Good afternoon, and welcome to the F5, Inc. Q3 Fiscal 2022 Financial Results Conference Call. At this time, all participants' lines have been placed on mute to prevent any background noise. Following the presentation, we will conduct a question and answer session, and instructions on how to queue up will be provided at that time. As a note, today's conference call is being recorded. If anyone has any objections, please disconnect at this time. I would now like to turn the call over to Ms. Suzanne DuLong. Ma'am, you may begin.
Hello and welcome. I am Suzanne DuLong, F5 Vice President of Investor Relations. François Locoh-Donou, F5 President and CEO, and Frank Pelzer, F5 Executive Vice President and CFO, will be making prepared remarks on today's call. Other members of the F5 executive team are also on hand to answer questions during the Q&A session. A copy of today's press release is available on our website at f5.com, where an archived version of today's audio will be available through October 24, 2022. Visuals accompanying today's discussion are viewable on the webcast and will be posted to our IR site at the conclusion of the call. To access the replay of today's call by phone, dial 888-674-7070 or 416-764-8692 and use meeting ID 468081.
The telephonic replay will be available through midnight Pacific Time, July twenty-sixth, two thousand and twenty-two. 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 to target. These forward-looking statements involve uncertainties and risks that may cause our actual results to differ materially from those expressed or implied by these statements. Factors that may affect our results are summarized in the press release announcing our financial results and described in detail in our SEC filings. Please note that F5 has no duty to update any information presented in this call. With that, I will turn the call over to François.
Thank you, Suzanne, and hello everyone. Thank you for joining us today. In Q3, we delivered above the midpoint of our revenue guidance and well above the top end of our non-GAAP EPS guidance. Software growth of 38% drove 4% revenue growth year-over-year, partially offsetting continued supply chain constraints for systems. Overall, we delivered 5% product revenue growth. While supply chain challenges continue to limit our ability to ship systems, our demand signals remain strong and we remain ahead of our initial FY 2022 demand plan. While we have not seen meaningful improvement in supply volumes in the last three months, we also have not seen further deterioration. In general, our suppliers commitments held up better in Q3 than in the previous two quarters.
Based on what we see today, we continue to expect our ability to ship systems will improve during our Q2 of fiscal 2023 as a result of our efforts to design out the most constrained components and the additional capacity our key suppliers expect beginning in the last calendar quarter of 2022. We likewise continue to expect that fiscal Q1 2023 will be the low point in systems revenue. We continue to see our growth opportunity fundamentally tied to applications to the growing number of apps, as well as increased usage and heightened business value. In Q3, we saw strong demand as customers added, scaled, and secured their applications with demand for security and from our service provider vertical fueling sales in the quarter.
In fact, security concerns continue to drive the majority of our customer engagement, with demand showing up in both software and hardware form factors and across multiple consumption models. In one example from Q3, an existing BIG-IP hardware customer and one of the world's largest banking and financial services organizations turned to F5 when a Log4j incident revealed other vendor solutions were insufficiently protecting against zero-day threats. As a strategic partner, F5 demonstrated that our advanced web application firewall provided immediate protection against current and future vulnerabilities. Also during Q3, a large global retailer turned to F5 after experiencing challenges with their existing bot defense provider. Over a head-to-head three-month proof of concept against their current solution, our Distributed Cloud Bot Defense demonstrated significantly higher efficacy, and the customer is now deploying F5 to protect their apps and their customers.
We have said previously that our customers are increasingly operating both traditional and modern architectures and looking to F5 to unite their strategies and simplify their operations. In the latest example of this trend, during Q3, an American multinational financial services corporation selected a combination of BIG-IP and NGINX to secure and process their high volume of critical encrypted transactions globally. Last quarter, I also spotlighted our new SaaS offering, F5 Distributed Cloud Services, which we launched in February. With this platform, we are delivering security, multi-cloud networking, and edge-based computing solutions on a unified software as a service platform. While it is still very early, we are seeing good traction and customer interest.
During Q3, a global company specializing in clinical services and customizable medical devices selected our web application firewall and API protection solution to ensure rapid deployment of their security policy at scale and to provide global delivery of services in a hybrid multi-region support model, all via SaaS. Finally, service providers drove demand in the quarter as customers scale and secure 4G cores and begin to move 5G cores into production. In one win in the quarter, we expanded our carrier-grade firewall business with a North American service provider as they continue to grow both their 4G and 5G traffic. In another service provider win, we expanded our offerings with an APAC-based customer to include BIG-IP Cloud-Native Network Functions for its 5G mobile core. These recently introduced cloud-native functions are perfect for moving workloads from legacy VNF to a modern cloud-native architecture.
Cloud-native functions enable service providers and large enterprises to realize the full benefit of the cloud, automating and simplifying their operations with a more secure, more scalable network. Before I turn the call to Frank to review our Q3 results and our Q4 outlook, I will comment on the macro environment. As I said previously, we saw strong demand in Q3, and we've got a strong Q4 pipeline. At the same time, we also observed more back-end linearity in Q3, and our sales teams have noted some instances where more approvals were required to close deals. While we are not seeing it today, we believe the combination of macro uncertainty and inflation will put pressure on customer budgets and eventually force customers to reprioritize investments.
We will continue to closely monitor signals from our customers, and like others, we are assessing adjustments we would make in the event that the environment or our customers turn more cautious. We have built a stronger and more resilient F5 by expanding our solutions portfolio and our consumption models. As a result of our business transformation, F5 is positioned to benefit both from software growth drivers, including BIG-IP, NGINX, and our F5 Distributed Cloud Services SaaS offerings, and what we expect will be persistent demand for systems. As a result of our successful transformation efforts to date, we have a stronger business model that increases our confidence in our ability to deliver sustained revenue and earnings growth. Now, I will turn the call to Frank. Frank?
Thank you, François, and good afternoon, everyone. I will review our Q3 results before discussing our Q4 outlook. We delivered Q3 revenue of $674 million, reflecting a 4% growth year-over-year with 5% product growth. Product revenue represented 48% of total revenue in the quarter, and software represented 55% of product revenue. This is the Q2 in a row where the majority of our product revenue has come from software. Q3 software revenue grew 38% to $179 million. Systems revenue of $148 million declined 18% year-over-year due to ongoing supply chain challenges and resulting shipment delays. Similar to Q2, we added systems backlog of tens of millions of dollars in Q3.
Rounding out our revenue picture, global services delivered $348 million in Q3 revenue, up 2% from the prior year. Taking a closer look at our software revenue, subscription-based revenue contributed 82% of total software revenue in the quarter, a new high. Term-based subscriptions continued to represent over half of our subscription revenue, with smaller but growing contributions from software-as-a-service and utility consumption models. Revenue from recurring sources, which includes term subscriptions, software-as-a-service, and utility-based revenue, as well as the maintenance portion of our services revenue, totaled 72% of revenue in the quarter. This is another milestone for us and is up from 66% in the year-ago period. On a regional basis, Americas delivered 5% revenue growth year-over-year, representing 57% of total revenue.
EMEA declined 7%, representing 23% of revenue, and APAC grew 15%, representing 19% of revenue. I will remind you that given current supply chain constraints, our geographic revenue distribution in a quarter is not fully indicative of demand for each given region. Enterprise customers represented 70% of product bookings in the quarter, service providers represented 18%, and government customers represented 12%, including 3% from U.S. federal. I will now share our Q3 operating results. GAAP gross margin was 80.6%. non-GAAP gross margin was above our guide at 83.2%. While we continue to experience increased component prices, expedite fees, and other sourcing-related costs, our Q3 gross margin reflects some improvement in average selling price on systems in the quarter. We are not ready to say it's a trend, but we are encouraged about the overall direction.
GAAP operating expenses were $436 million. Non-GAAP operating expenses were $367 million. This is lower than our guided range as a result of some investments we delayed in anticipation of potential macro headwinds that did not materialize in the quarter and lower international expenses related to the strengthening dollar. Our GAAP operating margin was 15.9%. Our non-GAAP operating margin was 28.8%. Our GAAP effective tax rate for the quarter was 18%. Our non-GAAP effective tax rate was 17.4%, largely driven by a non-recurring benefit associated with the filing of our federal income tax return during the quarter. GAAP net income for the quarter was $83 million or $1.37 per share.
Our better than guided gross and operating margin performance and lower tax rate contributed to non-GAAP net income of $155 million or $2.57 per share. I will now turn to cash flow and the balance sheet. We generated $71 million in cash flow from operations in Q3. This is net of more than $30 million of payments to partners related to securing component inventory to support future hardware builds and component expedite fees. Capital expenditures for the quarter were $9 million. DSO for the quarter was 61 days. Similar to last quarter, this is up from historical levels due to back-ended shipping linearity in the quarter resulting from ongoing supply chain challenges. Cash and investments totaled approximately $757 million at quarter end.
During the quarter, we repurchased approximately $250 million worth of F5 shares or approximately 1.5 million shares at an average price of $171 per share. Deferred revenue increased 14% year-over-year to $1.64 billion, up from $1.60 billion in Q2, largely driven by subscriptions and SaaS bookings growth and to a lesser extent, deferred service maintenance. Finally, we ended the quarter with approximately 6,900 employees. I will now share our outlook for the Q4 . Unless otherwise stated, please note that my guidance comments reference non-GAAP metrics. We expect Q4 revenue in the range of $680 million-$700 million. Our pipeline indicates Q4 demand that would put our software revenue growth towards the high end of our 35%-40% target for the year.
As François discussed, however, we are very cognizant of the broader, more cautious environment, and as a result, we see more risk at the top end of our software growth range than there was a quarter ago. Given the Q3 strength in global services, we now expect global services revenue to grow approximately 1.5%-2% for the year. We expect Q4 gross margins in a range of 82%-83%. We are seeing component costs continue to rise and expect that they will be higher still next year. As a result, we implemented an approximately 15% price increase in systems effective July 1. Given our backlog, we expect it will take some quarters for the price increase to manifest into sustainable gross margin improvements.
We estimate Q4 operating expenses of $374 million-$386 million, which would put our FY 2022 operating margin at approximately 29%, an improvement of 100-200 basis points from our prior outlook. Factoring in the tax rate benefit from Q3, we now expect FY 2022 effective tax rate will be approximately 19%. Our Q4 earnings target is $2.45-$2.57 per share. We expect Q4 share-based compensation expense of approximately $61 million-$63 million.
Finally, as we announced in the earnings press release, our board authorized an additional $1 billion for our share repurchase program. This new authorization is incremental to the $272 million remaining in the existing program. As we have over the last two years, we expect to continue to balance share repurchases with other strategic uses of cash. This concludes our prepared remarks today. Operator, would you please open the call to Q&A?
Thank you, sir. Ladies and gentlemen, we will now begin the question and answer session. If you would like to ask a question, please press star followed by the number one on your telephone keypad. If you would like to withdraw your question, please press star followed by the number two. Please stand by while we compile the Q&A roster. Your first question comes from Sami Badri of Credit Suisse. Please go ahead.
Hi. Thank you for the question. First thing I wanted to just clarify was, I think there was a reference to the backlog increasing, it or at least, you know, adding more revenues to the backlog. Could you clarify if the backlog exiting fiscal 3Q is actually higher than where it was exiting fiscal 2Q 2022? That's my first question. The second question is there's a lot of interest in the investor base around the software growth trajectory of the business. I know you guys discussed coming in at the higher end of the range in fiscal year 2022, but could you characterize or give us indication on what fiscal year 2023 is going to look like just because, the growth rates are rather significant?
Sami, I'll take the first question, then I'll let François speak to your second question. Yes, the backlog was higher and significantly higher in Q3 than it was in exiting Q2. We did not quantify that. We talked about that we would do that at the end of the fiscal year. We'll actually release the number as part of the October call, and you'll see it in the K.
Sami, I'll take the second part of your question. You know, obviously this is not a time where we're guiding for fiscal 2023. You know, overall, if you look at our the performance of the business in software, you know, we guided 35%-40% at our investor meeting about almost two years ago now in November 2020. You know, we have delivered that in the first year in 2021. This year, you know, we're delivering closer to the top end of the range of that guidance.
We feel very, very good about the drivers of software growth in the business that we talked about, including modern applications, the strength we're seeing in security, and, you know, the adoption of multiyear agreements with F5 driven by digital transformations and automation. We'll talk more about software growth for 2023 in October. When you look at 2023, frankly, the factors, I think some of the factors that will affect that, one, of course, like every other company, is the macro environment and will that have you know, an effect on our growth rate?
You know, today, frankly, it's too early to say because we haven't seen a fundamental change in the buying behaviors of our customers across the globe based on the macro at this point. I think the other factors will be, you know, through the pandemic, Sami, and this is specific, I would say to the BIG-IP part of our business. We have seen continued demand for hardware, and we have seen a number of customers that had declared that they would move to software pretty quickly that have actually recommitted to hardware and stayed with hardware longer. We're seeing very strong resilience and strong demand in hardware, you know, sometimes at the expense of customers that would have moved to software.
If that kind of mix shift will, if you will, continue in 2023, that may affect our software growth rate some, but it wouldn't affect the top line because it would be more of a mix shift factor if we continue to see that shift in customer behavior.
Got it. Thank you for that color. I just wanted to follow up on specifically service providers, 'cause that came up a couple times on this call. Could you just give us some more specifics to what exactly the inflection is at this point for why service provider customers are relying more heavily, you know, what specifically are they seeing in the F5 portfolio that's most helpful or the right solution for them? Could you give us just specifics on, you know, a little bit more detail on what's going on, maybe even type of service provider?
I think, Sami, there are two dynamics to that. Our service provider business is doing very well, and it's the result of kinda two series of investments that are intercepting, I think, the market at the right time. On the software side, we have invested, you know, heavily in cloud-native functions that allow service providers who want to build 5G cores to evolve to these more cloud-native environments and be able to do that with us. We have now a number of design wins in this area that are starting to go into production. This quarter, we had more of these going into production, and so it's turning into revenue.
Our expectation is that will continue, but we feel well positioned for the cycle of, you know, kinda next generation software deployment with service providers, both in the core infrastructure and at the edge. The other dynamic that's going on with service providers is that they continue to increase capacity in their 4G environment for, you know, increasing traffic, specifically 5G traffic. I think as we shared before, we have continued to make investments in our hardware platforms to prepare for these increased demands for capacity.
As a result, you know, we've been able to get to, you know, some price performance points that are really meeting the demands of high scale, high capacity service provider deployments, especially in the Gi-LAN part of the network, for things like carrier-grade firewalls. That's driving strong demand and execution in the service provider vertical.
Got it. Thank you.
Your next question comes from James Fish of Piper Sandler. Please go ahead.
Hey, guys. Thanks for the questions here. Wanted to go off the software question from before. Is there a way to think about how much the unattached software deal flow is either independent or dependent on some of the systems deal flow, given you're already selling into some of the largest organizations out there? Also, you mentioned there, François, multiyear agreements just now. Is duration actually extending for software?
I'll start with the latter part of that question, Jim. No, I think the trends are pretty steady, Jim, on the multiyear agreement. Typically, they're three-year agreements, and we haven't seen a fundamental change in duration. In terms of the first part of your question, you know, if you take our software business, Jim, obviously, you know, the part of the business that's driven by kinda net new modern applications, largely served with NGINX, is not attached to any dynamics around hardware and our managed services and SaaS business, you know, Distributed Cloud Services, is not attached to any dynamics around the hardware business.
With BIG-IP, what you're seeing is the majority of the, I would say the majority of the software business is not attached to the dynamics in hardware. However, there are, you know, we still have a number of customers who are migrating from a sort of hardware first environment to a software first environment. Where we have seen changes, I would say not specifically this quarter, but over the last, you know, 18 months, is we have seen a number of customers who had declared that they would go to a software first environment sooner.
And we have seen a number of them constantly delay that and stay with more of a hardware first environment. I'd say that's where you have an effect, specifically, in that area of the BIG-IP business where, you know, you're seeing, you know, very strong resilience on the hardware, but it's affected a little bit our software growth rates.
All right. Maybe for Frank, I do want to unpack your guide a bit here. You essentially bracket the street for Q4. Is there a way to understand for how much during the year will be a net issue from the supply chain constraints versus that prior, I believe $60 million-$90 million headwind versus the macro impact you're now including in guide?
Jim, I think you'll probably be able to see that more specifically in Q4 when we talk about, you know, the backlog number. We've you know as a policy, if the backlog number is more than 10% of product revenue, then we will release the actual number, and that's fully our expectation right now. I think you'll be able to, you know, effectively pull out what was the difference in that change and, you know, make some assumptions on what that would have meant for the software revenue or the total revenue overall. If you can, you know, hold off for three months, I think you'll get your answer.
Your next question comes from Meta Marshall of Morgan Stanley. Please go ahead.
Great. Thanks. This is Meta. Couple of questions. Just, you know, on the supply chain piece, when you're expecting loosening by kind of the Q2 of next year, does that mean that the redesign process is kind of complete at that point, or that there's component availability you expect to take place at that point? And then maybe as a second follow on question, just how is the rSeries transition from iSeries progressing versus expectations? Thanks.
Hi, Meta. When we're talking about improvements in our shipments in the second fiscal quarter of 2023, Meta, that's driven by two factors. The first is what we expect to be better component availability from our suppliers based on commitments they've made to us. Generally, from what we see, they are on track with execution against these commitments on some of the most constrained components. That's factor number one. Factor number two is we have also been doing some design work to design around or redesign around some of the most constrained components.
Those design efforts should complete towards the tail end of the calendar year, which would allow us to, you know, ship with the new components in the Q2 or in the second fiscal quarter of 2023. Those are the two factors driving that, Meta. As of today, both of those factors are really on track. Now we're talking about things that are, you know, happening in the next six to nine months and then, you know, looking at the full second half of 2023. You know, I'll caveat that by saying there's still a ton of execution to come and commitments to be delivered by our suppliers.
Generally we're on track, and I would say, you know, we feel incrementally better about that than we did three months ago from what we've seen from our suppliers' commitments and our own work. As it relates to rSeries, we are very happy with the ramp of rSeries. It actually is right now the fastest ramping new platform that we've had. The ramp is happening two times faster than prior new platform introductions. And that's largely due to the benefits of the rSeries platform. It's an investment we started a few years ago, really to bring to our customers several of the elements of the cloud to their on-premises environment.
They're getting, you know, a lot of automation benefits from rSeries, the ability to run multiple software tenants on the same platforms. For those customers that really wanna automate their environments, which is at the heart of a lot of the digital transformations, what they're getting from rSeries is not just the price performance benefits that you get from a new hardware platform, but also a lot of the cloud-like benefits of automation and multi-tenancy into the platform. That's a good ramp, and I think we're pretty excited about what rSeries is gonna do for the business, not just this year, but for the next few years. Great. Thanks.
Your next question comes from Tim Long of Barclays. Please go ahead.
Thank you. Just a few on the software business. First, any, you know, update on getting more consistent metrics here, RPO, ARR, net dollar retention. Love to get an update on when we could potentially see those numbers more specifically, and then maybe related to it, if we're not gonna get them now, Frank, could you talk a little bit about, you know, kinda what you're seeing as a nice jump in software, you know, new deals versus true forwards. How do we look at that aspect of the software growth this quarter? Then maybe the last one is maybe for you, François, we're coming up on three years of three-year anniversary of some of the really large first-term deals.
Could you talk to us a little bit about, you know, how you think those renegotiations or renewals would be working and how that can, you know, work into the model? Maybe just a little color on, you know, that first set of deals. It should be a, you know, pivotal time to renew those deals, I would think. If so, you know, are those deals like some of the other business where it's kind of been running above run rates, so those the renewals could potentially be larger than the initial contracts? Thank you.
Sure, Tim. Thanks so much for the question. I'll start and then I'll turn it over to François. In terms of the split out on the software metrics, as we've talked about, you know, ongoing, we're just starting to hit the second term of where, you know, a lot of this business started to take off. We are still tracking those metrics internally. We're not ready to release them externally. Again, as I've said in the past, we wanna make sure that they are used in the right way, and they can be predictive for the future outlook of the business.
As we get, you know, more and more of these data points over the next coming quarters, we do expect it's gonna be more of a when, not if, we do release these metrics. You know, more to come on that, in FY 2023. I know you had another question for François, specifically on some of the renewals.
Yeah. Generally, Tim, on the renewals, you know, the early indicators on the revenue expansion opportunity are really good on those large multiyear agreements. What we're seeing is, you know, continued growth in application usage. That's a part of what's driving the expansion in some of these opportunities. It's early days as you said, but it's going very well. I would say the other driver both of renewals and new multiyear agreements is security. We had a very strong quarter again in security. What we're seeing is that you know, the portfolio that we've put together that allows our customers to put security capabilities across their environment is really making a difference.
You know, this quarter we had a very strong quarter on security with BIG-IP and WAF, and in fact, WAF across all of our form factors in BIG-IP. We had a very strong quarter with NGINX security. This was the Q2 in a row where we had over 100 wins of NGINX with security. We had very strong debut, if you will, for our Distributed Cloud Services WAF offering, which is our SaaS offering on security. We're, you know, we're bringing all of these security offerings, you know, over time under a single SaaS console that will allow our customers to push the same policy to all of their environments for protecting their applications. That, if you will, competitive differentiation. We're seeing the benefit of that both in terms of expansion of existing agreements as well as new agreements that are driven by our security software.
Frank, if I could just to follow up on the metrics. In the past, you talked a little bit about, you know, the software growth in the subscription businesses being driven by, you know, true-ups and/or, you know, new deals in the pipeline. Could you just give us a little color on kind of mix of growth between, you know, true-up contribution and incoming new deal contribution?
Yeah, Tim, we're not gonna split that out of the quarter. I think both of them were quite healthy. When I take a look at you know, where we have been in the past, the true forward contribution was along our expectations for the growth in new business. That was also in line with our expectations, and it resulted in the 38% software growth. I'm not gonna give a specific split between the two for the call.
All right. Thank you.
Yeah.
Your next question comes from Alex Henderson of Needham. Please go ahead.
Great. Thank you very much. Across the presentation, you've made a number of references to, you know, buying behavior. Specifically said at one point that buying behavior patterns haven't changed. Another point you said that there's some increase in the number of signatures required. You've weighed into your guide the expectation of continued softness in the broader economy. Can you talk a little bit about, you know, where you are in terms of the pipeline of activity that you're chasing, whether the activity is more robust, less robust, than you would expect for this time of year? Particularly whether the deal sizes are bigger, smaller, how the price increase might impact, you know, that longevity, and within the backlog, whether there's any concern around cancellations of orders.
Alex, let me start with the last part of your question. No, with the backlog, we have absolutely no concerns about cancellations of orders. That's because we haven't seen any. There hasn't been any trend into cancellation. Also our lead times, you know, while elongated are still at about four months. Relative to, you know, some of the other hardware networking players, our lead times are still less than a number of others. In fact, we have seen some of our orders delayed because customers were waiting to get their some networking gear that had 12 months of lead times before ordering from F5 that only has, you know, 2-6 months of lead times, depending on which platform you pick. We're not worried about cancellations at all.
Let me talk to the other dynamics. You mentioned the customer buying behavior, the implications of price increases. If I take a picture right now, Alex, of where we're at, no, we haven't seen on a global level, I would say with the exception of Europe specifically. I'll come back to that in a moment. We have not seen a fundamental change in buying behavior. We have seen a little back-ended linearity this quarter. Yes, some deals that had a little more scrutiny in terms of the number of approvals, but when we looked at the overall demand signals in the quarter, they were very strong. We didn't see a fundamental change in close rates, if you will, from our pipeline.
That is, I would say, across the globe, it's true. In Europe specifically, we did see some continued softness and very back-ended linearity, and we think the macro is definitely affecting buying behavior in Europe already today. Now when you look forward around, you know, what we think we will see in coming months, let's start with our pipeline. Our pipeline is strong for Q4, and it is about what we would expect to have, you know, as of today for our Q4 pipeline. We have a number of large deals, specifically in software. Q4 is always a quarter with some of the largest deals, and we have that pipeline of large deals to deliver against our guidance.
That being said, what we are cautious about is, you know, of course, you know, we see the dynamics in the macro environment, and I think the combination of inflation, you know, in the U.S. and elsewhere, and also outside the U.S., foreign exchange, which, you know, ends up making our gear more expensive to, you know, customers in Europe, you know, Latin America and Asia. Those increases in cost to customers will force them to, you know, make prioritization calls on their investment. We think that may result in some deals being pushed out, or, you know, a different prioritization of projects than what we are currently expecting.
We haven't seen any sign of that to date, but our view is that given that every other networking vendor out there has made increases in prices, including us, you know, customers at some point, their budgets are not going up exponentially, and they'll have to make these prioritization calls. I think that's the macro effect that we you know we think we are likely to see in the next few months.
Your next question comes from Samik Chatterjee of J. P. Morgan. Please go ahead.
Oh, great. Thank you. Hi. Thanks for taking my questions. François, I just wanted to start with, you've talked about the deprioritization of spending from your customers or the cautious environment you're in, but also sounds like you're already starting to prepare internally for that to some extent. I mean, more curious about hearing how you're thinking about the levels you can pull or the changes or reprioritization in terms of F5 internally.
Would you sort of increase more sales incentives on the software business or focus more on security? Like, what are the levels you're thinking you can sort of drive towards as you if you do see the customer behavior changing because of the macro? Then just quick follow-up. I mean, since the 15% price increase on systems, what have been the order trends that you've seen? Thank you.
Samik, just the last part of your question, about the 15% price increase. What was your question about that?
Oh, any color on the order trends since instituting the price increase, pushing through the price increase?
Let me just start with that part of the question. Samik, yes, we did have a price increase that took effect on July first. You know, we as a result of that, we had a number of orders that were pulled into our Q3 by customers, you know, wanting to order early to not be affected by that price increase. When we look at the demand signals for Q3, we normalize out these orders that were pulled in. Even if you normalize out for these orders, it was actually a strong, you know, I would say a strong to very strong demand quarter.
In terms of the order trends post the price increase, you know, we are early in the quarter and, you know, the linearity that we're seeing today is, you know, not really different than what we would see in the first month of a quarter. To the first part of your question around how we're preparing for what may transpire in the macro. You will see that, you know, we are being cautious. I want to be clear, we're not seeing any change in our demand signals to date. Given everything else that's going on in the macro, you know, we have out of caution significantly slowed down hiring in the last month across functions.
There were some, you know, kind of investment initiatives that we had that we have, we have delayed, you know, to see more clearly what's going to transpire in the macro, and see if we push forward with these investments or not. Right now, Samik, it's more on the, you know, management of our OpEx and OpEx run rate that we have, focused our, if you will, our preparation and readiness. Our incentives for software for our teams are pretty strong, and they're gonna, you know, continue to remain strong. And hopefully you've seen that in the results we're having on our software growth rate. Okay. Great. Thank you. Thanks for the responses. Thank you.
Your next question comes from Rod Hall of Goldman Sachs. Please go ahead.
Yeah. Hey, guys. Thanks for the question. I wanted to come back to the comment. I think, François, you made it, about the back-end loaded nature of the quarter and kind of the DSOs. I guess I was curious about the, you know, the drivers of the back-end loading. I mean, you guys are saying you're not seeing demand impacts, but I wonder what, you know, how would you characterize the drivers for the back-end loaded nature of the quarter? Was there a particular type of product you were selling more in the back end of the quarter? Was there a promotion, something like that? And I'm curious also on the DSOs, whether you think next quarter those might come back down again. Thanks.
Yeah, Rod, let me start with the DSO side of the question and then let François talk about some of the back-end linearity of it. The DSO, a lot of that, Rod, I think is gonna be a little more linked to, not bookings, but just frankly, you know, when things can be shipped. It's the components that came in in the back half that then had the shipments go out, the bills then go out associated with that, and that drove the increase in the AR balance, which is the calculation for your DSO. It's likely going to see, you know, a return to normality when we get into the back half of FY 2023. That's when we're going to, you know, see DSOs come back down.
I will note that the quality of those receivables, we haven't seen any aging increase. It just happens to come after the end of a quarter. I will expect that, you know, DSOs, as François mentioned in the shipping side in the back half of FY 2023 to see when that's gonna start coming down and that AR balance coming down. Yes. Rod, on the back-end loaded quarter, first of all, yes, it was more back-ended, but on a very strong demand quarter. Yeah, I think I mentioned earlier that we saw at the very end of the quarter some orders that we felt should have come in Q4 that came in Q3.
We attribute some of that to, you know, customers ordering ahead of a price increase. I think if you normalize that out, that would normalize a little more the linearity of the quarter. The other factor is Europe, which was in fact back on track and loaded in linearity. We think that's got to do with the macro and the scrutiny there. If you normalize out these two factors, there was probably also an element that we started to see around more customers, I want to say outside of Europe, that had more approval cycles in their orders. It may have pushed some orders that you may have expected in the second month to happen in the third month of the quarter.
Okay. François, could I just follow up on one thing there? You're saying most of the types of orders you would have seen were systems kind of ahead of the pricing increases. Is that the right way to characterize the, you know, kind of the type of order you saw on the back end or?
Yeah, that phenomenon around or, you know, the sort of large orders very late in the quarter to avoid the price increase would have been more about systems than for software where I think we had a more kind of normal linearity.
Great. Okay. All right. Thanks a lot. Appreciate it.
Thanks a lot.
Your next question comes from Amit Daryanani of Evercore. Please go ahead.
Thanks for taking my question. I have two as well. You know, I guess maybe to start with on the software side, right? You're going to be at the higher end of the 35%-40% growth rate this year. Is there anything you would call out that's more one time in nature that you think helped you on software growth in fiscal 2022? You know, ELAs or big deal or something. I'm really curious, if you do end up in the slower macro environment in 2023, does that help or hurt your software business over time?
Let me start with that, and I'll let François take the back half of your question. There's nothing that is abnormal to what our expectations were. I will note that we did have, you know, large deal activities that happened three years ago that repeated itself this year. You know, that's going to be part of the normal process and reasons why we have potentially quarter-to-quarter volatility, even on, you know, larger numbers. As these numbers increase in the denominator, that fluctuation will again be muted and decreased.
We've, you know, talked about, you know, some large deal activity in FY 19 that repeated itself, you know, this year, and it's always been part of our expectations, even going back to AIM in November of 2020, when we thought about what a horizon two outlook would be.
Yeah. The second part of your question, you know, Amit, so the question is whether if we are in a recession in 2023, does that help or hurt our software business? Well, you know, I will just give you some thoughts around how I think about this. On the one hand, I think one thing we've seen in past recessions is people hunker down and not start, you know, new things, but continue the thing, to do the things that they've been doing.
What that would mean is for our customers that are on hardware, you know, it's likely that some of these customers would decide to just continue to stay on the hardware train rather than, you know, start a whole new architecture or a new project if they hadn't done that already. If you look at it that way, that would, you know, favor our hardware business, and less our software business for where there's this big IP, you know, opportunity between hardware and systems. On the other hand, you know, the vast majority of our software business is subscriptions.
We think, you know, there are a number of customers that would prefer to move to this OpEx model in that environment rather than do, you know, new large CapEx outlays, and that would favor more of our software business. If you step back from it, I think the way we look at it is we have now built a business model that we think is actually quite resilient because we can meet our customers where they are at with hardware form factors, software form factors as term subscriptions or perpetual, and even SaaS and managed services form factors.
If we have customers that, you know, want to add security capabilities to their environment, but they want to start with, you know, a lower expense and a pay-as-you-grow model, our SaaS offerings are gonna get traction very rapidly. They already are. That would favor that in 2023. Overall, you know, we feel that we've got the resilience in the model to be able to meet customers in the economic model that makes more sense for them in a recessionary environment.
Perfect. Thank you for that. If I may just follow up on the systems side. You know, you made some comments around fiscal Q1 in 2023 will be the low point for systems revenue. I'm just curious, was that an absolute revenue statement or a statement relative to the peak over there? You know, really if I look at all the stuff you have on the systems side from the backlog to the price increases and, you know, some of the pent-up demand, is there a reason why we don't see your hardware business show positive growth next year?
Yeah, let me start with that, and then François, I'll speak. We were giving an absolute in terms of revenue dollar value for when Q1 would be the low point in our systems revenue. That is purely a result of the components that are needed to ship when we see those schedules coming in. As François mentioned, the volatility associated with decommits has gone down from what we have experienced in recent quarters. That having been said, the commitments that we have will show that that will be the low point of what we can actually produce to that volume. That's why on a dollar basis, we expect Q1 to be the low point.
To the second part of your question, Amit, whether we would expect hardware to show positive growth next year, our expectation would be, yes, that our hardware will show positive growth next year. If, of course, we are able to, you know, have the recovery profile in our supply availability that we have talked about. You know, we are on track with that profile for now, and if that confirms, I would expect our hardware revenues to be greater next year than they are this year. Because we're not, you know, our backlog, frankly, is so large today that even if in a recessionary environment, the hardware demand was to be less than it is this year.
To be clear, this year, the hardware demand is much higher than, you know, the revenue we're printing. You know, even if the demand was to be less, you know, we would be able to ship more revenue than we have this year. At this stage, I'm not gonna speak to demand on our hardware business for next year because there are too many unknowns, and we know we're going into a macro environment. Specifically speaking to what hardware revenue could be, I would say yes, assuming that supply is there.
I mean, I will add-
Perfect. Thank you.
I will reconfirm what François said last quarter. Q1 will be the low point. We will see a build in Q2 from there. As you know, some of the redesigns and components become more available. We expect Q3 to be higher yet still because, you know, we're able to ramp production even more on the new platforms. Then ultimately by Q4, we may actually start to begin to bring down backlog because of availability. We do expect it, you know, to take a linear up curve on the revenue for systems actually.
Got it. Thank you very much.
Your next question comes from Jim Suva of Citigroup. Please go ahead.
Thank you. I just have one question. François, in your prepared comments, you mentioned additional signatures and a little bit more time to get deals to be completely approved. I'm wondering, does this also allow the CTOs more time or more contemplation to do, you know, virtual instances, more software VM type of production orders from you? Or is it kind of the cadence of what they're looking at kind of as you expect? I'm just kind of wondering, with the elongated closing time, does it actually allow them to kinda take a step back and look at the whiteboard a little bit more about the solutions that they're buying from you? Thank you.
Thank you, Jim. I think the expanded nature of our portfolio today, where we are able to engage our customers with a SaaS offering, you know, a software offering or, you know, a hardware offering where they want to look at that, or a combination of all of the above for their capabilities for addressing multiple applications in different environments, that's creating great strategic kind of architectural conversations with our customers, but they are happening early on in the cycle.
By the time we get into a project that's been defined and scoped by teams and getting into an approval cycle, I don't think it's a question of a CTO, you know, stepping back and saying, "Let me reconsider all of that." It's, and I think it's more of a, you know, in the first few quarters in the pandemic, there was such a rush to add capacity that I think, you know, people were just, you know, approving orders as soon as they were coming into the queue. Now, you know, especially perhaps with people knowing maybe there's a recession around the corner, they're making sure that the right levels of approvals exist in an organization, and they take their time, and when they make a decision, it's a full go.
I think it's more the effect, Jim, than a step back around architecture, which does happen, but it's happening upfront early on with the customers technology teams and our own technical teams.
Got it. Thank you so much, and I appreciate the clarity.
Thank you.
Ladies and gentlemen, due to time constraints, we will take our last question from Simon Leopold of Raymond James. Please go ahead.
Thank you. I wanted to get a quick clarification and then a broader question. On the clarification front, François, you indicated growth towards the high end for the software business for the year, and I think that might imply a sequential decline from the systems business in the September quarter. I want to verify that. If it is down sequentially, I just want to get a better understanding of why, because it sounds like supply chain constraints are somewhat better or the same, so not sure on that point. I wanted to see if you could talk a little bit more about unpacking your enterprise verticals. In the past, you used to disclose more detail about the composition of your enterprise customers.
In light of the concerns about a potential recession, I think it would help to get a better understanding of the profile of these enterprise customers and some sense that you have very little to no exposure to the SMB market within that enterprise vertical and where your vulnerabilities might be. Thank you.
Jim, let me start, and I'll let François pick up on the back half of your question. As you know, we as a policy don't really guide to specific mixes within the components of our product revenue. I did say last quarter that we expect, you know, either Q4 or Q1 to be the low point of our systems revenue purely due to supplier commitments and what we could actually ship. I'm not going to address are we going to be down sequentially quarter-over-quarter in terms of dollar revenue. That directionally, you know, I was saying last quarter and still feel that Q4 and Q1 are where the low points. We're saying now specifically Q1 may be lower than Q4.
I wasn't saying specifically what Q4 was gonna be in relation to Q3. On the supply chain dynamics, you are correct. We are seeing a bit of a stabilization on you know, most of the components. But we do have you know, the what we call the golden screw you know, component to building boxes, meaning that you have to have everything obviously to do it. There are still a few components associated with our builds that are constrained and continue to be constrained. If for whatever reason those are freed up, which is not our expectation, we could do better than these, but that's not the expectation that we wanna set for you.
There's still, though broadly the supply chain is getting better, for most components, there are still a few in our specific builds that are constrained. We talked about fiscal Q2 being better, not because those suppliers are able to ship us more, but more because of the redesign efforts that will likely go into effect in the back half of our fiscal Q1. That will help us with the improvements in builds in Q2.
To the second part of your question, we have no or virtually no exposure to the SMB segment. You know, so our exposure is really large enterprises, and of course, service providers and government. But those are the three verticals we serve. In the enterprise space, it's really the, you know, the large enterprises around the world.
Thank you.
Ladies and gentlemen, this concludes your conference call for this afternoon. We would like to thank you all for participating and ask that you please disconnect your lines.