F5 Q2 2022 Earnings Call Transcript

Quartr
Provided by Quartr
April 26, 2022

There are 13 speakers on the call.

Operator

Good afternoon and welcome to the F5 Incorporated Second Quarter Fiscal 2022 Financial Results Conference Call. At this time, all participants are in a listen only mode. After the speakers' presentation, there will be a question and answer session. Also, today's conference is being recorded. If anyone has any objection, please disconnect at this time.

Operator

I'll now turn the call over to Ms. Suzanne DuLong. Ma'am, you may begin.

Speaker 1

Hello, and welcome. I am Suzanne DuLong, F5's Vice President of Investor Relations Francois Loco Donneau, F5's President and CEO and Frank Peltzer, F5's Executive Vice President and CFO will be making prepared remarks on today's call. Other members of the F5 executive team are also on hand to answer questions during the Q and A session. A copy of today's press release is available on our website at s5.com where an archived version of today's call will be available through July 24, 2022. Today's live discussion is supported by slides, which are viewable on the webcast and will be posted to our IR site at the conclusion of today's discussion.

Speaker 1

To access a replay of today's call by phone, Please dial 800-585-8367-4416-621-4642 and use meeting ID 7,769,889. The telephonic replay will be available through midnight Pacific Time, April 27, 2022. For additional information or follow-up questions, please reach out to me directly at s. Duongf5.com. Our discussion today will contain forward looking statements, which include words such as believe, anticipate, expect and target.

Speaker 1

These forward looking statements involve uncertainties and risks that may cause our actual results to differ materially from those expressed or implied by these statements. Factors that may affect our results are summarized in the press release announcing our financial results and described in detail in our SEC filings. Please note that F5 has no duty to update any information presented in this call. With that, I will turn the call over to Francois.

Speaker 2

Thank you, Suzanne, and hello, everyone. Thank you for joining us today. As you all know, we entered our 2nd quarter with some significant challenges that limited our ability to fulfill demand from our systems business. We are pleased to have delivered above the midpoint of our revenue guidance and at the upper end of our non GAAP EPS guidance despite those challenges. Importantly, we continue to deliver strong results from our software business.

Speaker 2

With 40% year over year growth in the quarter, software represented the majority of our product revenue for the first time. Systems revenue declined 27% as a result of supply chain constraints and our global services revenue was flat year over year. Our second quarter reflected another in an ongoing trend where customers continue to rapidly grow and scale both their traditional and modern applications, while placing increased importance and focus on application security. This benefits F5 and translates to continued strong demand across our portfolio. While our view towards strong demand drivers remains clear, our visibility into resolution of hardware supply chain challenges is murky.

Speaker 2

Going into Q2, we discussed 2 primary supply chain challenges. I am happy to report that we successfully resolved the first, which was related to standard electronic components and required us to design in and qualify an alternative source. The second challenge we discussed is related to global shortages of specialty semiconductor components. While we have made some incremental progress on this issue, we continue to expect supply constraints will limit our ability to fulfill system demand through the end of the fiscal year. Part of our efforts to fulfill system demand included shifting customers from our I Series appliances to our next generation R Series appliances which launched in February.

Speaker 2

We are seeing solid traction in R Series sales and we are ramping manufacturing. However, semiconductor constraints primarily from a handful of suppliers continue to limit our ability to ship I Series and are now also impacting our ability to accelerate the ramp of R Series. As a result, our systems revenue recovery has been delayed beyond the expectations we had last quarter. Frank will review our outlook in detail later in our prepared remarks, but as a result of the delayed systems revenue recovery, we now expect to deliver fiscal year 2022 revenue growth in the range of 1.5% to 4%. This compares to our prior expectations for 4.5% to 8% growth.

Speaker 2

Our underlying demand remains strong, however, and we continue to expect to deliver software revenue growth near the top end of our 35% to 40% target for the year. In light of the sustained strength of our demand and our view that the supply chain constraints are temporary, we are not making changes to our operating structure and therefore our margins will be impacted correspondingly near term. We obviously feel a strong sense of frustration with this change and an equally strong sense of urgency toward resolution, so we can get back to reflecting the true health of the business in our reported results. We are taking every available path to resolve the issues as quickly as possible. Our suppliers expect additional capacity beginning in the Q2, which should translate into improvement during our Q2 of fiscal 2023.

Speaker 2

While the supply chain challenges are more severe than we estimated last quarter, they are temporary. In addition to seeing continued demand for hardware, We are seeing good traction across our software portfolio, including from security use cases and our ability to bring a broader solutions portfolio to customers. I will speak to our business momentum and demand drivers before Frank reviews the quarter's results and our outlook in detail. Our customers are increasingly operating both traditional and modern architectures and looking to F5 for solutions that simplify and unite their strategies for both. As an example, during Q2, an American multinational beverage company and a long time big IT customer select NGINX to service cloud and Kubernetes based workloads and modern use cases.

Speaker 2

The customer is using NGINX to automate app content delivery including its loyalty program and delivery services, both of which have experienced substantial growth during the pandemic. The addition of NGINX Technologies to the customer's multi year subscription resulted in a 2x extension of the subscription upon renewal. Approach to application security and delivery differentiates us from vendors who are siloed to a single environment. This means we are uniquely positioned to help customers with their multi cloud challenges. During Q2, We were selected by the Ministry of Health for a nation in our APAC region.

Speaker 2

Not being lost into a single cloud was an important consideration for this customer. They had intentions of modernizing in a single cloud short term, but plans to expand to additional clouds in the near future. This customer selected F5 over cloud native offerings as a result of our solutions clear value add and our cloud agnostic capabilities. We enabled the customer to create a true multi cloud architecture with both on premises and cloud environment in a deal spanning our portfolio including big IP hardware and software with advanced WAF and NGINX including App Protect and API Management. Finally, it's clear that hybrid architectures including on premises data centers and as a service offerings are here to stay.

Speaker 2

Applications and workloads also are increasingly containerized and mobile. This means complexity is here to stay too and that managing applications across disparate environments will remain a challenge for customers. Meeting that challenge is likely to require a distributed cloud architecture and platform agnostic security and delivery technologies that provide consistent protection, visibility and performance for all applications, legacy, modern and mobile across environments. In Q2, we took a large step forward towards helping customers better manage multi cloud complexities with the launch of our F5 distributed cloud services. With this platform, we are delivering security, multi cloud networking and edge based computing solutions on a unified software as a

Speaker 3

service platform.

Speaker 2

Our first solution for the platform, F5 Distributed Cloud Web Application and API Protection or WAP, augments multiple security capabilities across F5 Technologies in a SaaS offering. This offering reflects the first major step in our integration of our Voltera platform and F5 Software Security stack. F5 Distributed Cloud Services is globally available and we are seeing strong early enterprise and service provider interest. SoftBank announced one of the first notable wins for F5 Distributed Cloud this quarter. The Corporate Information Technology Division of SoftBank needed to improve low resource utilization and other inefficiencies of its private virtualized infrastructure, but its security requirements mandated on premises deployment with an option for future public cloud capabilities.

Speaker 2

It's sort of way to bring the effectiveness of cloud native microservices and containers to its private data center and turn to F5 Distributed Cloud Services. We are leveraging F5 Distributed Cloud branding to further integrate customers' experience with F5 by simplifying our product meaning. You will see we have united and renamed our SaaS and managed services portfolio including Shape, Voltera and Silverline under our F5 distributed cloud services umbrella. So expect to hear us refer to those solutions accordingly going forward. In summary, Despite our short term supply chain challenges, there is a lot to look forward to from F5.

Speaker 2

We have multiple current and future software drivers that are well aligned with our customers' most pressing application needs. Between BIG IP's ability to serve and secure traditional apps, NGINX's ability to serve and secure modern apps and the exciting opportunity to grow and expand F5 distributed cloud services, we are well placed to enable our customers to manage and secure their growing and rapidly evolving application estate. Now I will turn the call to Frank to review our Q2 results and our second half outlook in detail. Frank?

Speaker 4

Thank you, Francois, and good afternoon, everyone. I will review our Q2 results before discussing our second half outlook. We delivered 2nd quarter revenue of $634,000,000 above the midpoint of our guidance range and reflecting a 2% decline year over year. Software revenue grew 40 percent to $152,000,000 systems revenue declined 27% to 146,000,000 We delivered a 4% product revenue decline year over year with product revenue representing 47% of total revenue in the quarter and software contributing 51 percent of product revenue. Rounding out our revenue picture, Global Services delivered $337,000,000 in revenue.

Speaker 4

This is flat compared to last year and represented 53% of total revenue. Taking a closer look at our software revenue, subscription based revenue represented 75 percent of total software revenue in the quarter. This is down a bit from the 80% mix where it had been in the last couple quarters, but we do not see this as indicative of a trend. Rather, it reflects some activation timing variability for a couple of large multi year subscription agreements as well as a small number of larger deals in the quarter where customers preferred CapEx model. As a reminder, a significant component of our subscription business is term based licenses that are not recognized ratably and as such, we expect some quarter to quarter variability.

Speaker 4

Revenue from recurring sources, which includes term subscriptions, as a service and utility based revenue as well as the maintenance portion of our services revenue totaled 69% of revenue in the quarter. This is up from 64% in the year ago period. On a regional basis, Americas delivered 4% revenue growth year over year, representing 57% of total revenue. EMEA declined 9% representing 25% of revenue and APAC declined 6% 19 percent of revenue. In the quarter, we saw some signs of softness in EMEA.

Speaker 4

We believe this is in part related to the macro and global political concerns in the region. Enterprise customers represented 65% of product bookings in the quarter, service providers represented 15% and government customers represented 20%, including 7% from U. S. Federal. I will now share our Q2 operating results.

Speaker 4

GAAP gross margin was 80.1%. Non GAAP gross margin was 82.9%. We continue to experience increased component prices, expedite fees and other sourcing related costs. GAAP operating expenses were $433,000,000 non GAAP operating expenses were 358,000,000 Our GAAP operating margin in Q2 was 11.8%. Our non GAAP operating margin was 26 0.5%.

Speaker 4

Our GAAP effective tax rate for the quarter was 22.7%. Our non GAAP effective tax rate was 21.3%. GAAP net income for the quarter was $56,000,000 or $0.92 per share. Non GAAP net income was $131,000,000 or $2.13 per share. I will now turn to the balance sheet.

Speaker 4

We generated $127,000,000 in cash flow from operations in Q2. Capital expenditures for the quarter was $5,000,000 DSO for the quarter was 59 days. Cash and investments totaled approximately $922,000,000 at quarter end. During the quarter, we repurchased approximately $125,000,000 worth of F5 shares or approximately 610,000 shares at an average price of $205 Deferred revenue increased 17% year over year to $1,600,000,000 up from $1,580,000,000 in Q1. The growth in total deferred was largely driven by subscriptions and SaaS bookings growth and to a lesser extent deferred service maintenance.

Speaker 4

Finally, we ended the quarter with approximately 6,700 employees, up approximately 150 from Q1. Francois shared our updated fiscal year 2022 revenue outlook in his remarks. I will recap the details of the second half outlook with you now. Unless otherwise stated, please note that my guidance comments reference non GAAP operating metrics. I will begin with our revised view for fiscal 2022.

Speaker 4

Given persistent and dynamic supply chain pressures, which are limiting our systems revenue recovery near term, we expect to deliver fiscal year 2022 revenue growth within the range of 1.5% to 4% for the year. This compares to our prior expectations of 4.5% to 8% growth. We continue to expect to deliver close to the top end of our 35% to 40% software revenue growth target for the year. We expect global services growth of approximately 1% to 1.5% for the year, reflecting the lower expected range of system sales. Because we believe the current supply chain challenges are temporary and do not reflect the underlying growth of the business, we do not intend to adjust our operating model near term.

Speaker 4

We believe doing so would risk compromising our ability to deliver future revenue growth. As a result, we are likely to see operating margin pressure over the next several quarters. We expect non GAAP operating margin in the range of 27% to 28% for FY 'twenty two. We would expect to regain the Rule 40 operating benchmark as we return to full manufacturing capacity. We continue to expect our full fiscal year effective tax rate will be in the range of 20% to 21% with some fluctuations quarter to quarter.

Speaker 4

We remain committed to repurchasing $500,000,000 in shares during the fiscal year. I will now move to our Q3 expectations. We expect Q3 revenue in the range of $660,000,000 to $680,000,000 Given component costs and the costs related to actions we are taking to mitigate supply chain pressures, we expect Q3 gross margins of approximately 82%. We estimate Q3 operating expenses of $368,000,000 to $380,000,000 Our Q3 earnings target is $2.18 to $2.30 per share. We expect Q3 share based compensation expense of approximately $63,000,000 to $65,000,000 With that, I will turn the call back over to Francois.

Speaker 4

Francois?

Speaker 2

Thank you, Frank. In closing, we will continue doing everything in our power to mitigate supply we believe constraints will begin to abate as we move through the next several quarters. Our software and software as a service App Security and Delivery Solutions will drive our future growth and our long term opportunity. We have created a portfolio and a roadmap that is well aligned with our customers' strategic priorities and because of that, we are more confident than ever in our position, our strategy and our long term opportunities. With that, operator, we will open the call to Q and A.

Operator

Sure. Thanks, sir. And thank you. Our first question comes from the line of Samik Chatterjee from JPMorgan. Please ask your question.

Speaker 5

Hi. Yes, this is Joe Cardoso on for Sonic Chatterjee. My first question is just on the supply challenges that you highlighted during your prepared remarks. Can you touch on some of the actions that you're taking or planning on sales to help alleviate some of the pressures from the headwinds that you're facing from the supply challenges? Like are you guys passing on higher pricing at all?

Speaker 5

Are you starting to see the benefit from higher pricing as some of the other networking peers in the space have done? And then just relative to the underlying components that are being constrained for the 2 product offerings that you highlighted, when do you start to see Or when should we start to see some improvement there? Have you been given any timelines from the suppliers? And what's driving your confidence around that timeline?

Speaker 2

So, Megan, it's Francois. Thank you for the question. Let me start on the pricing. We have been generally philosophically quite cautious about pricing with our customers. That being said, we have seen, as you know, significant cost increases and we did affect the price increase in the last few months.

Speaker 2

That was in the high single digits. And we will continue to review our costs and Kind of refine our models and look at whether we need to do anything else in coming months, but we're going to continuously review that in line with What we're seeing from a component perspective, but we've already taken a first action in that area as it relates to when things do get better. So based on conversations with our supplier, Samik, and all of this is really about the semiconductor supply And it's really a handful of strategic suppliers that we have. And we do have deep and broad conversations with them on a very regular basis, Including executive to executive conversations to really address the challenges that they and us are facing. And based on these conversations, We expect them to have improvements in their capacity in the 4th calendar quarter of the year, which should translate to improvement in our revenue in the 1st calendar quarter of 2023, which would be our 2nd fiscal quarter.

Speaker 2

We expect these improvements from them based upon their expectations of additional fab capacity and what we've seen in terms of their Consistent milestones around increasing that capacity. So we're not sitting on our hands and waiting for just the suppliers to make improvements. We are also driving aggressive actions on our side to drive improvement. So what are we doing? First is we are continuing to shift demand to R Series, which is our next generation platform because we Expect that platform to be less constrained than our I Series platform.

Speaker 2

And from the field perspective in terms of Customers taking on the R Series platform, we are seeing actually excellent traction on this front because the value proposition of the platform, the price performance of the platform is just Excellent. So we're aggressively shifting demand to R Series. We are increasing the velocity of qualifying alternative sources of supply for both platforms actually, so redesigns and qualifying additional suppliers on these platforms to alleviate the supply shortages. And of course, we continue to make aggressive advanced purchases with our suppliers. We have been doing that for several quarters, But we continue to do that very aggressively and providing them a lot of visibility into our forecast for future quarters.

Speaker 2

So with these actions, as I said, we expect better supply in our 4th Calendar quarter that will translate into the 1st calendar quarter of 2023 for improvement into our hardware revenue.

Speaker 5

Thank you. Appreciate the color guys.

Speaker 2

Thank you, Samik.

Operator

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

Speaker 6

Hey, guys. Good afternoon. Kind of a loaded question here, 2 Two parts, of course. The big question we're getting after ours is really around that software number. And Francois, while 40% growth is strong, It was against an easier compare than last quarter.

Speaker 6

Is there any way to quantify how much of that shift towards either the CapEx purchases over software as well as how much got to a future period on the software line occurred. And on the system side, What should we what should make us believe that we aren't in for another hardware cut here over the next quarter or 2? This is the 2nd quarter in a row of Cutting hardware and really I think giving us a sense around where backlog is versus the last quarter would be helpful for that.

Speaker 2

Let me start, Jim, with another part of your question around Hardware and then let's go to software after that. So, Jim, the reality is that There is so much constraint in the supply chain, in the semiconductor supply chain today that our visibility Into supply into our supply is not very long term. It's actually very short term. And so what we're doing is giving you the best visibility that we have today, just like we did last quarter. We did not anticipate in our forecast When we guided for the full year last quarter, we did not anticipate yet another significant deterioration in the availability of these semiconductor components and also the fact that the broker market has gone completely dry.

Speaker 2

And that's why we have another step down in terms of our ability to shift for the full year. In providing the view for the full year here, Jim, we've looked to be appropriately conservative based upon what we know today. That's not to tell you that there is 0 risk in the numbers we're giving you because, of course, those numbers rely Deliveries from our suppliers that are going to happen later this quarter and of course in Q4. So there is of course still some risk in the full year number, but we have looked to be appropriately conservative in how we've constructed it based upon all of the Conversations and information we have from our suppliers. On the backlog, Jim, we don't speak specifically to The backlog numbers, but of course our backlog has grown again this quarter by multiple tens of 1,000,000 of dollars.

Speaker 2

And if you look at our demand drivers, Jim, they're pretty strong. So demand has remained strong. When we look at demand, we are on track The first half of the year with what our plan was for the year. And so this is really a supply issue and not a demand issue. Let's go to software and Funko is going

Speaker 4

to take that. Yes, Jim. So on the software number, obviously, we do not sort of guide in a mix on any given quarter. And if you go back in time to the first half of well, if you go back to Analyst Day in November of 20 20. And we talked about software guidance in that 35% to 40% range.

Speaker 4

And after the second Q1, we had 70%. In the 2nd quarter, we had 20%. And there was a lot of question marks around will we ever be able to make that 35% to 40% range and we ended up at 37% for the year. We talked about at the beginning of this year that there was going to be less volatility and variability in that number. I think last quarter it was 47%.

Speaker 4

This quarter it was 40%. But there's no dynamic to speak of a mix shift or any other factor. It was an easier comp, but we do think about this Number of growth in terms of an annual basis, certainly not on a quarterly basis. We're quite happy with where we've ended in the first half and continue to expect reform in the second half to be near the top end of our 35% to 40% range.

Speaker 6

Thanks guys. I'll yield it back.

Speaker 2

Thanks Jim.

Operator

Our next question comes from the line of Amit Daryanani from Evercore. Please ask your question.

Speaker 7

Thanks a lot for taking my question. I guess I have a question and a quick clarification hopefully. The question I really have is on the operating margin structure. So If I look at the full year guide, you're talking about 27%, 28% operating margin, which is down, I don't know, like 400 basis points year over year, even though there is some revenue growth in the model on a year over year basis. So I'm just wondering like what sort of revenue run rate do you think you need to get back to the 32%, 33% kind of operating margin range on a quarterly basis?

Speaker 7

And alternatively, what do you need to see from a macro basis to perhaps say, I need to get more aggressive in optimizing my cost structure? I'd love to just understand How you think of OpEx as you go forward? And then is there anything you would call out in terms of why is software implied to decelerate in the back half Of the year fiscal year versus the front half. Is this something on the renewal that's happening there? Or just anything you would call out there would be helpful.

Speaker 4

Sure. So why don't I start and then I'll turn it over to Francois. So on the operating margin side, I think what we've said for the past two quarters is that our The plan has not changed and largely that is absolutely true. If you take a look at where our Where the expected point of operating expenses in relation to that 8% to 9% original growth rates that we had in the model and where we also had our gross margin expectations that would lead you to sort of the Expectation of what we have for operating expenses for the full year. And so the run rate for that 32% to 33% is exactly what we talked About at the beginning of the year what we would need.

Speaker 4

What we have seen is a shortfall in the hardware number because of the supply constraints, but because they are temporary, we don't think it's right to change the operating expenses to potentially hinder our longer term growth trajectory of the business. And so That's why we have not changed the operating model.

Speaker 2

And then Amit, your second part of your question was about Software growth?

Speaker 7

Yes. I guess, Francois, when I look at the guide for the full year, right, you started at low 40% growth, call In the first half of your fiscal year. And so just mathematically, you're talking about things decelerating in the back half of your fiscal year. So I'm wondering, is there something with the renewals that happened in the first half? Or this is just being a bit more pragmatic, but just what's driving that implied decel on software in the back half?

Speaker 2

Yes. No, I think that's what Funk was talking to this a moment ago that when you look back in it, we guided to 35 40% growth, first of all, for our Horizon 2 going back in 2020 And with a little 37% growth in fiscal 2021, we guided again to 35 40% growth this year. And in fact, we said we would get to the top end near the top end of that range, and we're on track to achieve that. We've always said, Amit, that we weren't looking at this on a quarter to quarter basis but more on an annual basis, in part because our software business It's not just a ratable SaaS model that it does include term subscriptions and therefore there would be some variability quarter to quarter. We did say that we would see less variability quarter to quarter this year than we did last year, and we're also on track to deliver against that.

Speaker 2

So there isn't A different dynamic, if you will, in terms of the software business than what we have seen in the past. The renewals that you just referred to, the Trends on these renewals are very, very encouraging as well as the True Forward and the expansions on the agreements that we signed in the past. So we are generally very pleased with the software drivers we're seeing.

Speaker 7

Perfect. Thank you very

Operator

much. You are next, Alex Henderson of Needham. Your line is open.

Speaker 3

Great. Thank you very much. I wanted to go back to the comment you made about EMEA is slowing a little bit and the decline in revenues in EMEA and APAC versus the growth in the U. S. And contrast that with the extremely strong demand conditions that you're dealing with, Obviously, outstripping your supply.

Speaker 3

Can you talk to why there was such a splay between The U. S. Results and the international results. And

Speaker 7

when you

Speaker 3

talked about Europe specifically, you mentioned A slowdown in demand there as a result of the economy. Can you feather that into the overall demand picture a little bit, please?

Speaker 2

Yes. So let me start there. What we saw In our 2nd fiscal quarter there and I would say really kind of starting in February and beyond is a slowdown of demand in Europe, we think and it's kind of accelerated a little bit into the last month of the quarter, which was in March. We think it is attributed to macroeconomic conditions, of course, Ukraine Russia war, Even though our business in Russia is very small, so there is no really direct impact territorially. But in terms of the whole sentiment in Europe around inflation and potentially the economy slowing down, we think that has caused Customers to be a little more cautious to scrutinize spend a little more and potentially to delay For motors that they would otherwise make.

Speaker 2

Now in the big scheme of things, we're not talking about multiple tens of 1,000,000 of dollars here. It's effectively a smaller effect than that, but it was noticeable enough in our trends that we felt that we should point it out, In part because we don't yet know how this will play out in Europe in coming quarters and whether With the continuance of the conflict and more inflation, whether this will continue or and to what extent. We also had very strong demand in the Americas in the enterprise space as well as for

Speaker 4

R2C or you may not see the clearest picture in terms of demand of bookings versus just recognized revenue because of the constraint that we have in hardware. And so normally in quarters before, there would be a tight link. But when we take a look at where some of the bigger backlog of activity was happening, it was more in the Americas that got shipped In the quarter associated with the revenue recognition of that systems, which is going to skew this number a little bit more.

Speaker 3

Is Europe more biased to systems and that's and less to software, is that part of it? And is there any change in your Supply chain in your pipeline in Europe in April that would suggest continued erosion in the conditions there? And then I'll see the flow. Thanks.

Speaker 4

Yes. So the answer to your first question is no. There's no specific activity. I mean, as a whole, Europe probably is slightly higher weighted towards hardware and APAC slightly towards hardware and bookings than some of the other businesses, but it's not dramatic. I think what you will See is just where we have got more backlog and the aging of that backlog, that's some of the first things that will get shipped out And we'll skew some of these hardware numbers and the overall revenue by geo number until we get Fully caught up on some of these supply chain constraints.

Speaker 4

And so as we talked about last quarter, we are trying to very much take a customer centric view towards meeting this demand with the limited supply that we've got and that is going to just skew these numbers a little We did point out because of some of the delays of bookings that we saw in EMEA, particularly in Month 3, when you have the geopolitical concerns really creep up, That's what we saw. We wanted to point that out on the demand side of the equation too.

Speaker 2

And Alex, just your question about April, I think The pipeline for EMEA for Q3 actually looks better than what we saw in Q2, but we are cautious because of the macro environment in Europe currently.

Operator

Your next question comes from the line of Paul Silverstein of Cowen. Please ask your question. Once again, Paul Silverstein, your line is open. If you're on mute, please unmute your line. Paul?

Operator

There seems to be no response from the line of Paul. We will now be proceeding to the next question coming from the line of Sami Badri of Credit Suisse. Please ask your question.

Speaker 3

Hi, this is Ryan on for Sammy. Thanks for taking the question. So basically, our first question is for customers who historically want system, whether they will opt out in to software given the constraints we're seeing for the past quarter. And I have a follow-up.

Speaker 2

Yes, I'll start. So we just broadly speaking, we have not seen A hardware to software substitution in the business. And the reason for that is that when customers For customers to move to software, generally, they have to have considerations from not just F5 but other providers in their environment. And generally, these other providers also have elongated lead times. They also have to have done some architectural So work to move to a virtualized environment, which a number of customers haven't done if they're still on hardware, so they're not ready to move to software.

Speaker 2

And for those reasons, what we've seen is the majority of customers who have larger states on hardware, The lead times the change in our lead times alone is not a factor that is moving them to software. Now, For those on the margins who can make that move, we are working aggressively with them to make that happen, but we have seen that to be a marginal A very marginal phenomenon to date. Whether that will change in the future if our lead times continue to be elongated Is yet to be seen, but we've not seen any meaningful hardware software substitution to date.

Speaker 3

Got you. Appreciate the color on that. So my follow-up is, so does the reduction in the Guidance implies that 2023 could be a much bigger revenue year or is this demand that is essentially going away given the extent of the

Speaker 2

No, we don't think demand is going away. Let me be clear about that. We have We are seeing very strong demand. We haven't seen any trend in any order cancellations in any form. We haven't seen any loss of business to competitors because generally other vendors also have challenges The lead times and despite all of the challenges that we're having, our lead times are worse than they used to be, but they're kind of in the mix with other folks there.

Speaker 2

And we continue to see a strong demand from our customers across the board. So we don't think that our lead times and our challenges in shipping hardware right now are causing demand destruction, if you will. Going into next year, This is we're not guiding yet to 2023, but of course, it's going to be about how fast Can we get back to shipping to demand? And with the visibility that we have right now, We think effectively our fiscal Q1 is going to be more of the same. It may even be a low point in what we see from availability of supply to date.

Speaker 2

We think we will start to see improvement in our 2nd fiscal quarter for 2023. And our expectation is that we will be back to shipping to full demand in the back half of Of our fiscal 2023.

Speaker 3

Got it. Appreciate the color. Thanks so much.

Speaker 2

Thank you.

Operator

Your next question comes from the line of Meta Marshall of Morgan Stanley. Your line is open.

Speaker 8

Great. Thanks. I just wanted to get a sense of maybe kind of breaking down the I Series and R Series, Whether the resolution of some of the supply chain issues

Speaker 2

Exit our fiscal 2023, we expect to be Almost near 100 percent of serving the demand of our customers primarily with our series. And that will ramp through You know, the next 5, 6 quarters. Your second question was about I Series and R Series Constraints. So right now both are constrained by semiconductor components, But we are shifting more of the demand to R Series because we expect R Series to be less constrained because it's a newer platform going into the new year because there are less parts effectively on our series that have these constraints than on I series. So that's why we are aggressively shifting the demand to R Series.

Speaker 2

But we're also doing some work, of course on iSeries to be able to continue to meet demand in the next few quarters for customers that really need to be on that platform for a number of reasons.

Speaker 8

Got it. So when you say calendar Q4, that's more for resolution of R Series, not I Series is kind of ongoing. R Series is calendar Q4.

Speaker 2

Yes. R Series is calendar Q4. I Series, we should see some improvements in also calendar Q4 in terms of the supply we get there. However, going into the new calendar year, we will be continuing to shift to R Series. So R Series will progressively become the majority of Both the demand and the revenue and shipments.

Operator

The next question is from Simon Leopold of Raymond James. Please ask your question.

Speaker 9

Hi, guys. This is Victor Chiu in for Simon Peter Paul. Are you guys observing any trends in

Speaker 4

the public cloud adoption impacting

Speaker 9

the uptake of F5 Subscription in the cloud. And you noted you don't anticipate any customers prematurely moving away from systems deployments to virtual deployments, but can we see customers Accelerating

Speaker 10

the shift

Speaker 9

of workloads, more workloads into the public cloud given the constraint in supply, is that something that could encourage them to move in that direction?

Speaker 2

I think, Victor, over the long term, we will continue to see customers Rebalancing their environment to these multi cloud environments. I think our belief system, which frankly has been our belief for the last Several years is that ultimately the applications will land on the best infrastructure environment for the application. And in a lot of cases that will be public cloud, in some cases that will be a private cloud And in a lot of cases that will continue to be a traditional private data center with hardware environment. I don't think that current supply chain challenges will fundamentally alter that future destination and that future distribution of applications. And so and we also can see it from the customer behavior that we're seeing today.

Speaker 2

I think for customers that Really need capacity for their applications and can't get hardware. The best way the best plan B, if you will, for that is to move to F5 software on virtual machine. But to do that, of course, customers need to also have the servers available and Those also have elongated lead times in a number of cases. But moving to a cloud, A public cloud is an entirely different kind of architectural consideration, and it takes planning. It takes Quite a bit of time and so we don't think that the supply chain challenges are particularly accelerating A move to the public cloud.

Speaker 2

But generally, we think the destination for all of our customers is multi cloud. Most of our customers are already in multi cloud environment. And we intend to and we've designed our portfolio to serve them for these multi cloud environments.

Speaker 9

That makes a lot of sense. What about for customers that are on defense or in the process of straggling their workloads already between on premise and Public cloud, is this not going to encourage them to move one way or the other? Is that something you envision,

Speaker 2

I think customer who maybe for greenfield environment, Victor, where customer are just deploying new workloads if they could Go to a virtualized environment and they have either the servers in house available or they could use F5 software in the public cloud, which many thousands of our customers do that today. That would be a way to get to where they want to be faster. That's a I would say that's a minority of situations today, but it's a possibility for customers that are not But a building greenfield environment.

Operator

Our next question comes from the line of Jim Suva of Citigroup. Please ask your question. Thank you. Could you give us

Speaker 11

a little bit of color on the operating margin trajectory and kind of the steps As far as the timing and the magnitude of those steps, you talked about several of them in your prepared comments, but how should we kind of think about the timing in each of those steps? Thank you.

Speaker 4

Yes, Jim, why don't I start and then if Francois has got anything to add, By all means, please do the so Francois sort of laid it out in a couple of questions ago on where we see The hardware side of the business over the next call it 3 to 4 to 5 quarters. And we think that largely the operating margin It's going to ramp back up along with that shipment of hardware back to where we get to our Rule of 40. But in the immediacy of Certainly over the next couple of quarters, we're going to be below that 37% or the 27% to 28% mark that we had set. And a lot of that is largely due to the step down in our gross margins that are impacting as Well as the less revenue coming from our systems business. And so those combinations are putting pressure on the operating margin in the near term, but we do expect to get back To our rule of force operating plan when we work our way through some of these supply chain constraints.

Operator

Our next question comes from the line of Rod Hall of Goldman Sachs. Please ask your question.

Speaker 12

Yes. Hi, guys. Thanks for the question. I just wanted to come back to the full year guide change. I'm calculating at midpoint about $91,000,000 of reduction there.

Speaker 12

And I guess it's due to these ongoing supply chain challenges. But then I'm curious what the duration of that change is. In other words, are you expecting most of that to happen Sooner here and then you think your supply comes in better as we get to September or do you have visibility all the way to the end of this fiscal year and That encompasses this $91,000,000 Can you just kind of give us an idea on timing there? Thanks.

Speaker 4

Yes, Rod, I'll start on that one, Budd. So look, I think as we lay it out in our models, the lower point on the hardware side is Likely not near term is in Q4, Q1, as we see the continued pressures that we've experienced for the past couple of quarters Continue on. I think Francois noted some of the green shoots that will be coming in calendar Q4 that will start to impact and ramp up And calendar Q1 of 'twenty three and you'll start to see that improvement. But on the system side, I I don't think the low point is this quarter. I think the low point is more in Q4 or Q1 of 'twenty three 'twenty two.

Speaker 4

Q1 of 'twenty three. Q1 'twenty three, Q4 'twenty two.

Speaker 12

Okay. And then I also wanted to Just checking with you regarding the Back on the demand side of things, do you are customers indicating to you that that's Temporary and I also noticed your DSOs have jumped up to 59 days. I assume that's due to supply, but Are people now starting to order further out or why are we seeing that jump in the DSOs? I guess two questions in there really. Sorry about that.

Speaker 4

Yes. Let me start on the DSO side and then I'll let Francois pick up the first one, Rod. So no change at all. This is purely a factor of When we were a lot of leading up to this quarter had been a lot of the shipments and therefore the billing going out for that hardware earlier on in the quarter. And in this quarter, it was a little bit more In month 3.

Speaker 4

And so just by nature of the AR balance going up, that's the DSO calculation. There is Nothing in terms of any dynamic to see there. It's just more a function of that AR balance going up on things that are in the legitimate net 30 day window cycle. So nothing there.

Speaker 2

Yes. And Rob, In terms of customer behavior, we have seen both. So some of our customers are who have, I guess us who are planning ahead and have the means to plan ahead and order ahead, we started to see their behavior move to Ordering well ahead to take into account the extended lead times. But at the same time, we also see other customers Who are pushing out and delaying orders, in part to create leverage and say, hey, I'll place the next order once you have shipped The order that I placed a few months back. And so when we net out those two behaviors, we land in about the same place, which is demand is kind of Where we expected it to be and it continues to be strong.

Speaker 2

What we are not seeing is lost demand due to supply chain delays. And that's been the trend for the last several quarters, including Last quarter.

Operator

Due due to time constraints. We will take our last question from Jason Ader at William Blair. Your line is open.

Speaker 10

Hey, this is Sebastian on for Jason. Thanks for taking the question. I just have one clarification and then an opening question. So Just in terms of the supply chain issues, last quarter you mentioned about $60,000,000 in revenue being pushed out of fiscal year 2022 For the specialized networking chips, I just want to make sure those lead times haven't changed at all and that's still the expectation and it's really like the standard components and those lead times that have been pushed out Further than expected and pushing revenue into fiscal year 'twenty three. Is that correct?

Speaker 2

So let me just clarify that. The entire you're right about $60,000,000 last quarter and the additional down guide this quarter, All of that is linked to specialty semiconductor components. Now some of that is networking chipsets And we also have challenges with components to make and lots of components that are not specific Specifically networking chipsets, but they're more on the power side and power distribution, power shaping type of components. And it's the combination of all of that That's causing the delays in shipments and therefore the delays in revenues.

Speaker 10

Got it. Okay. That's helpful. And then as a follow-up, maybe a bit more open ended for you, Francois. In terms of as you guys shift more of your revenue to software subscription managed services.

Speaker 10

Is your relationship with the partner channel, the VARs, the MSPs, is that changing at all? Are you becoming less reliant on them to generate revenue or are you still sort of historical as you have been historically reliant on that channel to drive revenue growth?

Speaker 2

No. Our partners and Distributors and resellers and our key partners and systems integrators, They continue to be a really important part of our ecosystem and part of what we have wanted to do as we've moved to software is embark them on that journey with F5 such that the transformation of F5 towards a software centric business model can also benefit their model. And a number of them are actually, frankly, some of them were ahead of us and were part of Helping us accelerate our own transformation, but we're seeing that a number of them have embraced these new models and You know, have found great ways to add a ton of value to our customers in a software centric model. And in fact, that has contributed to our software growth over the last several quarters. So, no, we're going to continue with a partner centric model And we're going to continue to innovate with our partners to bring great software solutions to our customers.

Speaker 10

Got it. Thank you. That's all I had.

Operator

And this concludes today's call. You may now disconnect.

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Earnings Conference Call
F5 Q2 2022
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