Q2 2023 F5 Inc Earnings Call

Speaker 1: The.

Speaker 1: The.

Speaker 2: Good afternoon and welcome to the F-5, Inc. second quarter fiscal 2023 financial results conference call. At this time, all participants are in a listen-only mode. A brief question and answer session will follow the formal presentation. If anyone should require operator assistance during the conference, please press star zero on your telephone keypad.

Speaker 2: Also, today's conference is being recorded. If anyone has any objections, please disconnect at this time.

Speaker 2: I will now turn the call over to Ms. Suzanne Dulong. Thank you, ma'am. You may begin.

Speaker 3: Hello and welcome. I am Suzanne Dulong, F5's Vice President of Investor Relations, Francois Locodinot, F5's President and CEO , and Frank Peltzer, F5's Executive Vice President and CFO , will be making prepared remarks on today's call.

Speaker 3: Other members of the F5 executive team are also on hand to answer questions during the Q&A session.

Speaker 3: A copy of today's press release is available on our website at f5.com, where an archived version of today's audio will be available through July 24, 2023. The slide deck accompanying today's discussion is viewable on the webcast and will be posted to our IR site at the conclusion of the call.

Speaker 3: To access the replay of today's webcast by phone, dial 877-660-6853 or 201-612-7415 and use meeting ID 1373-7373.

Speaker 3: The telephonic replay will be available through Midnight Pacific Time, April 20, 2023. For additional information or follow-up questions, please reach out to me directly at s.dulong at f5.com.

Speaker 3: Our discussion today will contain forward-looking statements, which include words such as belief, anticipate, expect, and target. These forward-looking statements involve uncertainties and risks that may cause our actual results to differ materially from those expressed or implied by these statements. We have summarized factors that may affect our results in the press release announcing our financial results.

Speaker 3: in this call.

Speaker 3: With that, I will turn the call over to Francois.

Speaker 4: Thank you, Suzanne, and hello, everyone. Thank you for joining us today. Our team delivered second quarter revenue at the midpoint of our guidance range and earnings per share above the high end of our range. These results come despite persistent macro uncertainty, which has led to broader and more severe customer budget scrutiny.

Speaker 4: impacting both our software and hardware demand.

Speaker 4: We have strong conviction that customers' constrained spending is a temporary headwind, and that we are well positioned as a trusted and innovative partner for customers as they look to secure, scale, modernize, and simplify their hybrid and multi-cloud application environments.

Speaker 4: In my remarks today, I will speak to the quarter's results, the near-term spending dynamics we are seeing, and why we remain confident in our positioning and growth opportunities longer term.

Speaker 4: First, on our Q2 performance.

Speaker 4: We delivered 11% revenue growth in Q2 as a result of stronger-than-expected system shipments and strong maintenance renewals.

Speaker 4: 11% revenue growth in Q2 as a result of stronger than expected system shipments and strong maintenance renewals. Our systems revenue grew 43%.

Speaker 4: As positive as this is for the quarter, it is more a reflection of our team completing comprehensive board redesigns efforts ahead of plan than it is a demand marker.

Speaker 4: You will recall that last year, rather than just wait for supply chain to improve, we initiated multiple board redesigns with the goal of designing out the hardest-to-get components and opening up new supply. The successful completion of this work is making it possible for us to fulfill waiting customer orders sooner than we anticipated.

Speaker 4: And as expected, we have seen no order cancellations in the process.

Speaker 4: Our global services revenue grew 8%, driven by continued strong renewal rates, which improved across nearly all cohorts.

Speaker 4: Wrapping up our Q2 results, we also delivered OpEx within guidance and non-GAAP EPS of $2.53 per share, above the top end of our guidance range.

Speaker 4: So the quarters results were strong, but they obscure underlying customer spending patterns.

Speaker 4: Since our December quarter, we have seen customers scrutinizing budgets and deferring spend for anything except the most urgent projects. These dynamics were even more pronounced in Q2 when we saw previously approved projects going through multiple additional levels of approvals.

Speaker 4: In some cases, approvals are reaching the C-suite or board level only to be delayed or downsized.

Speaker 4: The impact of this extreme spending caution is most evident in our Q2 software revenue, which declined 13% year over year.

Speaker 4: This was well below our expectations for the year and our long-term growth expectations.

Speaker 4: We believe there are several reasons why we are seeing this kind of impact in our software revenue.

Speaker 4: These include the relative size of the software projects we tend to be involved in and the percentage of our software revenue derived from term subscriptions.

Speaker 4: First, the majority of our software growth to date has come from transformational type projects of size, often six or seven figure deals. We are seeing larger projects come under more scrutiny resulting in delays, sometimes by multiple quarters, or downsizing into smaller, more incremental additions.

Speaker 4: Second, the majority of our software revenue comes from term-based subscriptions, which have upfront revenue recognition.

Speaker 4: As a result, when we see a decline in new term-based subscriptions as we have in the last few quarters, it is immediately evident in our software revenue and much more so than it would be if our software was predominantly ratable or fast driven. Now, there is some good news to point to in software.

Speaker 4: We have a base of software renewals which is growing. Our renewal consists primarily of second-term multi-year term subscriptions. And similar to Q1, in Q2 our software renewals performed largely as expected.

Speaker 4: In addition, our SAS and Managed Services revenue is growing, and we expect it will become a more significant and predictable contributor to our software revenue over time.

Speaker 4: The spending patterns I have described were not limited to our software demand.

Speaker 4: We also experienced softer systems demand in the quarter as customers push the capacity of their existing systems, swept their assets, and work to deploy delivered systems into production. We expect these headwinds on both software and systems will persist at least through the end of this fiscal year.

Speaker 4: As a result, we now expect low to mid single digit revenue growth for FY23. This is down from the 9-11% growth we previously forecasted.

Speaker 4: I will now speak to my third point, why we are confident that the current demand environment is temporary, and why we are uniquely positioned to help customers simplify their hybrid multi-cloud challenges.

Speaker 4: We are confident that current demand levels are temporary for several reasons.

Speaker 4: First, because of the direct commentary we are getting from customers.

Speaker 4: Customers are telling us that the delays we are seeing are a matter of budgets and approvals, not competitive pressures or architectural shifts.

Speaker 4: During Q2, I met personally with roughly 100 customers and partners.

Speaker 4: It was clear from my discussions with customers that the Xpect S5 will be a key part of their future hybrid and multi-cloud architectures as the only company capable of securing and delivering applications and APIs in all environments.

Speaker 4: Partners too are leaning into the new F5 and our rapidly expanding set of distributed cloud services are accelerating that movement.

Speaker 4: Second, because of our win rates. While the direct customer commentary is reassuring, we also consistently analyze our win rates. When we look at the first half of FY23 compared to the first half of FY22, we see broadly steady win rates across our theaters and product lines.

Speaker 4: confirming we continue to win our fair share of the deals we are involved in.

Speaker 4: Third, our factored pipeline, which accounts for the probability of a deal closing, is up from where it's been the last couple of quarters, suggesting customer activity is increasing and deals are reaching a higher level of maturity.

Speaker 4: This too is encouraging, but given what we have seen in the first half, we believe it is prudent to remain conservative on expected conversion of this factored pipeline.

Speaker 4: Fourth, our strong maintenance renewals signal customers are delaying purchasing decisions by sweating assets.

Speaker 4: We see this in the substantial attach rate increase on all the deployments where you would expect the behavior of sweating assets would be most pronounced.

Speaker 4: We also are seeing a substantial increase in deferred maintenance revenue compared to prior year trends. This behavior is consistent with what we have seen during past periods of micro uncertainty. With apps and APIs continuing to grow, however, customers can only postpone investment so long if they want those apps and APIs to improve.

Speaker 4: We are now producing our global headcount by approximately 620 employees, or approximately 9% of our total workforce.

Speaker 4: We expect these actions, combined with other cost reductions, including rationalizing our technology consumption, applying additional scrutiny to discretionary projects, and reducing our facility's footprint will drive ongoing operating leverage.

Speaker 4: In addition, we are substantially reducing the size of our corporate bonus pool in 2023 and further reducing travel.

Speaker 4: As a result, we expect to deliver FY23 non-GAAP operating margins of approximately 30% and non-GAAP earnings growth of 7-11%.

Speaker 4: Further, the leverage from these cost reductions, combined with our anticipated gross margin improvement, positions us to deliver meaningful non-GAAP operating margin expansion and double-digit non-GAAP earnings growth in FY24. While customers are spending only were critical near term, the

Speaker 4: they continue to face significant challenges ahead, including creating engaging digital experiences, managing resource constraints, and addressing technical debt.

Speaker 4: Their business velocity and long-term growth will rely on finding ways to connect and protect applications and APIs across distributed environments.

Speaker 4: With our unique ability to secure and deliver applications and APIs across all environments, we are differentiated in our ability to help customers with these challenges.

Speaker 4: We believe this position will drive sustainable long-term growth. As we have evaluated and adjusted our business, in addition to reducing costs, we have also intensified our investments in areas we believe will drive the highest mid and long-term impact for our customers, including software and hybrid and multi-cloud.

Speaker 4: Now I will turn the call to Frank. Frank?

Speaker 5: Thank you, Francois, and hello everyone. I will review our Q2 results before I speak to our third quarter outlook and provide additional color on our FY23 expectations.

Speaker 5: We delivered Q2 revenue of $703 million, reflecting 11% growth year over year.

Speaker 5: Global services revenue of $363 million grew a strong 8% due to the high maintenance renewals and the impacts of the price increase introduced in Q4 of last year.

Speaker 5: Our revenue remained roughly split between global services and product, with global services representing 52% of total revenue.

Speaker 5: product revenue grew 14% year-over-year, reflecting strong system shipments against an easier comparison in the year-ago quarter. As Francois described, our successful redesign efforts enabled systems revenue of $209 million, representing growth of 43% year-over-year.

Speaker 5: At $132 million, Q2's software revenue was down 13% compared to last year.

Speaker 5: Let's take a closer look at our software revenue, which is comprised of subscription and perpetual license sales.

Speaker 5: Subscription-based revenue, which includes term subscriptions, our SaaS offerings, and utility-based revenue, totaled $109 million, or 83%, of Q2's total software revenue.

Speaker 5: Within our Q2 subscription business, as Francois described, new term subscriptions perform significantly below plan in the quarter.

Speaker 5: In contrast, and similar to last quarter, software renewals continue to perform largely in line with our expectations.

Speaker 5: Perpetual license sales of $23 million represented 17% of Q2's software revenue.

Speaker 5: Revenue from recurring sources contributed 65% of Q2's revenue.

Speaker 5: This includes subscription-based revenue as well as the maintenance portion of our services revenue.

Speaker 5: On a regional basis, we saw growth across all theaters, though I'd note that these trends are more reflective of shipments in the quarter than current demand. Revenue from Americas grew 7% year-over-year, representing 54% of total revenue. AMIA grew a strong 22%, representing 27% of revenue.

Speaker 5: and the APAC grew 9%, representing 18% of revenue.

Speaker 5: Looking at our major verticals during Q2, enterprise customers represented 67% of product bookings, service providers represented 13%, and government customers represented 20%, including 6% from US Federal.

Speaker 5: I will now share our Q2 operating results.

Speaker 5: Gap gross margin was 77.9%. Non-gap gross margin was 80.4% in line with our guidance for the quarter.

Speaker 5: Gap operating expenses were $441 million. Non-GAP operating expenses were $374 million in line with our guided range.

Speaker 5: Our gap operating margin was 15.1%. Our non-gap operating margin was 27.2%. Our gap effective tax rate for the quarter was 25.1%.

Speaker 5: Our non-GAAP effective tax rate was 20.8%. Our GAAP net income for the quarter was $81 million, or $1.34 per share. non-GAAP net income was $154 million, or $2.53 per share, above the top end of our guided range of $2.36 to $2.48 per share.

Speaker 5: This reflects improved operating margins from strong cost discipline as well as a benefit to our tax rate in the quarter.

Speaker 5: I will now turn to cash flow and the balance sheet which remains very strong. We generated $141 million in cash flow from operations in Q2.

Speaker 5: Capital expenditures for the quarter were $11 million.

Speaker 5: DSO for the quarter was 62 days, flat with Q1 and up from historical levels primarily due to strong service maintenance contract renewals in the quarter and to a lesser degree back-end shipping linearity.

Speaker 5: Cash and investments totaled $760 million at quarter end.

Speaker 5: We did not repurchase any shares in Q2. We remained out of the market as we analyzed the potential impacts of the cost-saving measures we discussed previously, as well as the changes we were seeing in the demand environment and its effects on our outlook.

Speaker 5: Deferred revenue increased 12% year-over-year to $1.8 billion up from $1.76 billion in Q1.

Speaker 5: This increase was largely driven by substantially higher maintenance renewals on our install base of products sold 4 plus years ago.

Speaker 5: Finally, we ended the quarter with approximately 7,100 employees. This number does not reflect the reductions we announced today.

Speaker 5: We expect these headcount reductions will result in annualized savings of approximately $130 million.

Speaker 5: We expect to incur approximately $45 million in severance and benefits costs and other charges related to these actions in FY23.

Speaker 5: to incur approximately $45 million in severance and benefits costs and other charges related to these actions in FY23. I will now share our outlook for Q3.

Speaker 5: Unless otherwise stated, my guidance comments reference non-GAAP operating metrics.

Speaker 5: We expect Q3 revenue in the range of $690 to $710 million with gross margins of approximately 82%.

Speaker 5: With the partial quarter impacts of our announced cost reductions, we estimate Q3 operating expenses of 348 to 360 million.

Speaker 5: and our Q3 non-GAAP earnings target is $2.78 to $2.90 per share.

Speaker 5: We expect Q3 sharebase compensation expense of approximately $60 to $62 million.

Speaker 5: Finally, we plan to repurchase at least $250 million worth of shares during Q3. We remain committed to returning cash to our shareholders and continue to expect to use at least 50% of our annual free cash flow toward share repurchases. I will now speak to our FY23 expectations.

Speaker 5: We expect low to mid single digit revenue growth in FY23.

Speaker 5: Given our first half results and the environment for new software projects, we no longer see a path to 15-20% software growth in FY23 and are not offering guidance for the second half product revenue mix at this time.

Speaker 5: Based on current visibility and our earlier than anticipated systems recovery, we expect to see lower systems revenue in Q3 and Q4 than in Q2. We expect that we will continue to substantially work down our systems backlog over the second half of FY23.

Speaker 5: We expect FY23 non-GAAP operating margins of approximately 30% and non-GAAP earnings growth in the range of 7 to 11%. Incorporating our year-to-date results, we have narrowed our estimate for our FY23 affected tax rate to 21 to 22% for the year. I will now turn the call back over to Francois. Francois?

Speaker 5: FY23 non-GAAP operating margins of approximately 30% and non-GAAP earnings growth in the range of 7 to 11%. Incorporating our year-to-date results, we have narrowed our estimate for our FY23 affected tax rate to 21 to 22% for the year. I will now turn the call back over to Francois. Francois? Thank you Pentagon.

Speaker 4: Like last quarter, I'll ask that you take away three things from this call. We believe the current demand environment is temporary and while we cannot predict when it will recover, we are confident it will for the very simple reason that applications and APIs continue to grow. We are also confident that as customers resume more normal levels of...

Speaker 4: we believe will be most impactful for our customers over the medium and long term, including software and hybrid and multicloud.

Speaker 2: Operator, please open the call to questions. Thank you, sir. We will now be conducting a question and answer session. If you would like to ask a question, please press star 1 on your telephone keypad. A confirmation tone will indicate that your line is in the queue. You may press star 2 if you would like to remove your question from the queue.

Speaker 2: And for participants using speaker equipment, it may be necessary to pick up your handset before pressing the star keys.

Speaker 2: One moment, please, while we poll for questions. And our first question comes from the line of Sammy Badri with Credit Suisse. Please proceed with your question.

Speaker 6: Thank you. I had two questions.

Speaker 6: First thing, maybe Frank you could help us just to understand modeling parameters for the year. And the reason why I asked that is we were not really forecasting a fairly large growth contribution from services revenue and that's clearly looking like that's changing as a fiscal 2Q and into.

Speaker 6: the second half of the year? What should we be assuming for services growth now given things have changed and customers are sweating assets? And then kind of backing into product, I think you made a comment saying you aren't going to make guidance for software growth in the second half of this year 23 for software, but

Speaker 6: I kind of just need a little bit more color in that just given the systems commentary as well. And then I have a follow-up after this.

Speaker 5: Yeah, sure, Sammy. So, we did not update the mid-single digit outlook that we did update in Q1 on services. Obviously, we outperformed that in Q2 and for all the dynamics that you highlighted, we continue to think services contribution is going to be strong through the course of the year.

Speaker 5: as customers continue to sweat assets, and particularly when we look at some of the aged assets and their decisions around that. And so we don't have an update, but I think that mid-single digit is well intact, and we'll see what happens. Specifically, we did not give any guidance on mix and product, and the results of...

Speaker 6: Okay, got it. And maybe a question for Francois. I think one thing we really kind of want to know is if you're to think about which customer industry group really caused the majority of the drag or the impact to the revision of the guide for Fiskier 23, which customer cohort or customer vertical really kind of caused that if you could put your finger on one.

Speaker 4: Thanks, Sami. So a couple of indicators on that. The first is what we have seen in our second fiscal quarter is this pullback in spending has been broader and more severe, likely across all vertical and all geographies.

Speaker 4: And so I would say all verticals and geographies are affected at this point. If I had to pull out a couple, I would say the financial services, especially in the second half of March, where we saw a number of large deals being pulled out, delayed or down.

Speaker 4: that I would call out is service providers, where we had a number of customers that had expectations around their budgets, I would say in our fiscal Q1, so calendar Q4. And when the budgets were settled in the February timeframe, the budgets were a lot less than they expected.

Speaker 4: And that's driven by, I think in some cases, certainly in the MSO sector, cable sector, worries about our service provider customers perhaps losing or reducing the growth on their highest margin customers.

Speaker 4: And we're seeing that also with certain mobile operators around their planned spend on 5G.

Speaker 4: So that's, I would say those are the two verticals that perhaps have been where we've seen perhaps the strongest differential between where they were in Q1 and where they are today.

Speaker 2: Got it, thank you. And the next question comes from the line of Ray McDonough with Guggenheim Securities. Please proceed with your question.

Speaker 7: Great, thanks. Two, if I could. The first one, Francois, can you comment, or maybe even for Frank, can you comment on uh...

Speaker 7: How or if new business declines accelerated from from last quarter, I believe And with that I also believe a part of the renewals that you expected to come in came from the true forwards How have they performed versus expectations from the beginning of the year and is a move towards optimizing cloud spend

Speaker 7: from customers impacting those true forwards at all given pricing is somewhat based on what customers consume per year in those contracts? Or, Ray, I'll start and certainly Francois wants to pick up the can. I think, you know, we saw a challenge in new business sales in both Q1 as well as Q2. Did it accelerate in Q2?

Speaker 5: probably slightly versus our expectation, but not necessarily when you take a look at the the wrong number. So that's how I'd answer that one for you. I think in terms of your second question around...

Speaker 5: On the true forwards that we saw, those were slightly below our expectation level. We do keep that in the renewal bucket and so when we said that it largely performs to our expectation that was the one piece that did not perform to our expectation where we think that people are being a bit more critical.

Speaker 5: around their consumption and being much closer to what they had planned to consume and not going over. And that's not what we experienced up until this year.

Speaker 7: Okay, that makes sense. And then maybe a follow-up prank for you. Can you help us on the direction of cash flow margins for this year and where you think they can go? You know, you have the benefit of supply chain challenges subsiding somewhat, at least. You're lapping the initial cohort of term license.

Speaker 7: that would preclude you from hitting that sort of target or range? Yes, right. We don't specifically guide to cash flow. I think the dynamics that you mentioned are the similar ones to the ones that we are experiencing. We did have...

Speaker 5: some unusual cash hits to last year in relation to component costs and other supply chain challenges that we do anticipate are going to work their way out of our model by Q4. You saw some of that happen in the Q2 time frame. You'll see more of that happen in Q3. But we don't guide to a specific margin percentage because we don't guide to cash flow.

Speaker 2: Thanks for taking the questions. Appreciate it. And the next question comes from the line of Tim Long with Barclays. Please proceed with your question. Thank you. I have two as well on software. First, you guys said a few times the renewals came in as expected. It would be helpful if you could give us a little color about what you were expecting.

Speaker 2: the core virtual ADC, how much of this is maybe not fully monetizing GenX, how much of this is not really able to bundle other software offerings on top of virtual ADCs, so anything you can give us on that.

Speaker 2: what's missing when you look back at the acquisitions and what it was supposed to do for the software business, what's not happening. Thank you.

Speaker 4: Thank you, Tim. I'll start with the second part of your question and then Frank will…

Speaker 4: come back to the renewables question. So if we could –Applause

Speaker 4: So let me start with the product piece. Where we have seen an impact is in the ADC area, we are impacted both on hardware and software. And then what I mean by that is really traditional ADC, both systems and software. And we are seeing very strong evidence that this...

Speaker 4: it is clear that where they can avoid spending right now, they are avoiding it or delaying making these purchases later. Part of our security business is attached to ADC, and that part of the business we have seen an impact, and it is affected. Last week our senior

Speaker 4: And we're also seeing a bigger impact in the service provider vertical in security, whether they've tried to reduce their capex pretty quickly. Our software security business is more resilient, and our SaaS and managed services security business actually continues to grow.

Speaker 4: orbit at a lower rate than last year but continues to grow. So if you parse it out, I would say those are the areas and of course with NGINX we have continued to see growth there. Of course the growth rate is also impacted but we continue to see growth there. When you step back from this then.

Speaker 4: and you mentioned the overall portfolio and acquisitions. We are absolutely clear, and it's the feedback from our customers, that the world is going more and more to hybrid cloud and multi-cloud. And the portfolio that we have assembled is essentially the only portfolio in the industry that can secure and deliver every application.

Speaker 4: of our customers going forward. Where we think we are seeing the more severe slowdown in the short term is in ADCs where customers can actually perhaps sweat the assets for a little longer, but we expect that demand will resume in short order.

Speaker 5: And Tim, on the renewal question, I'm going to separate out the maintenance renewals, which are probably being quite strong on the services side, and the software renewals, which are also strong, and you were saying, you know, what are your expectations? Can you think about the way we've talked about the business and have...

Speaker 5: FCPs have been the predominant amount of growth that we've seen in our software business, and that's the majority of what comes up for renewal in any given quarter. Those have performed largely to our expectations, and in many cases growing from the levels that they were when they ended year three. There has been some this year where we've taken a look at years two of the agreement and years three of the agreement, where that true forward amount has not been up to the level of expectations that we had.

Speaker 5: look back three years ago as a comparison.

Speaker 8: Okay, thank you.

Speaker 2: And the next question comes from the line of Samik Chatterjee with JP Morgan. Please proceed with your question. The next question comes from Samik Chatterjee with JP Morgan.

Speaker 9: Thank you and hi thanks for taking my questions. I guess for the first one I think just to clarify I think Francois you may recommend about fiscal 24 talking about double-digit earnings growth. Just want to see sort of how you're thinking about top line sort of underpinning that expectation. You know you talked about gross margin.

Speaker 9: improvement as well as operating margin but sort of maybe give us a bit more color about how you're thinking about the top line underpinning that guide and have a follow up. I missed part of the question but is it about top line in fiscal 2024? Yes, I think you made a comment about double date earnings growth so just curious sort of how you're thinking about the top line as you talked about margin expansion being.

Speaker 9: but maybe give us a bit more color about how you're thinking about the top line underpinning that guide and have a follow up. I missed part of the question, but is it about top line in fiscal 2024? Yes, I think you made a comment about double data earnings growth, so just curious how you're thinking about the top line as you talked about margin expansion being the key driver there.

Speaker 4: Yeah, so look, Samik, when we look at fiscal 24, of course, we're not in a position or have the visibility really to guide to the top line for 2024, but I could give you just a few pointers here. It is clear from where we're at with our ability to ship today that we will ship the vast majority of our backlog.

Speaker 4: in fiscal 2024, either by the end of the third quarter or the end of the fourth quarter. Sorry, by the end of fiscal 23, sorry. By the end of Q3 or the end of Q4 fiscal 2023. So when you look at that on a normalized backlog level in 2024, clearly that's gonna represent a headwind.

Speaker 4: to revenue growth in 24 in the order of six to eight points of growth, given that dynamic. On the other hand, we also see that the...

Speaker 4: We're seeing a lot of projects that are delayed and our view is that customers can only sweat their assets for so long. And that at some point, demand is being pent up and demand is going to pick up. When that is going to happen, it's a bit of an uncertainty.

Speaker 4: it's reasonable to assume that we would see some of that at some point in 2024. So I can't give you a position on revenue growth for 2024, but what we can control, of course, is our cost base. And you see that we have made an adjustment to our cost base that will give us.

Speaker 4: meaningful expansion of operating margins in 2024 and secure our ability to deliver double digit earnings growth in fiscal 2024. Thank you. And so for my follow up, it was on the cost structure, obviously with some of the...

Speaker 9: expansion of operating margins in 2024 and secure our ability to deliver double digit earnings growth in fiscal 2024. Thank you and so for my follow-up I mean it was on the cost structure obviously with some of the actions you're taking.

Speaker 9: the roles you're sort of taking out, you'll operate at a much lower level of operating expenses, a percent of revenue than you have historically. I mean how much of that is sort of sustainable and you can operate at that level for a multi-year period versus just more a function of how you're looking at the macro and trying to be more conservative around it? Like is there a more structural upside to how you can how you think about operating margins in

Speaker 4: operating it as a lower cost structure? Well a couple of things there, number one is, you know, our objective has been and continue to be to drive operating leverage in the business and we think from where we're at today at the 30% operating margin for the year.

Speaker 4: If you look at it in the second half of the year, you know, it's going to be the first half within the 26, 27% zone. The second half of the year is going to be meaningfully higher than that. You know, when you look at the full year being at 30%. And from there, our intent is to drive further operating leverage in 24 and beyond. And we see the opportunity to do that.

Speaker 4: with a combination of getting more efficient in our business and driving productivity, as well as continuing to drive top-line growth. We said at our analyst day in 2020 that we were going to invest in driving some efficiencies and costs out of the business. We have been doing that. Today we're announcing some changes to our cost base, but whilst we're doing that, we're also

Speaker 4: doubling down on investments in automation that will allow us to drive operating leverage going forward. So we see that as an ongoing journey of driving operating leverage, which we'll start to see the benefits of that in the second half of this fiscal year, but that will continue in 24.

Speaker 2: Okay, thank you. Thanks for taking the questions. Thank you. And the next question comes from the line of Simon Leopold with Raymond James. Please proceed with your question.

Speaker 6: Thank you very much for taking the question. First, it does seem as if there's maybe a bit of a potential conflict in sort of the tone of really describing the situation that's temporary but taking the action of cutting staff levels and cutting expenses because...

Speaker 6: I guess the expense cuts sort of imply something about the duration of how you see the risk. And I just, I've heard everything you've said. I just feel like maybe it would be helpful to get a little bit more hand-holding of how you're thinking about the duration and what led you to make the decision. Maybe it's where are the cuts coming from. I appreciate you can't give us all the details.

Speaker 4: We spend quite a bit of time in the first half of our fiscal year looking at the demand signals that we were seeing from our customers. And if you recall, Simon, last year, we had challenges on our revenue in the second half of the year that were driven largely by issues of supply. And at the time, we said we did not want to reduce our staffing levels.

Speaker 4: because this was not a demand issue, it was a supply issue. We also said at the time that if we did see a softening in demand, that that would cause us to relook at our call space and potentially address our staffing levels, and that's exactly what we're doing. This year we're seeing a softening of demand, and whilst we appreciate that that is driven by macro environment and it is temporary, we are also being quite disciplined about driving our earnings performance, but also ensuring that in this environment we are operating as lean as we can be and as lean as we should be.

Speaker 4: And that's what's driven our approach to reducing our staffing levels. We do feel that with these staffing levels, we are well positioned to drive growth and capture the opportunity when demand levels normalize and our customers are ready to spend. In terms of giving you a couple of pointer assignments on where we have made some cuts.

Speaker 4: the G&A organizations for the size of the company we are post-discussed. In sales, we have looked at realigning or consolidating some territories and reconfiguring some of the roles in our go-to-market to have a leaner go-to-market motion and having a focus on the territories that will drive the best returns in the near to medium term.

Speaker 4: And then in our product organizations, we have looked at all R&D projects that we have on the way and really are focusing on the ones that will drive the best returns. And where we have made cuts is on those projects that are perhaps more speculative or have longer term returns. And all of those really amount to.

Speaker 4: us focusing on our top priority projects and really being leaner and positioned for when demand will normalize. I would add that whilst we're doing that, we are doubling down on investment in our software, our hybrid and multi-cloud portfolio because we're seeing growing evidence from customers from architecture conversations that we are ideally positioned for where their applications are going, where the security challenges are going, which is really about securing and delivering apps, not in a single infrastructure.

Speaker 5: Yeah, so I mean we we we are not in. We are not in the in the.

Speaker 5: Our normal course is not to update backlog in any one particular quarter. We talk about it at the end of the year. We tried to highlight people during this particular call that we did expect to be through most of our shippable backlog by the end of the physical year. Whether that's Q3 or Q4, I can't tell you.

Speaker 2: but we didn't quantify where we were at the end of Q1, and we're not quantifying where we are at the end of Q2. Thank you for taking the questions. Yep. And the next question comes from the line of Meeta Marshall with Morgan Stanley . Please proceed with your question.

Speaker 10: Great, thanks. A couple for me. Maybe to start with, you mentioned that customers are kind of running their networks at higher utilization of the F5 equipment. Just wondered if you could give a sense of...

Speaker 10: Is that matching previous levels that you've seen in prior macro pullbacks or just where we are on how hot they're running their networks versus peaks that we've previously seen if there's any way to contextualize that maybe as a first question.

Speaker 4: I would say on that front, the sample size of customers where we have really the ability to see that and understand that is limited. But for those where we can see it, we have a number of customers that are getting close to or exceeding kind of a

I want to call it a red line, but the maximum they would have normally gone to in normal times. And so that just points to us that at some point they will expand capacity.

And this is consistent actually with what we have seen in prior macro slowdowns where customers have tended to sweat their assets in this way. And in the past when we have seen customers sweat their assets this way, we have seen it happen for four to six quarters.

Now, every micro slowdown is different in shape and different in how it plays out, but that's what we have seen in the past. What we are also seeing, made out of evidence to this behavior, is that the attached rate, the services attached rate, is different in shape and different in how it plays out.

that we see on our platforms, especially the platforms that are four years old and beyond, we're seeing the maintenance attachments on these platforms go up, which is also very typical of customers sweating these older assets for a little longer. And that again is consistent with what we have seen in Pro Micro Slowdowns.

So all of that points to us that that's the behavior of customers, that they're sweating assets, that it's not a change in their thinking around architecture or a change really in our competitive position. We're seeing customers kind of hunkering down with us for a period of time.

Got it. That's helpful. Then maybe as a follow-up question, obviously, a lot of your software revenue tied to these.

cloud transformation projects are now being delayed a little bit with cloud optimization projects. But is there a way to, you know, is that largely virtual ABC projects which are being postponed, but security projects are going ahead? I'm just trying to get a sense of, is this kind of across the board, or are there certain projects that are being postponed?

that are more security attached that are getting higher prioritization. Anything that would be helpful in terms of what software projects are getting approved versus not.

I think that our security software business has been more resilient. I would say all, we're saying all product lines are affected, but our security software business has been more resilient. And for managed services and software as a service part of our business, which is still a small part of our business.

and attached security, but these projects have enormous scrutiny. We've seen, you know, a couple of them where they are approved all the way up to the CIO only for the CEO or CEO on the board to come and say we're not doing this project. And of course, that happens with these multi-million dollar projects.

but it doesn't happen as much with normal deals that are a few hundreds of thousands of dollars. In fact, this quarter, if I just speak in terms of volume, the number of multi-year subscription software deals that we did was up significantly relative to a year ago.

But when you look at it in terms of dollars, because the large multi-million dollar projects were those that were most affected or postponed, you saw the impact on our software revenue.

So that's the difference we're seeing in terms of the scrutiny on the smaller deals versus the big multimillion dollar deals. And those deals, from the feedback we're getting from customers, are not going away. They're essentially delayed by one or multiple quarters. But we do see that demand coming back down the road.

the difference we're seeing in terms of the scrutiny on the smaller deals versus the big multimillion dollar deals. And those deals, from the feedback we're getting from customers, are not going away. They're essentially delayed by one or multiple quarters. But we do see that demand coming back down the road. Great. Helpful caller. Thank you.

Thank you. Due to time constraints, we will take our last question from the line of James Fish with Piper Sandler. Please proceed with your question. Thank you.

Hey guys, most of mine have been asked but just wanted to follow up. Francois, you actually made the comment that you expect some of the, maybe it was Frank, some of the working capital stuff to kind of work itself out by fiscal Q4 and I know you don't want to talk about backlogs specifically but...

It sounds like if it's going to work itself out by fiscal Q4 that we should expect to kind of exit the year at a more normal backlog level now. Is that the right way to kind of think about it at this point? Yes, Jim. That is the right way to think about it.

Okay, and just lastly, I know you called out SaaS being more resilient and that it's still growing on a year-to-year basis. Just given now that that's become a more resilient part and it seems like it should be at this point material part of the business.

Any further color as to what percentage of the total recurring software business now sat overall and if it grew actually sequentially?

Yeah, Jim, we have not split that out and we are not currently splitting that out now. In terms of growth year over year, yes, but we just have not split that out yet.

Okay, I understood. Thanks, guys. This concludes today's call. Thank you for attending. You may now disconnect your lines.