F5 Q4 2023 Earnings Call Transcript

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Provided by Quartr
October 24, 2023

Key Takeaways

  • Q4 revenue was $707 million, up 1% year-over-year, driven by an 11% increase in software (with subscription software +27%) and 9% growth in Global Services, while systems revenue fell 25% on lower backlog-related shipments.
  • For FY2023, total revenue grew 4% to $2.8 billion, non-GAAP operating margin expanded by 130 basis points, non-GAAP EPS rose 15%, and 58% of free cash flow was returned to shareholders via share repurchases.
  • Subscription renewals performed “largely to plan” and F5’s Distributed Cloud SaaS customer base exceeded 500 (29% net new), offsetting a 25% decline in systems and displacing traditional ADC competitors in both hardware and software form factors.
  • FY2024 guidance calls for flat to low-single-digit revenue decline (including a $180 million systems backlog headwind), non-GAAP operating margin of 33–34%, and non-GAAP EPS growth of 5–7% (at least 10% on a tax-neutral basis).
  • Long term, F5 expects to return to mid-single-digit revenue growth in FY2025 with further margin expansion (gross margin 83–84%, operating margin ≥35%) and at least 10% compound annual non-GAAP EPS growth, leveraging its position in multi-cloud application and API delivery, security and emerging AI inference workloads.
AI Generated. May Contain Errors.
Earnings Conference Call
F5 Q4 2023
00:00 / 00:00

There are 12 speakers on the call.

Operator

Thank you, Suzanne, and hello, everyone. Thank you for joining us. In my remarks today, I will speak to our Q4 and FY2023 highlights as well as our expectations for FY2024. Frank will then review the details of our Q4 and FY2023 results and provide some additional color about our outlook. We delivered a solid Q4 in an environment that showed some additional signs of stabilization.

Operator

We saw strength from our enterprise vertical, including technology and financial services customers, offset by softness from service providers. The result was Q4 revenue near the high end of our guidance range. Our continued operating discipline helped us deliver earnings per share well above the high end of our range. Our Global Services team delivered robust 9% revenue growth driven by strong maintenance renewals and reflecting the benefit of price increases announced last year. In addition, software revenue grew 11% aided by 27% growth in subscription software.

Operator

Software revenue from renewals, which have performed well all year, ticked up in Q4 over Q3. And while new subscriptions remained down year over year, we saw some improvement compared to the first half. Strength in Global Services and Software offset a systems decline of 25%, which reflects a lower level of backlog related shipments than we had for the 1st 3 quarters of the year. Stepping back and looking at fiscal year 2023, we adjusted to the environmental challenges we faced, resolving supply chain pressures and largely returning to normalized delivery times. We took size of action to adjust our operating model to the realities of the demand environment, driving meaningful improvement to our operating margins and delivering 15% EPS growth.

Operator

We also returned 58% of our annual free cash flow to shareholders via share repurchases. Highlights from FY2023 include: 1st, subscription renewals performed largely to plan for the year. In today's tough IT spend environment, this is a strong signal that customers are getting the value and return they expect from our software solutions. 2nd, F5 Distributed Cloud Services SaaS offerings are gaining traction with both new and existing customers. In fact, 29% of Distributed Cloud SaaS customers are new to F5.

Operator

In total, we now have more than 500 for our SaaS services on distributed cloud, an increase of more than 200% since Q4 of last year. 3rd, we are having very good success displacing a traditional ADC competitor in both software and hardware form factors. And finally, we delivered meaningful operating improvements, driving our non GAAP operating margin up 130 basis points from FY2022. As we look ahead, we enter FY2024 in an environment that seems to be stabilizing. In fact, From a demand perspective, we saw encouraging early signs with enterprise customers in Q4, though it is too soon to say if what we are seeing is a durable trend.

Operator

As we contemplate our outlook for FY2024, we consider a number of factors. At the macro level, we expect continued application and API growth fueled by automation efforts and new use cases, including generative AI. We also expect customer spending caution persists into FY2024, but is stable. And finally, We believe the tension between application and API growth and customers' ability to sweat assets will reach a tipping point causing them to reinvest in their application infrastructure likely beginning sometime in FY2024. At the F5 level, we also consider.

Operator

First, we have an approximately $180,000,000 revenue headwind from FY2023's backlog fulfillment, primarily in systems. 2nd, we expect flat to modest total software revenue growth in FY2024 as a result of a number of dynamics including continued subscription renewal strength and steady distributed cloud SaaS revenue growth. These positive trends will be offset by a series of transitions we are executing in our SaaS and managed services offerings. And 3rd, we expect our global services revenue will return to low single digit growth as we lap price increases. As a result of these factors, we expect our FY2024 revenue will be flat to down low single digits from FY2023, inclusive of the 6% headwind related to FY2023 backlog shipments.

Operator

We also expect to return to mid single digit revenue growth in FY2025. Whether we achieve the low or high end of our revenue range, we are committed to driving continuing strong profitability and we will continue to manage our operating model with discipline. We expect to deliver FY2024 non GAAP operating margin in a range of 33% to 34%. We are also targeting FY2024 non GAAP EPS growth of 5% to 7%, reflecting growth of at least 10% on a tax neutral basis compared to FY2023. Our growth opportunity is fundamentally linked to the continued growth of applications and APIs and the need to secure, deliver and optimize those apps and APIs.

Operator

F5 is the only company that can deliver, secure and optimize any app and API anywhere. Our security and delivery solutions offer a custom fit for each app and API. Modern apps and APIs require different solutions than legacy apps. We have the right solutions for both. In addition to delivering the right tools for the right app or API, our combination of deployable software and hardware and SaaS and managed service offerings means we are the only vendor that can serve every app and API across all environments in a data center, public cloud and at the edge.

Operator

We are the only company who can do this today. And going forward, further integration and convergence of our solutions will make it much easier for our customers to secure and deliver their apps across all infrastructure environments. The power of our converged portfolio is resonating with customers who are able to deploy the solutions they need today with the knowledge that F5 will be with them on every step of their multi cloud journey. Before I pass the call to Frank, I will speak to some customer highlights from each of our product families. Our SI BIG IP family serves traditional applications either on premises, co located or in cloud environments.

Operator

BIG IP's data plane performance, automation capabilities and seamless integration into public cloud environments continues to differentiate the platform. And we continue to win against competitors. From a hardware perspective, the value proposition with our next generation platforms is resonating with customers with our R Series and Velos platforms representing more than 80% of Q4 systems bookings. In one example of a BIG IP win from Q4, we displaced a competitor at a North American healthcare customer. The opportunity arose as a result of the incumbent provider's inability to handle a mission critical upgrade to the customer's physician portal.

Operator

The customer selected F5 BIG IP based on its advanced application delivery capabilities, secure access management, our partnership with their healthcare records platform and confidence in our roadmap. In addition to providing the mission critical functionality the customer needed urgently. We replaced all of the competitors' use cases with the customer, simplifying their application environment and future proofing their data centers. F5 NGINX delivered a very strong Q4. NGINX serves modern container native and microservices based applications and APIs.

Operator

We continue to see large enterprises adopt NGINX for their cloud and Kubernetes workloads and as those applications scale, we are seeing our NGINX opportunity scale as well. In addition, customers are also leveraging NGINX for app layer security for containers. As an example, in Q4, when the e commerce division of a global technology customer needed to comply with new data security standards, they selected NGINX App Protect to implement app layer security to the containers processing consumers' credit card data. We have invested both and inorganically to build our F5 distributed cloud services, a portfolio of SaaS and managed services. Apart from the offering transitions I mentioned, we are really excited about the future for Distributed Cloud.

Operator

We are intercepting 2 citing emerging growth categories, web app and API protection or WAP and secure multi cloud networking or secure MCN that will drive future growth for Distributed Cloud Services. In one WAP win for the quarter, We are helping an EMEA based banking customer evolve from its traditional WAF security posture to a more comprehensive WAF solution that encompasses web application firewall as well as API protection, bot defense and Layer 7 DDoS protection. This customer approached us when they came under attack by a malicious foreign actor that their existing WAF could not handle. Against multiple competitors, we successfully demonstrated the superiority of our WAP offering, including our ability to protect major payment companies' APIs. Early traction for our secure multi cloud networking offerings includes a Q4 win with a large retailer in Latin America that also offers a range of financial services to its customers.

Operator

As part of its digital transformation efforts, We needed a solution to enable them to grow and manage their expanding body of cloud native applications. They also planned to migrate their large existing footprint of virtual machines and on premises appliances to the cloud. After a thorough proof of concept, The customer selected our secure multi cloud networking solution because of our ability to use the customer edge to make the move 100% transparent to both internal users and consumers. We are also seeing cross portfolio traction with customers who are operating in hybrid environments choosing to deploy F5 across multiple form factors. In a win that highlights the synergies of our product families, During Q4, we secured a win with an APAC based financial services provider.

Operator

The customer launched a multifaceted modernization project designed to add and consolidate applications and enable scalability to handle exponential traffic growth. They also needed help stopping a barrage of constant automated attacks. In a competitive bid, our combination of BIG IP and F5 Distributed Cloud Bot Defense won out. The combination enables the customer to manage on predictable traffic growth, customized services for each application and enhance their security posture with our ML based AI engine. These real life use cases offer a view to how we are enabling customers to secure, deliver, optimize and manage their applications and APIs and how we simplify the challenges of operating in a complex hybrid multi cloud world.

Operator

Now I will turn the call to Frank. Frank?

Speaker 1

Thank you, Francois, and good afternoon, everyone. I will review our Q4 and FY2023 results before I elaborate on the outlook Francois shared. We delivered Q4 revenue of $707,000,000 reflecting 1% growth year over year with a mix of 54% global services and 46% product revenue. Global Services revenue of $382,000,000 grew a strong 9% due to continued high maintenance renewals as well as the price increases we introduced last year. Product revenue totaled $325,000,000 down 7% year on year.

Speaker 1

Systems revenue of $134,000,000 declined 25% year over year, reflecting a lower level of backlog related shipments than we had in prior quarters and demand that showed some signs of stabilization, albeit at lower levels than we have seen historically. In contrast, software revenue grew 11% over the year ago period to a new high of $191,000,000 Subscription based revenue grew 27% year over year to $166,000,000 another record high, representing 87% of Q4's total software revenue. Perpetual software license sales of $25,000,000 represented 13% of Q4 software revenue. Revenue from recurring sources contributed 76% of Q4's revenue, another all time high. Recurring revenue includes subscription based revenue as well as the maintenance portion of our services revenue.

Speaker 1

On a regional basis, Revenue from Americas was down 6% year over year, representing 57% of total revenue. EMEA grew 16 percent of revenue and APAC grew 4%, representing 17% of revenue. Looking at our major verticals, During Q4, enterprise customers represented 72% of product bookings, service providers represented 9% and government customers represented 19%, including 7% from U. S. Federal.

Speaker 1

Our Q4 operating results were strong, reflecting operating discipline and a full quarter benefit from the cost reductions announced in April. GAAP gross margin was 80.1%. Non GAAP gross margin was 82.7 percent, an improvement of 125 basis points from Q4 of FY2022. GAAP operating expenses were $394,000,000 non GAAP operating expenses were 345,000,000 Q4 non GAAP operating expenses as a percent of revenue was below 49%, resuming pre-twenty 19 acquisition levels. Our GAAP operating margin was 24.3%.

Speaker 1

Our non GAAP operating margin was 33.9%, representing an improvement of more than 600 basis points from Q4 of FY2022. Our GAAP effective tax rate for the quarter was 13%. Our non GAAP effective tax rate was 14% below our initial expectations for the year as a result of IRS guidance issued during the quarter relating to foreign tax credits. Our GAAP net income for the quarter was $152,000,000 or $2.55 per share. Our non GAAP net income was $209,000,000 or $3.50 per share, well above the top end of our guidance range of $3.15 to $3.27 per share.

Speaker 1

This reflects the combined impact of our gross margin improvements and operating expense discipline as well as the Q4 tax benefit. I will now turn to cash flow and the balance sheet, which also remain very strong. We generated $190,000,000 in cash flow from operations in Q4 driven by our improved profitability. Capital expenditures for the quarter were $15,000,000 DSO for the quarter was 58 days. Cash and investments totaled of approximately $808,000,000 atquarterend.

Speaker 1

Deferred revenue increased 5% year over year to 1,780,000,000 We repurchased $60,000,000 worth of shares in Q4. For the year, we used 58% of our approximately $600,000,000 of free cash flow for share repurchases. I note that in each of the past 3 years, we have met or exceeded our share repurchase commitments. Finally, we ended the quarter with approximately 6,500 employees. I will now recap our FY2023 results.

Speaker 1

For the year, revenue grew 4 percent to $2,800,000,000 Global Services revenue grew 7% to $1,500,000,000 representing 53% of total revenue for the year. Product revenue grew 1% to $1,300,000,000 representing 47% of total revenue. For the 2nd year in a row, software represented roughly 50% of product revenue. Software revenue was flat compared to last year at $664,000,000 This was down from our initial expectation of 15% to 20% growth as a result of customers delaying large transformational projects. As Francois noted, software renewals performed largely as planned.

Speaker 1

We delivered $671,000,000 in systems revenue during the year, representing 3% growth. I would now like to provide some additional information regarding software revenue. We've said we intended to provide additional software revenue details as the SaaS business scale. As we said last October, we had several SaaS and managed service transitions planned. We started these transitions in FY2023 and they will continue through FY2024 and FY2025, leading to some short term revenue variability that is not indicative of potential future performance.

Speaker 1

We believe that providing visibility to our SaaS and managed service revenue and to the transitions that are underway provides greater clarity on both our FY2024 revenue expectations and our and expectations of returning to mid single digit revenue growth in FY2025. Today, I will speak to 3 components of our FY2023 software revenue. The first, term subscriptions the second, SaaS and managed services and the third, perpetual licenses. We intend to continue to report the SaaS and managed service portion of our revenue on an annual basis going forward. In FY2023, revenue from term based subscriptions comprised of BIG IP and NGINX subscriptions contributed $353,000,000 to software revenue, up 9% year over year.

Speaker 1

Under ASC 606, sales of term based subscriptions are recognized largely upfront as software revenue. The remainder is deferred and recognized as service revenue over the term of the subscription. The majority of our term based subscriptions are contracted for 3 years. Term subscriptions include both new, renewal and Trufford or expansion revenue for both annual and multiyear subscriptions of deployable software. New revenue includes new customers as well as new use cases or offerings sold to existing customers.

Speaker 1

In FY2023, Renewal and Truford, our expansion revenue, experienced healthy year over year growth offsetting the weakness in new term subscription software projects. Renewals performing largely to plan in FY2023 is encouraging for several reasons. First, given the current levels of customer spending scrutiny, Strong renewals are a signal that customers are getting the value they demand. 2nd, our renewals motion is still relatively new and it's great to see confirmation that it is working as intended. The second component of our software revenue, SaaS and Managed Services contributed $203,000,000 in revenue in FY2023, up 2% year over year.

Speaker 1

SaaS and managed service is comprised of our F5 distributed cloud SaaS offerings, revenue from managed services including our legacy 5 Silverline offering and our anti bot and anti fraud offerings as well as revenue from legacy SaaS offerings. SaaS and managed service sales are recognized ratably as product revenue over the term of the subscription. At the end of FY2023, our SaaS and managed services ARR was $198,000,000 down approximately 2% year over year. There were 4 primary contributors to this performance. First, we are seeing solid early momentum from our F5 distributed cloud service SaaS offerings.

Speaker 1

2nd, in FY2023, our most advanced anti bot and anti fraud managed service solutions underperformed relative to our plan as a result of customer spending caution and budget scrutiny. 3rd, in FY2023, we began migrating customers from our legacy Silverline managed service offerings to our F5 distributed cloud SaaS offering. And 4th, we began executing the planned retirement of legacy SaaS offerings from companies we acquired. Both the Silverline customer migrations and the retirement of legacy SaaS offerings resulted in planned revenue churn. The 3rd component of our software revenue is perpetual licenses, which contributed $108,000,000 in software revenue down year over year after unusually strong FY2022.

Speaker 1

In FY2023, 71% of our revenue was recurring, up from 69% in FY 'twenty two. Several years ago, we began breaking out our security related revenue annually. This year, our total security revenue, which includes standalone security, attached security and security related to maintenance revenue was approximately $1,100,000,000 or 40 percent of total revenue. Our standalone security product revenue grew 5% to approximately 4.70 $5,000,000 We are seeing good traction with the lower end anti bot offering delivered through distributed cloud services as well as from security on NGINX. Our FY2023 secondurity revenue growth was affected by customer spending caution including stalled transformational projects and the underperformance of advanced anti bot, anti fraud solutions as I mentioned previously.

Speaker 1

During the year, we overcame supply chain challenges and successfully returned our lead times to normal levels. As a result, our FY2023 product backlog returned to pre supply chain challenge levels and we closed the year with approximately $53,000,000 in product backlog. I will now turn to our FY2023 operating performance. GAAP gross margin in FY2023 was 78.9%. Non GAAP gross margin was 81.5%, down 110 basis points from FY2022 as a result of higher supply chain costs in FY2023.

Speaker 1

Our GAAP operating margin for FY2023 was 16.8% and our non GAAP operating margin was 30.2%, up 130 basis points from FY2022 as a result of our previously announced cost reductions. Our GAAP effective tax rate for the year was 18.7%. Our non GAAP effective tax rate for the year was 18.3%. Our FY2023 annual tax rate was lower than expected primarily due to IRS guidance issued during the Q4 related to foreign tax credits. GAAP net income for FY2023 was 395,000,000 were $6.55 per share.

Speaker 1

Non GAAP net income was $705,000,000 or $11.70 per share, representing growth of 14.8 percent over FY2022. Francois outlined our annual and longer term outlook at start of the call. I will recap it with some additional color. I will also provide our outlook for Q1. With the exception of revenue, my guidance comments referenced non GAAP metrics.

Speaker 1

In our FY 'twenty four outlook, we've made the following assumptions. We expect customer spending caution will continue into FY 'twenty four, though we also expect customers will begin to reinvest at some point in the year. We expect our global services revenue will return to low single digit growth as we lap price increases. We have approximately $180,000,000 revenue headwind in systems from FY2023's backlog fulfillment. We expect to continue to take share in the traditional ADC space with BIG IP in both hardware and software form factors.

Speaker 1

Within our software revenue, we expect continued strength from our term subscription renewals and continued growth from our F5 distributed cloud SaaS offerings. As I discussed previously, we will have some planned revenue churn as we work through the SaaS and managed service transitions I discussed. We expect these transitions will be largely complete in FY2025. In FY2023, ending ARR associated with the transitions is approximately $65,000,000 a little more than half of which is associated with the offerings we intend to transition onto distributed cloud over the next 2 years. The net of these assumptions combined with the current demand levels leads us to expect FY2024 revenue in the range of flat to down low single digits from FY2023.

Speaker 1

Excluding the $180,000,000 or 6% headwind from our FY2023 backlog reduction, our guidance range would reflect low to mid single digit revenue growth in in the Q4. Whether we achieve the bottom or top end of this range largely depends on when customers resume more normal levels of spending. We expect some continued quarter to quarter variability as a result of upfront revenue recognition related to our term subscription offerings. Regardless of our revenue performance, we remain committed to driving strong profitability. From an operating perspective, we supply chain related cost pressures working their way out of our model.

Speaker 1

We expect our continued operating expense discipline will result and FY2024 non GAAP operating margin in the range of 33% to 34% for the year. On a percent of revenue basis, This would put our operating expenses roughly in line with 2018 levels at roughly 49% of revenue. We expect our FY2024 effective tax rate will be 21% to 23%. In FY2024, We expect to deliver 5% to 7% non GAAP earnings growth, which translates to at least 10% year over year growth on a tax neutral basis. Finally, we expect to use at least 50% of our annual free cash flow for share repurchases consistent with the approach we have discussed previously.

Speaker 1

As of the end of FY2023, we had $922,000,000 remaining on our previously announced authorized share repurchase program. We also want to take the opportunity to speak to our expectations beyond FY2024 as we believe it will help signal how we intend to run the business longer term. As Francois noted, we expect mid single digit revenue growth in FY2025. We expect to drive additional gross margin improvements and to deliver gross margins between 83% 84%. We expect to grow our operating expenses slower than revenue, resulting in operating margin of at least 35 We will continue to prioritize profitability adjusting our operating model if needed to enable us to deliver at least 10% compounded annual non GAAP EPS growth.

Speaker 1

Finally, we intend to continue to use at least 50% of our annual free cash flow towards share I'll conclude with our expectations for Q1 of FY2024. We expect Q1 revenue in the range of $675,000,000 to $695,000,000 We expect gross margins in the range of 82% to 83%. We estimate Q1 operating expenses of $332,000,000 to $344,000,000 We are targeting Q1 non GAAP EPS in the range of $2.97 to $3.09 per share. We expect Q1 share based compensation expense of approximately $58,000,000 to $60,000,000 I will now turn the call back over

Operator

to Francois. Francois? Thank you, Frank. Before we open the call to questions, I want to address our view on F5's AI opportunity. At the highest level, we believe customers use of AI will accelerate the growth of applications and APIs and the corresponding need to deploy, manage and secure them, which is what we do best.

Operator

We also believe AI inference, the process of using a trained model to make predictions on never seen before data will become increasingly distributed. Organizations will need to support it anywhere from data centers to manufacturing floors to public clouds. We believe every application and API will soon require inference just as they require security and traffic management. With our rich history of delivering innovative ML based security solutions, including bot defense, protection against denial of service attacks and anti fraud and our role in the flow of application traffic. We are uniquely positioned to secure AI workloads wherever they reside and to empower our customers to run AI wherever they need it.

Operator

In conclusion, we are leveraging our incumbency and our position in the flow of 40% of the world's Internet traffic to deliver hybrid multi cloud solutions that dramatically simplify application and API deployment, security and management for our customers. We are also significantly reducing our customers' total cost of ownership. We are uniting and automating all of our customers' apps and APIs across their data centers, cloud and edge environments. We are encouraged both by the early signs of stability we saw in the second half of twenty twenty three and with the resonance our converging portfolio is having with customers. We have an installed base of 20,000 customers, all of whom have an acute and significant multi cloud challenge.

Operator

Other than F5, there is no one company that can address this challenge. With F5 Distributed Cloud Services, we have created a platform to drive SaaS growth in the future. In closing, I will reiterate the 3 pillars of our long term operating model, which will enable us to drive double digit earnings on a compound annual growth rate. Number 1, delivering sustained mid single digit revenue growth supported by our differentiated positioning in attractive end markets along with our durable, high margin Global Services Business. Number 2, driving non GAAP operating margin expansion, which we will achieve through gross margin improvement and operating discipline.

Operator

And number 3, returning cash to shareholders via share repurchases using at least 50% of our annual free cash flow. Operator, please open the call to questions.

Speaker 2

Thank you.

Speaker 3

Our first question comes from the line of Amit Daryani with Evercore. Please proceed with your question.

Speaker 4

Good afternoon. Thanks for taking my question. I guess, Francois, maybe to start with, you talked about software growth being Flat to I think up modestly, but that included some of the headwinds around the business transition you're taking place on the managed services side. I didn't appreciate this, but Is the headwind from this transition $65,000,000 or is it half that number? And maybe just flush out how much that is and what are the transitions that you're doing?

Operator

Hi, Amit. So in total so we talked about roughly $200,000,000 SaaS embedded services. In that $200,000,000 there's about $65,000,000 of revenue stream that essentially are going to go away. Now about more than half of that is revenue streams coming from a legacy manager of this platform, Silverline, that we are retiring, but we intend to migrate the customers over to distributed cloud. So we would expect a portion if not a significant portion of that revenue stream to go on to distributed cloud over time.

Operator

The other a little less than half of that $65,000,000 are offerings that we are retiring completely that when we looked at our portfolio and looked at the offerings we wanted to rationalize that we felt were underperforming, We decided to retire these offerings completely to focus on the products that are going forward and successful, rationalize our cost and improve our efficiency.

Speaker 4

Got it. That is really helpful to get understand the split on the 65,000,000 And then I think, Francois, in your comments you sort of talked about you're seeing encouraging signs from enterprise customers in September quarter. Can you just perhaps talk about what are these signs? Is it just the assets are running at high utilization, you can't select them anymore? And is there any sort of geo or vertical where you're starting to see Initial positive signs that you made from customer demand?

Operator

I mean, I wouldn't say there is a particular geography where we are that's really different than others. I would say North America has been probably more solid and stable than our Asia and European markets. If we look at verticals in terms of where we're seeing stabilization, I think the enterprise market, we're seeing more stabilization. The service provider market has been soft. That's for a number of factors.

Operator

Service providers continue to sweat assets and be really ruthless in their prioritization. The 4 gs to 5 gs transition is a little slower that anticipated. So service providers in general have been soft and we're kind of expecting that to continue. What we were encouraged by, especially in the second half of the year, but specifically in Q4 is in the enterprise space specifically, We saw some customers that had been sweating their assets and got to kind of the end of that cycle and started demanding hardware again or ordering hardware again. So we did see a rebound in hardware orders in the 4th fiscal quarter.

Operator

Coming from, A, we think some customers having sweated their assets, but also it took a long time for us to ship equipment to a number of our customers in 2023. And in Q4, we saw some of these customers that finally had received their hardware and had been able to deploy that to start ordering again. So we were encouraged by those trends.

Speaker 4

Got it. Thank you very much.

Speaker 3

Our next question comes from the line of Alex Henderson with Needham. Please proceed with your question.

Speaker 5

Great. Thank you so much. Looking back at your prior longer term expectations, I think you had talked about growth rate in software in excess of 20% and high to mid single declines in systems. Can you give us an update on what Do you think those percentages might look like longer term once you get through the wobble in FY2024?

Operator

Yes. So Alex, We're so today we're so I don't want to talk about what's beyond FY2025. I'm going to talk about FY2024 and 2025. Beyond FY2025, I think our view of our end markets haven't really changed. And so in the future, that opportunity to return to 20% plus growth in software.

Operator

They're based on the end markets that we are targeting. But let's talk about FY2024 and FY20 FY2024, we've talked about growth in software being flat to modest. And that's If you take the 3 components of software that we've just talked about, we expect the perpetual base of the business to be roughly flattish. We have a similar view on the SaaS and managed services part of the business based on the transitions we're going through. And potentially, in the term subscription part of the business is where potentially we would see some modest growth.

Operator

Going into 2025, From a revenue perspective, we don't necessarily expect growth from perpetual or the SaaS and Managed Services business because of the transitions that we're going through. But we have strong visibility into our the renewals and expansions in our term subscription business. The expansions are very strong from what we're seeing and we expect that to continue and be amplified in 2025. So in 2025, we would expect software growth to return to double digit, really powered by our term subscription business.

Speaker 5

I see. Just if I could follow-up, you talked about your backlog having been normalized, but You've also had orders out for components that were driven off of the tight supply environment. When do you expect the full normalization of the component costs in your cost of goods sold? Is that already achieved or is that going to be something that's going to feather in over the next year, maybe year and a half?

Speaker 1

Alex, it's Frank. So largely most of that has been achieved. There is still some of the purchase price variances that are coming through in FY2024. By FY2025, we expect that to be fully out in a normalized level.

Speaker 5

Can you give some sense of what the 2024 variance would be?

Speaker 1

Alex, I think it's probably in the range of 25 to 50 basis points where we'll see improvement just based off of that in comparison to expectations for gross margins in FY2025.

Speaker 5

Great. Thank you so much.

Speaker 3

Our next question comes from the line of Samik Chatterjee with JPMorgan. Please proceed with your question.

Speaker 6

Hi, thanks for taking my question. I guess Francois, just relative to your fiscal 20 25 outlook for mid single digit, I'm Just curious if you've changed your view about what the long term trajectory in systems demand looks like, particularly as you mentioned, you've seen orders pick up a bit. Maybe you can also talk about when you talked about AI demand, do you expect how do you expect it to play out between systems related to sort of software within your portfolio and have a quick follow-up. Thank you.

Operator

Sameet, thank you, Deane. So over For a long period of time, I think we think the hardware business would be more of a low single digit decline over time. However, that is a statement that is based on first, a normalization of the hardware business and we're not there today, right? There's been, as you know, the demand was much softer in 2023. And so we actually expect our hardware business to rebound in 2024 and we saw some signs of that already in this Q4.

Operator

And I'm giving you more of a long term trend kind of beyond 2025, but I think at least for 2024, we expect to rebound in the hardware business. In terms of where AI will play in our business. So the way to think about it, Samik, is We the portfolio that we're putting together, which is hardware, software and SaaS, we expect that will enable our customers to secure and deliver their API and their applications in any environment. AI workloads are going to be modern applications, some of which may run on prem, but we think a lot of them will run-in software environment. And so it's likely that supporting AI workloads will accrue more to our software business over time.

Operator

And in addition to that, we think we have a very unique position in that with our distributed cloud capabilities, We are able to run inferences really in any cloud environment and beyond. So we can run inferences in any public cloud. We can run it at the edge. We can run it in our own cloud. And increasingly, we're hearing from customers that they will want to run these inferences on manufacturing floors or in retail branches for retail customers or in vehicles for some far edge use cases.

Operator

And we have the ability to run and secure and deliver these inferences in any environment, whether it's in a cloud or in any one of these far edge environments and that makes F5 very unique in its position for running AI inferences in the future. All of that, of course, will accrue to our software business.

Speaker 6

Got it. Got it. For my follow-up, Francois, you mentioned the green shoots you're seeing in terms of enterprise So spending and the recovery there. I think one of the pushbacks we've seen from investors on that front has largely been the expectation that There might be a pickup here in the back end of the year just from a budget flush perspective from the enterprises and you might sort of see a pullback again as we enter into Stuart and more sort of budget cuts. Any insight that you're already getting from your customers about how budgets look for next year or in relation to whether this sort of pickup is anything to do with a more temporary flush of budgets before the year end?

Speaker 6

Thank you.

Operator

Thank you, Samik. I don't think it was related to budget flush for the end of the year because the comments we made in resumption were really things we observed in the quarter that ended in September for us. When we look at next year, No, we do not have visibility into exactly what budgets our customers will have in FY2024. We do have a strong pipeline entering the fiscal year on hardware. And it will come down to what are the close rates on that pipeline.

Operator

In Q4, the close rates that we saw on our pipeline entering the quarter were better than in the prior three quarters of the year. That's also part of why We talked about stabilization and green shoots in Q4 is because what we saw in the close rate. So we're going into the fiscal year with a stronger hardware pipeline. Recent data points from close rates that are positive. But of course, we are cautious because there's still a lot of uncertainty out there around the macro.

Operator

As you noted, we continue to see customers In certain occasions, delaying deals or having continued budget scrutiny and more approvals, we are seeing that phenomenon continue. And so overall, we're still cautious going into the year.

Speaker 6

Thank you. Thanks for taking my questions.

Speaker 3

Our next question comes from the line of Meta Marshall with Morgan Stanley. Please proceed with your question.

Speaker 7

Great. Thanks. Maybe building on Samik's question to start. As you look at your pipeline, is your view that a lot of this is Okay. We've sweated assets as much as we can or the utilization of the appliances is too high or Are we starting to see kind of growth in multi cloud projects again?

Speaker 7

Just trying to get a sense of as you look at your pipeline, is it Traditional applications are expanding use cases. And then maybe as a second question, you mentioned kind of having Plays as AI and inference cases grow. Is that going to require productization of any kind of suites of products today or just kind of tailoring to kind of have AI ready solution. Thanks.

Operator

Thank you, Meta. Veeel, so let me start with the first question and my comments on pipeline. They are more related to what we're seeing in the on the hardware side of things, where we had a number of customers that A, number 1, have been swelling their assets and they're getting sometimes to utilization levels where we know that At some point in 2024, they will have to do something. Or number 2, customers who had placed orders in FY2022 have not been able to receive equipment for these orders who now have and have started to deploy that capacity and are starting to be ready to order again. So that is accruing to a stronger hardware pipeline.

Operator

In terms of big kind of multi cloud what we've called this transformational software project. We are not yet seeing a substantial resumption of these kinds of projects. That's what I was saying earlier is customers are still very cautious on undertaking big projects like that. And we're not seeing a different pattern going into the year on those aspects. As it relates to AI and whether it will require productization, we have essentially so On the aspect of being able to run inferences in any environment, we have these capabilities in distributed cloud.

Operator

I think we need to ensure that we harden these capabilities and there is a strong go to market effort to be made around that to make customers aware of that in the future as they start deploying these AI workloads. As it relates to being able to secure and deliver AI workloads, those capabilities exist today and we are ready to go with that already.

Speaker 1

Mehta, I just wanted to add that last year we talked about in our outlook, particularly in software that We were a little less than 50 percent of our outlook at the time was coming from the renewals in the True Forwards portion of our term subscription agreements and that and our SaaS based of revenue, and that's a little more than half was going to come from new. This year as we take a look at that same formula and we look out over 60% of what we expect in that flat to modest software growth is coming from both the renewals pieces of the SaaS and managed service business, plus the renewals true forts of our term subscription business. So we tried to take into account the fact that we don't see these transformational projects on the horizon as we thought about the guidance.

Speaker 7

Great. Thank you.

Speaker 3

Our next question comes from the line of Michael Yang with Goldman Sachs, please proceed with your question.

Speaker 2

Hey, good afternoon. Thank you for the question and for all the comments on the outlook. I just had 2 both on software.

Speaker 1

First, I was just wondering if you

Speaker 2

could talk a little bit about your visibility into the term business. You called out term as something that would help drive the double digit software revenue growth in fiscal 2025 as well as Potential growth in fiscal 2024. And then second, I was just wondering if you could talk a little bit more about this migration from Silverline To DCS, it sounds like it's a multiyear headwind, something that contributed to the Weakness in ARR in fiscal 2023, but it also seems to be a headwind in fiscal 20 24 and fiscal 20 25. So Maybe you could just talk about that and how that transition is rolling off and over how many years? Thank you.

Speaker 1

Sure, Mikael. I'll start with the first question and then I'll let Francois jump in on the second on the Silverline side. So on the first on the term subscription, particularly the true forwards and the expansions that we have seen with the second terms coming on and we've had probably about 7 or 8 quarters now of run rate and are getting much more comfortable with the early signs that where massive expansions continue. And so getting very, very strong utilization from that base of deployed flexible consumption programs. And this specifically covers right now, the IP and the NGINX portfolio within our business, as I mentioned in the prepared remarks.

Speaker 1

And that's giving us a lot of comfort both in FY2024 and more importantly in FY2025. FY2025, we've got a bigger pool of expansion revenue than we do in FY2024 and 2024 is growing on top of 2023. So all of these continue to compile upon themselves. As I just mentioned to Mina that more than 60% of the outlook that we've got within our software revenue is coming from that cohort that we feel pretty good about seeing, which is the term renewals as well as Truforwards plus SaaS managed service renewal piece that we've got in the revenue stream. So both of those we feel very confident about and it's probably the highest visibility that we've got within the revenue stream.

Operator

Thank you, Frank. And to your second question, Michael, on SaaS and managed services. So if we talk about FY2022 to FY2023, you saw that the ARR there was flat to slightly down. There are two Reason for that, one is, yes, the transitions we talked about started in 2023 and there was about, call it roughly $12,000,000 of ARR that we transitioned out of the business in 2023. The other reason is at the high end of the bot business, we saw quite a bit of softness, especially in the second half of the year as customers had significant budget scrutiny and were reluctant unless they were under immediate attack to really implement our most sophisticated solutions.

Operator

We think over time That will change, but specifically this year with the macro pressures and budget scrutiny, we saw a lot of softness there, both in new bookings and in some churn in some cases. So that is the FY2022 to FY2023 from going into 2024, you asked about if this transition is a multiyear transition. Yes, we expect that the $65,000,000 of revenue stream that we are transitioning will work themselves out over the next couple of years. So over FY 20 24 and FY 25, they are a headwind to total growth. However, we are quite excited by what's happening with the SaaS portion of our offerings, specifically SaaS on FI Distributed Cloud.

Operator

We have launched a WAP offering, a security offering, about 18 months ago. We are seeing Extraordinary traction on that. As I said earlier, we've won over 500 customers in that period, all of whom are enterprise customers. And we are seeing very rapid traction on that. We're also seeing rapid traction on the multi cloud networking market, where we bring both networking and security capabilities and we're quite differentiated to anybody in the market.

Operator

So that has grown fast and we that portion of the business to continue to grow fast and over time become a majority of this SaaS and managed services portfolio.

Speaker 2

Thank you, Frank. Thank you, Francois. Very helpful.

Speaker 3

Our next question comes from the line of Tim Long with Barclays. Please proceed with your question.

Speaker 8

Thank you. 2 effects out as well. First, Francois, I think

Speaker 9

you talked about replacing a competitor within the ADC, both hardware and software domain. Could you dig into that a little bit more? Is that something that you think was kind of some one offs? Or do you think there's a sustainable move there and how is that happening? And then second, just on the changes and the transitions in software, It sounds like moving to distributed cloud services makes a lot of sense.

Speaker 9

Having looked at some of those businesses and kind of moving on from them, Does that change your view of kind of synergies across product offerings? Or is it a sign that maybe those businesses didn't have the same synergy and Why you're not going forward with them? Thank you.

Operator

Thanks Tim. Maybe let me start with the second part. No, it's not about synergies. So there are two aspects So that Tim, in terms of the transitions, we're talking about the $65,000,000 of transition. 1 is a legacy platform that we had that on which we had built managed services offering.

Operator

We have now built with FI Distributed Cloud a much more modern platform with an architecture that's differentiated and that's creating rapid traction and we want to transition our customers to this modern platform. And that was always the plan. That was always the plan to do that. However, we had to, 1st of all, build the platform and build all the security capabilities on the platform to be able to start this transition. So we're very excited that we were able to do all this work on the Voltera platform over the last couple of years and we're able to start this transition in 2023.

Operator

The second part of the revenue stream that is being retired is not about synergies, it's new offerings that we have launched recently that we hoped would do well in the market. But given the macro environment and what we've seen as Early traction on these offerings, we made some decisions, as you know, in April to rationalize our portfolio and focus on the most attractive investments and we decided to not go forward with these products. So that's the second part of your question. On the I should say that the last thing I would say about that is in terms of the synergies between elements of the portfolio, No, we are actually very encouraged on what we're seeing. We're seeing actually a number of customers who already have BIG IP adopt distributed cloud.

Operator

So for a set of applications, they have big IP on prem or in the cloud, so hardware or software. And then they want to have software as a service for other applications in their state and they really want to have the consistency of security engine, security policies across all these environments, and we're able to do that with BIG IP as well as our SaaS and managed services. NGINX also had a very strong quarter in Q4 and that was driven in part by the security capabilities that we ported from BIG IP onto NGINX and that same security stack is now in use in distributed cloud. So the synergies, especially in terms of security for our portfolio are playing out and we expect that they will accelerate actually over the next couple of years as we do more and more convergence between the SaaS and Deployable products. Now to the first part of your question, in terms of the ADC competitors, Look Tim, here it's we have over the last 4 years, we made a decision to continue to invest in the future of the ADC franchise and specifically building the next generation hardware form factors for our ADC franchise and the next generation software form factors that together bring to on prem deployments the benefit of the cloud, such as multi tenancy, rapid upgrades, seamless upgrades and make it way easier for customers to operationalize ADCs and have a better total cost of ownership.

Operator

Those investments are paying out in the market in terms of us gaining share and being able to displace our traditional competitors in even in situations where they are incumbent and take share from them. And we think that that's not a one off our expectation is that will continue and we're pretty excited because this year we're introducing the next generation software platform on BIG IP that we think is also even more differentiated than what we've had in the market. So I expect that, that will continue and it's hopefully a payoff for the investment we've made over the last 4 years.

Speaker 8

Okay. Thank you.

Speaker 3

Our next question comes from the line of Ray McDonough with Guggenheim. Please proceed with your question.

Speaker 10

Great. Thanks for taking the questions. Francois,

Speaker 4

Given some

Speaker 10

of the changes you're making to your software portfolio, it seems like in a way you're simplifying or even converging some of your solutions. So as we think about the roadmap for distributed cloud in particular, what can you do to accelerate adoption and make sure you capture the potential voluntary churn that you've talked about? Or even how should we think about the priorities around distributed cloud next year?

Operator

Thank

Speaker 1

you. Look,

Operator

our goal is to make it ridiculously easy for our customers to secure and deliver their applications. And Distributed Cloud is getting a lot of traction because it does that for our customers. So when you look at the priorities next year, of course, it's scaling the platform, so it's available in more markets, in more environments and Continue to add services to the platform. We have the 2 I would say first two sets of services, WAP and multi cloud networking. We have a backlog of other services that we want to add to the platform that our customers will want to add.

Operator

We've recently added CDN capabilities on the platform after the acqui hire of lilac a few months back and we're starting to Customers adopting our CDN because it's convenient for them to attach that to load balancing and security in some cases. So the first priorities are scaling the platform and adding services. As far as go to market, frankly, the priority is going into that are already F5 customers that have our hardware or software, but want a SaaS solution to make it easier to use F5 to front a bunch of applications for which they don't want to manage the life cycle of deployable products. And if you look at the 500 customers or so that are on Distributed Cloud today, over 2 thirds of them are actually existing BIG IP customers. So about a third of them are net new customers that have never bought anything from F5 and 2 thirds of them are existing VIP customers.

Operator

And we think actually with both net new and with existing customers, there is a lot of growth and that's where the focus is. And the focus is going to continue to be with large enterprise customers where F5 has a strong presence.

Speaker 5

I appreciate that.

Speaker 10

And if I Steak one more in, maybe for Frank. Certainly appreciate the continued focus on operating margins and EPS growth. But can you help us think through how we should think about cash flow margins in fiscal 2024? I know you typically don't guide cash flow, But should we think of cash flow growing in line with operating income ex some of the tax headwinds you had in fiscal 2023? Any even directional thoughts would be helpful.

Speaker 1

Yes. Ray, as you described, I think that's roughly correct. Cash flow is one of the harder things for us to predict, but those dynamics, it should mirror a bit that net income growth with some exceptions to the true tax impacts, some of the restructuring expense we had last year that we don't have this year that are real cash, but split out for non GAAP purposes. So there's a few ins and outs, but it should be roughly close to that.

Speaker 10

Great. Appreciate it.

Speaker 3

Our next question comes from the line of James Fish with Piper Sandler. Please proceed with your question.

Speaker 11

Hey guys, thanks for sticking me in. I'll just make it simple here. You guys talked about in the prepared remarks about subscription renewals performing well. Any more color into specifically what products are seeing those better renewals, the cross sell that you're seeing or Any qualitative or quantitative color around net retention rates, understanding you have this headwind around specifically the SaaS and MSP business of about $65,000,000 How should we think about that net retention rate within the term business or the aggregate overall when you kind of exclude even the impact of that SaaS piece? Thanks guys.

Speaker 1

Sure. Tish, why don't I start and if Francois wants to add anything that would be great. So within our term subscription business, it's generally our big IP software as well as NGINX and that's the expansion rates that we have seen. It's not the easiest Task in the world to convert that term into an ARR type of business, because of all the moving parts. But When we try to do that and try to convert and look at what would an expansion rate be or a net revenue retention rate, It's north of what you would think of as the industry norm of 120%, let me just put it that way.

Speaker 1

And that combination of where it is plus our SaaS managed service net revenue retention rate is still north of that 100 20%. So that combination is what gives us a lot of visibility and firmness and our expectation of those pieces of the business that will continue to do well.

Speaker 11

Makes sense. And just on the go to market side, any changes in terms of incentives or approach as we turn the page into this next fiscal year and as we have No, transitions now within the overall software transition.

Speaker 1

The incentive plans between the 2 years are largely The same, Fish. There's always going to be a couple of tweaks here and there as we're looking and seeing what was successful the year before and not, but nothing major.

Speaker 11

Thanks guys.

Speaker 3

Our last question comes from the line of Simon Leopold with Raymond James. Please proceed with your question.

Speaker 8

Great. Thanks for taking the question. I just want to get a better sense of where The systems business is stabilizing in that I assume the September quarter did not have much, if any, backlog drawdown in it. And so other than maybe some seasonal movement, I'm just trying to get a sense of is sort of this $120,000,000 to $130,000,000 per quarter level, sort of the new normal for systems. And then just quickly on How the software is trending with the Silverline exit, does that manifest itself gradually throughout the year?

Speaker 8

Or is that something that shows up in a particular quarter. Thanks for that.

Speaker 1

So I'll start for the first one and then Francois, I don't know if you want A second. But in terms of what we have said, I think in both prepared remarks and some of the answers, we did We do believe that we hit a trough in FY2023 in terms of systems bookings and we're equating that to The term demand. Now the offset or the balance of that is that there was FY2022 bookings that they were delivered in FY2023. And so the shipments that they actually received, which is the revenue that we recognized, that came in, in FY2023 and started to be utilized. Now as that utilization started to increase and more capacity was needed.

Speaker 1

We started to see that come through in Q4, which was our best Systems bookings quarter of the year. It looks like on a revenue basis that wasn't necessarily the case, but from a demand perspective or a bookings perspective that was the case. There will still continue to be fluctuation. There's probably a bit of leveling or even improvement that we've seen in the enterprise side. On the SP.

Speaker 1

As Francois mentioned, service providers have been hesitant and we expect that to continue on. And in Q1 in particular, we've got A federal government that isn't necessarily functional right now and we'll see what that means as an impact to bookings for systems in Q1 and we're trying to take that into account as we looked at the guidance and the expectations. We do expect, As we've talked about many times in the past, there is that 4 to 6 quarter lull and the dynamics that I just talked about explains why sometimes that takes 4 to 6 quarters, particularly in a supply chain, sustained environment. So we do expect at some point during the year that we will pick up and bookings from that Q4 level and return back to a higher level. I can't say normalized level because it's tough to know when exactly that will take But our outlook and our expectation is not that we are going to do $180,000,000 less in systems bookings, our systems revenue.

Speaker 1

Our bookings will improve, but the revenue will be down from last year because of that $180,000,000 of headwind.

Operator

And to the second part of your question, in terms of Silverline, no, it's not going to be all in 1 quarter. It's going to bleed off over the next couple of years, kind of every quarter. And it's going to be time when customers are at a point where they have to renew or migrate their subscription that there will be a decision point. And so you're going to see it, I think, over the next 6 to 8 quarters.

Speaker 8

Thank you.

Speaker 3

Ladies and gentlemen, this does conclude today's teleconference. Thank you for your participation. You may disconnect your lines at this time and have a wonderful day.

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