there are potential productivity enhancements to come from AI. I would say the three areas where we are most focused today is one, at the front end of the business with our sales team, building propensity models that allow them to identify better which customers are likely to buy the next product. All matters of content development and helping them build more customized content development for customers faster with better productivity. The second area is in our engineering and research and development effort.
Anything from code development, an assistant to, to building code, to automating routine tasks or, or routine configurations, all of those are sources of potential productivity improvements in, in our R&D teams. And then third is in support. And so, for our customer services organization, helping them deliver content and knowledge, knowledge articles to our customers way faster, being able to customize their response way faster, and also being to Enabling them to support customers to self-serve a lot better than they have in the past. So all in all three areas, we see the potential for substantial productivity gains. We're early stages, but a number of these cases have now moved into production at scale in the organization.
Okay, got it. Moving to discussion on the business side now, you called it out in your strategy day earlier this year, what we had seen for a few years already, which is a lot of sentiment in relation to all the apps moving to the public cloud, which proved wrong, and you had correctly identified that even in presentations-
Mm-hmm.
In prior years. But did that really change the opportunity set for F5 in relation to application services? Like, what was... As that progressed with the enterprises and you're seeing enterprises really more invest on a hybrid infrastructure, how is that impacting the TAM that you think of for application services?
... Well, it's impacting us positively. If you recall, Sami, and I, we'll go back to the time that I joined F5 in 2017, I was hearing you know a lot from the industry and from some of our customers that were saying: "Look, I'm gonna move all my infrastructure that's in my data center, and all of that's gonna move into a single cloud. In that single cloud, I will have everything I need, native cloud services, security, better reliability, et cetera." When I look today at what has happened, for 99% of our customers, the reality is very different. We have today, close to 90% of our customers are in more than three cloud environments, and almost 40% of our customers are in more than six infrastructure environments, including multiple public clouds.
And so that hybrid multi-cloud reality creates a need for more application services. Things like securing APIs that connect, there's things for ADCs between clouds, things for, you know, networking applications together. All of these are new application services, and we have been positioning for that opportunity for the last several years. And so now we have a unique portfolio to be able to solve this challenge. We have given this challenge a name, as you know, we call it the ball of fire, which is all of the complexity that comes from this hybrid multi-cloud environment. And today, with the portfolio that we're built, we really are the only company that can secure, deliver, and optimize every application or every API, regardless of, which infrastructure environment it sits in.
Okay. The next question is going to be a bit more sort of background on what you just mentioned-
Mm-hmm.
—which is, just run through quickly how you've invested in the portfolio across all these sort of different points that enterprise is now looking to leverage, and how is that positioning F5 to succeed in this landscape where you're seeing enterprises run across hybrid, but including multiple cloud? Where... Since you joined in 2017, which are those exact sort of areas that you invested in, in terms of the portfolio?
So we, since 2017, we invested in three big areas. Number one, our ADC franchise, which historically was primarily a hardware franchise, we refactored the franchise both on technical capabilities and commercial terms, to ensure that it could perform very well in hybrid and multiple cloud environments. That's our BIG-IP franchise, and that was a big part of our transition to software. We then acquired NGINX. That allowed us to go into container-native environments and become the de facto networking and security ADC for these Kubernetes orchestrated environments.
And then third, we invested in security because we saw that increasingly the challenge for applications was application security, and so we bought several security companies, Shape Security, which is focused on bot detection and bot protection, Threat Stack against a threat for workloads in public clouds, and Volterra, that brought the foundation of a SaaS platform for F5. So with these investments in our core franchise, in container-native environments and in security, we have built this portfolio now, which can basically serve, protect, and secure any application, any API, in any environment. But we also now have built a portfolio that is unique in that it is hardware, software, and SaaS. And so all the capabilities of F5 can be delivered in any one of these form factors, which is pretty, pretty unique in the industry.
Can you discuss a bit more on the competitive dynamics then? When you run across these different points in your portfolio, who do you see as the primary competitors, and break them out maybe between who is more of a platform solution versus a point product role?
Well, I think. So it's interesting. If you look at hardware, software, and SaaS, in each of these three areas, I would say we generally compete with different providers. Certainly in hardware, software, there's a set of competitors in one hand, and SaaS, there's another set of competitors. Then if you look at our capabilities, whether it's API security, or bot, or web application firewalls, or ADC, in each of these categories, we have different point solution providers, you know, best-of-breed point solution providers in each of these categories. But where we are uniquely positioned, and really are unique, is in one, our ability to do all this in hardware, software, and SaaS. And for large enterprises, that matters, because large enterprises will have hundreds of thousands of applications.
For some of them, they prefer deployable products, hardware or software, so that they can turn the knob of the product on their own. For others, they would rather have a service and not have to deal with the lifecycle management of the service. But whether they use hardware, software, or SaaS, ideally, they want consistency of their services, consistency of security policies, consistency of application delivery, and our portfolio allows us to do that, and we're pretty uniquely positioned. The second, other than the consumption factors, which is hardware, software, and SaaS, if you go to platform capabilities, we have now built essentially a single platform that our customers can go to deliver and secure all of their apps and APIs.
That's also pretty unique in the capabilities that we have consolidated in a single platform, especially in application security and delivery.
Okay, so let's hit the mid-single-digit growth that you've guided to on a medium-term basis. Just break that down. How do you think about what we should expect for growth in virtual solutions, systems, and then how to think about Distributed Cloud as well contributing to it?
Yeah, Sam, why don't I take that one? First of all, let's just talk about the three different areas of our total revenue. First, you've got global services, which is roughly about 50%, and then you've got our product revenue, the other 50%, split between systems and software. So first, on global services, we've talked about over a long period of time, we expect that to be flat to low single-digit growth. A lot of those drivers are really just shifts that are happening between perpetual and term and managed service. So, it's healthy, but stable as we would expect, and that's what we've talked about for this year.
The other 50% coming from our product revenue, systems, over a longer period of time, on a unit basis, we've talked about that being probably mid-single-digit decline. There are some offsets potentially to that on a revenue basis, that could be, things we do in pricing, things we do with competitive wins, other factors, that will, hopefully allow us to be better than that. But on a unit basis, that's always been part of our mindset, is that, it's in probably the mid-single digit, declining basis. Then on the software pieces, you know, a couple of different factors to take into place there. First, you've got, perpetual, that is roughly, you know, $100 million-$120 million, not growing a lot.
We've got our term base, which has got a large set of renewals activity, and when we talk about renewals, we also put expansion in that base of revenue. And then finally, we have our SaaS and managed service. And each of those have different growth rates, but overall, what we said is, this year it's going to be, you know, roughly flat to modestly up. So far in the first half of the year, we've done better than that. Given the first half results, we'd be disappointed if we ended up in that range, but we talked about that going to double-digit growth in FY 2025, really largely off the back of the renewal base that we see.
So, this year, in particular, in total revenue, we have a headwind of about $180 million coming from the improvement in backlog for deals that were sold in FY 2022, recognized in 2023. From a booking standpoint, we're actually growing. We're just not seeing that in revenue this year, but we do expect to get to mid-single-digit growth next year.
Okay. Let's talk about security bit and how important it is as part of the broader application services, provided by F5. How do you think about the opportunity to expand F5's position in the security market with the offering as part of the broader platform? And what are F5's growth expectations from security standalone?
Well, security has grown faster than our overall portfolio, and our expectation is that it's gonna continue to grow faster than total revenue. Specifically in security, we've made a choice to be narrow in the sense that we have focused on application security exclusively, and have not gone into other security markets. We've made that choice to be narrow because we believe that application and API security is going to be a big challenge over the next decade as applications proliferate, as APIs continue to proliferate, and as more and more applications get distributed. And we think that AI is going to accelerate the distribution of workloads, the distribution of applications, and is potentially going to make the use of APIs explode.
And so we have focused on application and API security, but within that segment of security, we have gone deep, meaning we, you know, we offer web application firewalls, protection against DDoS attacks, of course, securing and APIs, but not just securing them, discovering all APIs, testing APIs, cataloging the vulnerabilities, and of course, we offer bot defense, in leveraging our own AI to do that. So when you look at our application security portfolio, it's pretty deep. It's consolidated on a single platform, and we expect that to continue to grow faster than the business across the form factors of software, SaaS, and hardware.
Okay. Okay. A similar question, but just trying to think about what you're seeing for demand for application services, how tied it is to public cloud growth. How are enterprises leveraging F5 solution as well on the public cloud? If you can just provide us a bit more sort of deep dive into what you see enterprises doing, and how we should think it's tied to the public cloud revenue growth that we see as well.
So if you look at the last several years, you know, when we, we really started, customers really started to use F5 in the public cloud, I think was in the 2017, 2018 time frames. And at the time, it was customers kind of lifting and shifting applications and using the virtual editions of BIG-IP to put applications in a single cloud, or starting in 2019, using NGINX, you know, in a single public cloud environment. Increasingly, what we are seeing is more customers are in multi-cloud, hybrid and multi-cloud environments, and they need to secure or deliver applications in multiple cloud environments and on-prem at the same time. And they're now using us increasingly to provide consistency across all these environments.
And they can do that with our software, they can do that with our SaaS offering. But that's why we've put so much focus on building this distributed, application security and delivery platform. It's to enable customers to secure and deliver all their apps across all these cloud environments, and we think that's going to accelerate with AI because workloads are gonna be more distributed.
Okay. Okay, you outlined a $34 billion TAM in 2028, comprising deployable products as well as SaaS. I think the individual growth rates that you gave, deployable TAM growing at 10%, SaaS TAM growing at 20% CAGR. Obviously, if you take a blended of that, it would imply your mid-single-digit growth, you're almost implying you underperform the two individual markets. Just flesh that out a bit more, and how do you think about F5's positioning in each of those areas as well?
Yeah, absolutely, Samik. So look, you're absolutely right. In February, we talked about updated our TAM outlook, and deployable was $11 billion growing to $16 billion, 10% CAGR. SaaS was $5 billion growing to $18 billion, and 26% CAGR. So, you know, you can take a look, and our outlook for 2024 has been, you know, on a normalized basis, probably mid-single-digit growth, if you take into account the backlog improvement that we had last year, and we're also talking about that for FY 2025.
And so you would naturally say: "Okay, why aren't you in that growth rate for your TAM?" Well, in the deployable, which is more where most of our revenue is coming from today, particularly when you're taking services into account, the portion of that market that the majority of our revenues have come from in the past and still represent today, are probably flat to low single-digit growth, and that's in the ADC hardware as well as software space. And so, it is why we have been investing in these other models, particularly SaaS and managed service, that have got a much higher growth rate associated with that.
And I think over time, you will see that overtake, you know, the deployable piece, but it will take time, just given the base of legacy revenue that we've got today.
Okay. So just so that I understand it, then the way to think about this is you will not outperform the 10% CAGR for deployable products, but you'll hopefully outperform this—you'll hopefully outperform the SaaS market CAGR of 20%.
Over time, even on the deployable side, if more comes from the security piece of the business, then we have the opportunity to. But where we sit today and what we're expecting for FY 25, no, we will. There's just too much revenue to overcome in terms of the maintenance piece, as well as the deployable pieces within our business that's tied to ADC.
Got it. Any need for M&A to be able to fully leverage this $34 billion TAM opportunity? When you think about the portfolio, do you see any need for more M&A?
No. So, let me just... On the, you know, fully participating in this $34 billion TAM in hardware, software, and SaaS, we've got the products in the portfolio today to do that. A big part of the work there is to continue the integrations between our product lines, to continue to build out this single platform that allows customers to secure, deliver, and optimize apps and APIs across all environments. And that gives us a strong opportunity to participate in that, so we don't need M&A for that vision.
However, we, you know, we may see opportunities down the road, in areas that are of interest to us and are additive to our portfolio, specifically in security, that are additive to what we're doing and potentially could, you know, continue to drive our growth and in any of these form factors, but specifically in SaaS.
Okay. The Distributed Dloud services offering, most of the customer feedback we've seen has been positive. What are you finding out in terms of what's the point of differentiation that is appealing to them, and how do you sort of expect that differentiation to keep building on itself? Like, how do you keep that from competitors really taking over, coming and sort of copying that product?
Well, so if I look at just the standalone capability of Distributed Cloud, a couple of big differentiators. Number one is in security. We have a full stack of application security in Distributed Cloud, ranging from DDoS to bot to web application firewall to securing APIs. And in API security, in particular, we have a full end-to-end solution from discovery of APIs, all APIs, all the way to protection of these APIs. So that's a big... And I would say, the vast majority, close to 100% of Distributed Cloud customers, actually use our security in Distributed Cloud. The second big differentiator is the ability to automate the networking of applications together across cloud environments.
And when I say application-to-application networking, it isn't just layer three networking. It's also layer 4- 7 networking, which is where most of the complexity is. And so our ability to help customers do cloud migration and automate the process of cloud migration is a big differentiator for F5. That's on, you know, F5 Aistributed Cloud as a standalone value proposition. Where the differentiation will continue to grow is as more synergies are being built across the portfolio, such that, for example, BIG-IP customers can go to Distributed Cloud to visualize their BIG-IP estate and see the performance of their applications or can go to Distributed Cloud to push new policies to their BIG-IP environment. Same with NGINX customers.
The more these synergies grow, the more the cross-sell opportunity for F5, from existing customers to new, new products, is going to grow and is gonna grow the stickiness and differentiation of the whole platform.
... Yep. I'm going to sort of give you a longer-term question here, which is: since you joined over the last five, six years, you have been transforming the portfolio and the company from where it was, where it was a much more hardware-centric company. When you think sort of five years out, what do you envision sort of the company looking like in terms of both sort of relevance with enterprises as well as the mix between hardware, so software, SaaS? How do you envision that looking?
Look, we've. You know, I think we've made unprecedented progress in terms of expanding our portfolio and diversifying our consumption models. You know, in Q2 that we just reported, software revenue represented 53% of total product revenue. Five years ago, in the same quarter, it was 19%. So massive, massive growth in diversifying, you know, where that source is, particularly away from systems. In five years, I think we'd expect the vast majority of our product revenue to come from software, and so we're on track to making that happen. Also, in Q2, 75% of our product was from recurring sources. That includes the subscription revenue as well as the maintenance portion of our services revenue, and so all of these things are moving in the right direction.
In terms of software, we do offer it in three different models. We offer it as a perpetual model, we offer it as a term subscription, and we offer it as SaaS-managed services. And so, right now, the SaaS-managed service piece is, you know, one of the smaller components of that total revenue. Over time, we expect that to actually become the majority of that revenue. But it will take time. It's a ratable model, and it takes time to build up.
Okay, to that point, though, just following up, perpetual, like, when we think about software subscription, it's still the majority of your software revenue today.
Yep.
And yet, what we've generally seen is the predictability of the perpetual piece and the subscription piece has been a bit more challenging to do, at least on the investor side, right? And that's led to some concerns about the quarterly volatility in those numbers. How do you think about that? Any way to address it as you sort of look forward? How would you sort of generally sort of reassure investors there's nothing other than sort of just lumpiness of a business going through those numbers?
Yeah, look, so we do win deals, because we offer flexibility in how a customer can consume. And sometimes that flexibility to customers comes with a level of unpredictability, from a revenue base to customers, particularly in a subscription model that they are used to. But it's important from our perspective, to put the customers as the first primary focus of the company. And so, right now, you know, perpetual is in that $100 million-$120 million a year piece. Term out of the software base is the majority of that revenue, because of the conversion to 606 that we had to do in 2018. It is spiky.
It is predictable over a period of time, but it will be spiky in one given quarter, and it's why we don't really try to predict revenue in one quarter over quarter for the mix between systems and software. We give people the option in how they wanna consume. As I just mentioned, though, over time, as the ratable piece of our Distributed Cloud becomes more and more of a contributor, it will start to even out, smoothen out, but it's gonna take time for that to happen.
Okay. You have guided, though, to an uptick in subscription renewals in Q4 this year. What's driving the confidence there?
It's really the renewal base of what we see and the activities that are happening right now that lead to that. That visibility of what we see is, you know, what is a substantial step up between Q3 and Q4 in terms of total revenue. But it's the subscription piece associated with the term-based revenue and the growth that we've seen in the, in those contractual relationships that gives us that confidence. In all of our different revenue streams, even in tough macro times that we've experienced over the last couple of years, that actually has been the most predictable.
Okay. I have two more before we wrap up. You're on track to manage the business to mid-single revenue growth, which you've talked about, but also 35% operating margin. Typically, when you think about the Rule of 40, is that what we should consider the North Star for the company in terms of how you operate going forward? Is that what you're trying to balance between sort of revenue growth and margins, even as we think of your investment sort of priorities going forward?
Do you wanna... You want me to-
Well, I think, yes, the rule, you know, the... We have said the Rule of 40 was going to be a, you know, a way for us to manage the balance between operating margins and growth. We were there in, you know, in 2021. We went through the crisis in 2022, supply chain, then macro. We're intending to return to it in 2024. But if you think about it going forward, the double- We've committed to double-digit earnings growth on a consistent basis, and that really is the, you know, the commitment that we have to drive earnings growth. You know, do we have aspirations to do better than that? Absolutely.
You know, and we've, we're making a number of investments in, in the portfolio, in our go-to-market, to be able to drive, to drive better than that over time. But our, our commitment is to drive double-digit earnings growth, on a CAGR basis, and we've, you know, we've, we've done that last year. You know, we've said we would do that on a pre-tax basis here this year, and next year as well as part of our guidance.
... Yeah, interesting. So a good segue to when you think about double-digit EPS growth being what you've committed to, how does the $1 billion of cash on the balance sheet play into that? How do you think about excess cash? Why not sort of reaccelerate repurchases to essentially just accelerate what you get to in terms of EPS growth as well?
Sure. So the combination, and how we achieve double-digit EPS growth on a compounding annual growth basis is a combination of the revenue growth, the operating margin leverage that we're trying to achieve, as well as share repurchase. And we were fairly consistent on about $150 million a quarter for years. And then, when François came in the business, I came in a year later, we saw that there was some tech debt that we had, particularly as we were looking at being able to address any application anywhere, where it may exist.
We did not have the technology in order to do that at the time, and we knew to be a long-term business, we needed to acquire our way into some of those markets, and did that through three large acquisitions and several much smaller acquisitions. So, you know, we think that... I would say after the Volterra acquisition, where we had paused on share repurchase for a couple of years, we put a program back in place where we said we were gonna do $500 million, $500 million for FY 2021 and 2022, and then starting in 2023, it was gonna be 50% of our free cash flow. We've lived up to that commitment, and I think, you know, in the last three years, we've repurchased $1.4 billion.
And just, you know, so far, year to date, we're at 68% of our free cash flow that's been used toward share repurchase. So that is very much part of our strategy, is balancing opportunities that we may see in an inorganic basis, with the return of capital through share repurchase, which we think is the most tax-efficient way of doing it.
I mean, just to follow up on that, even if you're returning 68% of free cash flow, that leaves you with dry powder, which I'm imagining you're keeping the dry powder either for potential M&A or certain other opportunities. When do you get to... As cash builds on the balance sheet, when do you get to a point where you say, "This is excess relative to what we even need," considering the operations plus the need for M&A, given that there's only a certain size of M&A we go after?
Yes. So there are a couple of things there, Samik. So one, there is a portion of working capital on a global basis that we need to... Not all of the capital close to, I think, $900 million that we had at the end of this quarter is available to us on a domestic purpose. And so we've tried to be efficient in a tax-advantaged way as we could to not have repatriation tax cost in using any of that capital. And so, we've looked at... When I say 50% of free cash flow, it's a much higher percentage of our domestic cash available for share repurchase that we do use.
Okay, got it. We're getting up close to time here, so I'll wrap it up there. Thank you for coming to the conference, and thank you to the audience as well. Thank you.
Thank you.
Thanks so much.
Thank you, Samik.