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Edited Transcript of FFIV earnings conference call or presentation 24-Apr-19 8:30pm GMT

Q2 2019 F5 Networks Inc Earnings Call

SEATTLE Apr 26, 2019 (Thomson StreetEvents) -- Edited Transcript of F5 Networks Inc earnings conference call or presentation Wednesday, April 24, 2019 at 8:30:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Chad Michael Whalen

F5 Networks, Inc. - EVP of Worldwide Sales

* Francis J. Pelzer

F5 Networks, Inc. - Executive VP & CFO

* François Locoh-Donou

F5 Networks, Inc. - President, CEO & Director

* Suzanne DuLong

F5 Networks, Inc. - VP, Investor Relation

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Conference Call Participants

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* Ahmed Sami Badri

Crédit Suisse AG, Research Division - Senior Analyst

* Alexander Kurtz

KeyBanc Capital Markets Inc., Research Division - Senior Research Analyst

* Catharine Anne Trebnick

Dougherty & Company LLC, Research Division - VP and Senior Research Analyst of Data & Internet Protocol Networking

* Michael Edward Genovese

MKM Partners LLC, Research Division - MD and Senior Analyst

* Paul Jonas Silverstein

Cowen and Company, LLC, Research Division - MD and Senior Research Analyst

* Roderick B. Hall

Goldman Sachs Group Inc., Research Division - MD

* Samik Chatterjee

JP Morgan Chase & Co, Research Division - Analyst

* Simon Matthew Leopold

Raymond James & Associates, Inc., Research Division - Research Analyst

* Vinod Krish Srinivasaraghavan

Oppenheimer & Co. Inc., Research Division - Associate

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Presentation

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Operator [1]

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Good afternoon, and welcome to the F5 Networks Second Quarter Fiscal 2019 Financial Results Conference Call. (Operator Instructions) Also, today's conference is being recorded. If anyone has any objection, please disconnect at this time.

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

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Suzanne DuLong, F5 Networks, Inc. - VP, Investor Relation [2]

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Welcome. I'm Suzanne DuLong, F5's Vice President of Investor Relations. François Locoh-Donou, F5's President and CEO, and Frank Pelzer, 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&A portion of the call. A copy of today's press release is available on our website at f5.com, where an archived version of today's call also will be available through July 24, 2019. A replay of today's discussion will be available through midnight Pacific Time tomorrow, April 25, by dialing (800) 585-8367 or (416) 621-4642. For additional information or follow-up questions, please reach out to me directly at s.dulong@F5.com.

Our discussion today will contain forward-looking statements, which includes words such as believe, anticipate, expect and target. These forward-looking statements involve uncertainties and risks that may cause our actual results to differ materially from those expressed or implied by these statements. 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'll turn the call over to François.

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François Locoh-Donou, F5 Networks, Inc. - President, CEO & Director [3]

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Thank you, Suzanne, and good afternoon, everyone. Thank you for joining us today. I'll talk briefly to our business drivers before handing over to Frank to review the quarter's results in detail.

With 30% software revenue growth in the quarter, we're delivering strong results from the resource shifts we've made in the last 18 months. Customers are leveraging our multi-cloud deployment model and consuming our flagship software and offerings, both on-prem and in the public cloud. Increasingly, they are consuming for new vehicles, including subscriptions and enterprise license agreements. Security services, including Advanced WAF and bot mitigation are leading the vast majority of our customer conversations, and public cloud continues to be our strongest software growth area. I will speak to our software growth drivers in more detail later in my remarks.

Systems revenues declined in line with the market, down 5% in the quarter. As expected, with customers adopting a cloud-first mentality, hardware investment and use cases are being carefully evaluated, and we are seeing some elongations of deal timing as a result. That said, we continue to see systems growth opportunities in certain segments of the market such as high-performance security use case and in emerging markets. Our Services business delivered 4% growth in the quarter and continues to produce robust gross margins while maintaining world-class customer satisfaction scores. Our services capabilities continue to differentiate F5 as customers' application environment has become increasingly sophisticated and they recognize the need for reliable and responsive support from their most critical solution providers. We are achieving consistently strong 90%-plus attach rates. In fact the attach rate for the Americas increased 300 basis points in the quarter. As we discussed at our Analyst and Investor Day in March 2018, over time we do expect our services growth rates to slow as we transition to a higher percentage of subscription and other service offerings.

In summary, we're very pleased with the progress we are seeing in our software transition. Progress that will be augmented as we begin to see contribution from our recently launched as-a-service platform, F5 Cloud Services, and as we complete the acquisition of NGINX. I'll speak to both topics in greater detail after Frank reviews our Q2 results and our outlook for the third quarter. Frank?

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Francis J. Pelzer, F5 Networks, Inc. - Executive VP & CFO [4]

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Thank you, François, and good afternoon, everyone. As François noted, we delivered solid revenue and strong EPS growth in the quarter. Second quarter revenue of $545 million was up approximately 2% year-over-year and within our guided range of $543 million to $553 million. GAAP EPS was $1.93 per share. Non-GAAP EPS of $2.57 per share was above our guidance of $2.53 to $2.56 per share.

Q2 product revenue of $238 million was flat year-over-year and accounted for approximately 44% of total revenue. As François mentioned, software grew 30% year-over-year and represented approximately 19% of product revenue, up 80 basis points from Q1 as a percent of product revenue. Systems revenue of $192 million made up approximately 81% of product revenue and was down 5% year-over-year and roughly flat sequentially. Services revenue of $307 million grew 4% year-over-year and represented approximately 56% of total revenue. On a regional basis, in Q2, America's revenue grew 4% year-over-year and represented 56% of total revenue. EMEA was flat year-over-year and accounted for 25% of overall revenue. APAC revenue grew 1% year-over-year and accounted for 19% of total revenue.

Looking at our bookings by vertical. Enterprise customers represented 65% of product bookings. Service providers accounted for 20%. Our government business in the quarter reflected some modest impact from the government shutdown representing 16% of product bookings, including 6% from U.S. Federal. In Q2, we had 3 greater than 10% distributors: Ingram Micro, which accounted for 20% of total revenue, and Arrow and Tech Data, each of which accounted for 10%.

Let's now turn to operating results. GAAP gross margin in Q2 was 83.8%. Non-GAAP gross margin was 85%, in line with our expectations. GAAP operating expenses were $314 million. Non-GAAP operating expenses were $273 million. Our GAAP operating margin in Q2 was 26.2%, and non-GAAP operating margin was 34.9% in line with our expectations. Our GAAP effective tax rate for the quarter was 22.7%. Our non-GAAP effective tax rate was 21.8%.

Turning to the balance sheet. In Q2, we generated $194 million in cash flow from operations, which contributed to cash and investments totaling over $1.6 billion at quarter end. DSO at the end of the quarter was 53 days. Capital expenditures for the quarter were $29 million, up sequentially as we continue to build out our new facility in Downtown Seattle. Inventory at the end of the quarter was $33.5 million. Deferred revenue increased 15% year-over-year to $1.16 billion. Approximately 1/2 of the increase over the prior year quarter relates to the adoption of 606. We ended the quarter with approximately 4,795 employees, up 215 people from Q1 as we continue to hire aggressively as planned in our growth areas, including sales and research & development. In Q2, we repurchased approximately 617,000 shares of our common stock at an average price of $162.06 per share for a total of $100 million.

Now let me share our guidance for fiscal Q3 of '19. Unless otherwise stated, please note that all of my guidance comments reference non-GAAP operating metrics. Also, with NGINX not closed, our guidance today excludes any impact to revenue or cost from the transaction. Overall, we are pleased with the progress we are making with our software transition and remain confident in our position in the market and in the growth opportunities for the business. We also believe we are well aligned with the long-term trend towards multi-cloud environments and increasing demand for application security. In addition, we are seeing increasing traction with subscription and ELA offerings as they provide customers consumption flexibility and better agility for their ever-evolving software architectures. With this in mind, we are targeting Q3 of '19 revenue in the range of $550 million to $560 million. We expect gross margins of approximately 85% to 85.5%. We estimate operating expenses of $275 million to $287 million. We anticipate our effective tax rate for the year will remain in the 21% to 22% range we previously provided for the full fiscal year with some fluctuation quarter-to-quarter. Our Q3 earnings target is $2.54 to $2.57 per share. In the quarter, we expect share-based compensation expense of approximately $40 million and $1.7 million in amortization of purchased tangible assets. Capital expenditures are expected in the range of $110 million to $130 million for the year. This range includes approximately $70 million of cost related to our previously announced corporate headquarter move to F5 Tower in Downtown Seattle. The initial phase of the move occurred over the last several weeks and we expect to complete the move this summer. I'll reiterate that we continue to expect NGINX transaction to close in the second calendar quarter, but we have not included any revenue or cost impact from the deal in our guidance. We expect any revenue impact in the quarter will be immaterial and expect to provide contribution details when we report our Q3 quarter results.

With that, I will turn the call back over to François. François?

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François Locoh-Donou, F5 Networks, Inc. - President, CEO & Director [5]

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Thank you, Frank. I'll spend just a few minutes on the trends we're seeing in the business and highlighting some customer wins from the quarter before we move to Q&A. Focusing first on our 30% software growth. We are accelerating software growth across 3 vectors. First, we are capitalizing on significant customer demand for security capabilities packaged as software. This is particularly true as customers deploy multi-cloud applications, including applications in the public cloud where the demand for security is even more critical. As a result, security use cases continue to drive our software growth rate and account for a higher share of our overall product business. In particular, our anti-bot and machine-generated traffic monitoring and blocking capabilities is appealing to customers who continue to face an increasing array of threats. We are also seeing new security use cases emerge, including privileged user access, credential stuffing and zero trust. As an example, during the quarter, we deployed a combination of access policy manager and our Advanced WAF at an international energy company. They selected F5 to secure their application access. In other words, applications on their network are secured with an F5 application security policy. For example, F5 provides highly secure access to systems on their oil rigs and oil plants for third parties doing systems maintenance. The second vector accelerating software growth comes from our subscription and ELA consumption models, which were introduced last year and provide customers flexibility as they manage the transition to multi-cloud environments. Increasingly, customers are using ELAs to leverage our technology in public clouds. During the quarter, we closed 3x the number of opportunities and near that in value compared to the first quarter. While the overall dollars are still relatively small, ELAs are an important tool for our sales force and we have a robust third quarter ELA pipeline. As an example, during Q2, we closed an ELA with an online gaming company. The customer needed the flexibility to deploy Advanced WAF and API capabilities to protect the games' layer 7 DDoS, bots and bad actors. Using an ELA consumption model, we replaced other security vendors and gave the customer the flexibility to deploy the needed multi-cloud security application services when and where they want. The second ELA example came from an airline undergoing digital transformation and pivoting to a multi-cloud approach. This customer preferred an ELA to ensure flexibility as their needs scale. They selected our high-performance BIG-IP Virtual Edition as well as BIG-IQ. The same customer also upgraded from the public cloud native Web Application Firewall to F5's Advanced Web Application Firewall. They are using F5 to secure their consumer loyalty application with both bot mitigation and credential stuffing protection. This deployment offers an interesting example of how F5 can work across often siloed teams within an organization as we work successfully with both the network and the security teams. The third vector for accelerating software growth is our advanced capabilities in automation, orchestration and central management, which resonate with customers facing an increasingly complex combination of environments and sprawling deployments. In fact, our ability to unify and simplify deployments is unlocking new spend. For instance, during the quarter, we had a large U.S. payment processor purchase BIG-IQ to manage their global infrastructure deployment of BIG-IP. The customer had come to F5 last year looking for a solution to help them automate their infrastructure and operate at the speed of business. They are now deploying BIG-IQ to manage their global estate of hundreds of BIG-IP instances. As we look toward the back half of 2019, we believe we will continue to drive software growth with a number of catalysts. First, in Q2, we launched our F5-as-a-Service platform and the first SaaS offering running on top of it. F5 Cloud Services is designed to support modern deployment scenarios. These include cloud native applications in container-based environments with high availability, strong service, enterprise-grade SaaS solutions that are easily provisioned and configured within minutes. Launched with a basic DNS service set, we have a number of customers already in free 60-day trials. Later this year, we'll deliver even more F5 enterprise-grade SaaS abilities, including security services designed to protect applications from existing and emerging threats. Another catalyst for continued software growth is a new high-grade ELA consumption model we're launching in response to additional use cases. Customers have asked for an ELA that protects their entitlement when they are migrating from hardware to a software and cloud environment. With this new high-grade ELA, we are providing customers even more flexibility and license portability as they contemplate digital transformation and what it means for their businesses. We have already developed pipeline and we are excited about what this new model means for future multi-cloud application services.

Finally, we are increasingly confident in the opportunities enabled by our acquisition of NGINX. We continue to expect the acquisition to close in the second calendar quarter. In the weeks since our initial announcements, internal reaction from both F5 and NGINX has been very positive and initial integration planning is going well. Customers across all theaters are very excited about what they see as the strong potential of the combination and the ability to bridge the divide between NetOps and dev ops. Together, F5 and NGINX will be able to offer solutions that provide the requisite control to satisfy the CIO while giving application developers the freedom to innovate. We are excited by the complementarity between F5's cloud native app services platform and NGINX's controller. As a result, post-close we expect to converge both under 1 product family using the NGINX brand and maintaining the momentum in NGINX's current offering. This converged offering will address a larger total addressable market and will span a broader set of used cases across dev ops and Super-NetOps customer personas. When closed, we expect our F5 cloud native team to move under NGINX CEO, Gus Robertson, providing a significant increase to the NGINX engineering team and additional resources to accelerate new product capabilities and use cases. The traction we're getting with our software solution is perhaps the most demonstrable evidence that F5 is on a path to become the leader in multi-cloud application services. I mentioned in my opening remarks that customers are increasingly taking a cloud-first approach. We are as well. As our customers contemplate and begin to work across multiple environments, F5's value proposition actually increases. Organizations of all sizes are quickly learning that operating in multiple environments make things more complicated and F5's solution simplify that complexity with consistent, environment-agnostic policies, automation, orchestration and central management.

I'll speak briefly to our service provider business before we go to Q&A. We continue to drive our network function virtualization, or NFV, solutions in new areas of service providers' business. We are securing DNS and CGNAT wins in growth portions of providers' networks, and we see wirelined and MSO deals ramping. Recent wins with wireline carriers include DDoS, DNS and firewall services. In addition, we are also seeing opportunities emerge from managed web application firewalls. We continue to have conversations with mobile operators about 5G and while we continue to see the majority of near-term 5G spend focused on the spectrum and radio portions of the network, we are confident that as spending moves towards the core, there will be increased opportunities for F5. During Q2, we successfully expanded our use case with a North American communications provider to include security. We are now providing WAF to front-end all of their consumer-facing websites. The same communications provider was also experiencing numerous outages and network challenges in its field technician network, which was leading to unsatisfactory customer experiences. F5 proposed an access policy manager solution with manageability through BIG-IQ. This allowed the provider to achieve greater scale and reliability while supporting dual stack connection, allowing for better access and stability for internal users and delivering greater efficiency for remote field technicians. We're also having discussions with this customer as they contemplate the move from 4G to 5G and expect that as they transition, our sales motion with them will become more software focused. This is true with another service provider customer as well, where during the quarter we secured a large systems win to help them handle increased traffic and deployed NFV functionality with BIG-IP Virtual Editions.

In closing, my thanks to the entire F5 team, our partners, our customers and our shareholders. We are on this journey together. Our customers' digital transformation requires a continuous transformation of our business and we are embracing that challenge. With that, operator, we will now open the call to Q&A.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Your first question comes from the line of Paul Silverstein from Cowen.

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Paul Jonas Silverstein, Cowen and Company, LLC, Research Division - MD and Senior Research Analyst [2]

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First one, Frank, first from a regional perspective, was there anything unique in the quarter in the EMEA region? You have been posting strong growth over the better part of the past 6 quarters, and there was a significant downtick from your previous growth rate in the quarter. Similarly there was an uptick in the Americas. Can you discuss what's going on regionally? And then I've got a follow-up.

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Francis J. Pelzer, F5 Networks, Inc. - Executive VP & CFO [3]

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Yes. I think -- North America I think we had a solid quarter, specifically internationally, and I'll go to Europe where for the last 3 quarters we've got growth -- we've got year-on-year growth rate now in the 7% to 8% range. And this quarter, Europe was flat year-on-year. That was concentrated specifically in the U.K. where I think we saw this uncertainty around Brexit push up some deals. And I think we also had some softness in Germany, specifically sort of Germany, Austria region. And so as a result, we had less than perhaps we would've hoped in Europe. Overall, if you recall, Paul, about 18 months ago, we felt we were having some execution challenges in Europe. We made a lot of progress on those -- we made some changes both in leadership and in the way that we have put our formation in Europe. We feel we've made a lot of progress there with these challenges, but these progress are still in the -- with a backdrop of continued macro uncertainty in Europe. And so I think that's what we're dealing with. But generally, we're happy with the way we're -- our team is organized and performing over there. I think this quarter was specific to the U.K. and a little bit in Germany. And then in Asia-Pacific, we also had less cost than we've had in the last couple of quarters, but we think that's a little bit of lumpiness there. Generally, the trajectory for our business in Asia-Pacific is north, and we continue to expect good growth in that region. There isn't anything macro that we worry about there at the moment.

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Paul Jonas Silverstein, Cowen and Company, LLC, Research Division - MD and Senior Research Analyst [4]

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And François, on the Brexit comment, just playing devil's advocate, why now? Brexit has been hanging out there for a while. One would think that last quarter, the quarter before, no different than this quarter that, that would have presented a challenge to you and other suppliers, i.e. the uncertainty. And then I also want to ask you, last quarter you made a comment about lack of manpower in the federal government to actually process the paperwork, which was adversely impacting you from a rev rec standpoint. But there wasn't otherwise an issue related to federal government weakness. And I'm wondering if there's been any change with respect to that.

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François Locoh-Donou, F5 Networks, Inc. - President, CEO & Director [5]

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On Brexit, Paul, you're right. But the -- I guess there has been some uncertainty around it. But folks have known that the outcome would be -- that the U.K. would exit the European Union. In the last few months, the uncertainty around how that would happen and when, you probably followed all the episodes of this, has increased. And a number of companies have been trying to make contingency plans for what will happen in the very short term. So in the last month of the quarter, in the U.K. in particular, we saw folks push out decisions because they wanted to wait until they had clarity on what the real outcome would be. Specifically on the Fed, we did -- we had a reasonable quarter in the Fed. We -- it could have been better if the government shutdown had not taken place. The impact for us is we didn't lose any business, but there was some business that wasn't processed in the quarter. Even though the shutdown ended I think early February, there was some business that we had won that wasn't really processed in the quarter. So there is a few deals that could have come in the quarter that did not come. But overall, we thought we had a reasonable quarter in the Fed.

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Operator [6]

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Your next question comes from the line of Alex Kurtz from KeyBanc.

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Alexander Kurtz, KeyBanc Capital Markets Inc., Research Division - Senior Research Analyst [7]

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François, just on your commentary around the service providers, it sounded like you're becoming more constructive about the opportunity. I know it's been a challenging vertical over last couple of years. Is something changing there from a demand perspective? Should we start thinking about these group of customers maybe growing faster than the overall business for a period of time?

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François Locoh-Donou, F5 Networks, Inc. - President, CEO & Director [8]

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Alex, I would not conclude that for now. I think we're still cautious about the near-term opportunity with service providers. We felt better about a couple of the North America service providers this quarter than we were in Q1. But overall, if I look at the -- our use cases and spend globally with service providers, I still think we are in the middle of this 4G to 5G transition. And that there are good opportunities ahead of us sort of several quarters out, once we see the rollout to 5G radios and the capacity upgrades that will happen for us. In the meantime though, we are getting a lot of traction with service providers in 2 areas specifically. NSD, where we're seeing them use more and more our virtual solutions, so they did contribute to our growth in software as well. And also in security, on a number of use cases, including firewalls but also things like CGNAT and other use cases. So these 2 areas in service providers are doing well. And hopefully the 5G highway will come, but as we said that's a few quarters out.

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Alexander Kurtz, KeyBanc Capital Markets Inc., Research Division - Senior Research Analyst [9]

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And just clarify do you think 5G could be a better dollar opportunity for F5 and 4G wasn't? I know you weren't here for that. But just talking to the team that works those accounts. Is there a sense of just -- could it be at a better dollar opportunity?

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François Locoh-Donou, F5 Networks, Inc. - President, CEO & Director [10]

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We think so because of the sort of size and scale of these deployments. The fact that we're very well positioned to help teams like network slicing that are critical in 5G and then the way they'll have to handle the traffic, what's going to happen at the edge, around processing more and more traffic and applications at the edge. There are a lot of catalysts that give us a belief that this could be a meaningful, and perhaps more meaningful than 4G, impact on F5.

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Operator [11]

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Your next question comes from the line of Samik Chatterjee from JPMorgan.

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Samik Chatterjee, JP Morgan Chase & Co, Research Division - Analyst [12]

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François, I just wanted to clarify, I think in your comments about the system revenue being down 5%, you mentioned you are seeing some elongation of deal timing. Is it primarily you're seeing kind of them evaluating other solutions? Or potentially evaluating kind of a move to the cloud? Or is it more just kind of pause in spending that you're seeing? If you could just clarify what you're seeing there.

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François Locoh-Donou, F5 Networks, Inc. - President, CEO & Director [13]

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Samik, it's not a -- I wouldn't characterize it as a pause in spending. The phenomenon there is as customers adopt the stance that is more software first or cloud first, they do scrutinize their spend on hardware more. And as a result, the approval cycles for hardware are getting elongated. And I think that's what we're seeing really as the dynamics in large enterprise organizations. But those that have made a decision to go software first or to go cloud first, from the time we have a project that a team has approved and want to go forward to the time that, that transaction can be processed, there is lot more scrutiny on it. That's what I was referring to.

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Samik Chatterjee, JP Morgan Chase & Co, Research Division - Analyst [14]

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Okay. Got it. And just a quick second one. You've referred to the launch of the cloud native product as well as a service offering in the quarter. When you're going and kind of looking at these -- kind of asking your customers that look at these products, are they kind of opting to wait for the NGINX controller to be available that you mentioned you kind of put them together and have a converged offering? Or -- I mean, what are you seeing in terms customer behavior and as the NGINX controller being kind of a deciding factor and you would rather wait for it or kind of close the deals even before it?

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François Locoh-Donou, F5 Networks, Inc. - President, CEO & Director [15]

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Yes, so Samik, I think you're -- so there was an announcement in the quarter about F5 Cloud Services, which is, I think, a pretty important milestone because it's the first Software-as-a-Service offering of F5 and talking later about what I see as catalyst for F5 Cloud Services. But I think your question is specifically between NGINX and cloud native application services platform that F5 has been developing. So on that, it's actually fairly straightforward. The NGINX brings to the table elements of the portfolio that are not in the virtual ADC space. So they are completely complementary to what we have been doing. And it's really their API Gateway technology, what they've been doing in web server and app server space and those are completely new adjacent TAMs for F5. In the virtual ADC space specifically, NGINX has a controller that is in the market and our cloud native app services platform was really based on a controller that we have built organically, but hadn't been launched in the market yet. And so we've been in the initial stages of integration planning and where we're headed with that is there is significant complementarity between the 2 in the sense that the NGINX controller appeals to a -- I would say, a fairly sophisticated dev ops audience whereas our controller was more targeted, it was a mainstream enterprise buyer that really wanted an easy way to control their data plays. And so what we're doing is we're going to start with the NGINX controller because it is in the market, it is in use with customers, and we of course want to maintain and accelerate that momentum. But we are going to rapidly port the capabilities of our controller to the NGINX controller, so that the combined offering can target a larger addressable market from the very sophisticated dev ops users all the way to the less sophisticated that want an easy capability with all the analytics that come with it. So we're pretty excited about that potential acceleration of the combined offering.

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Operator [16]

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Your next question comes from the line of Sami Badri from Crédit Suisse.

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Ahmed Sami Badri, Crédit Suisse AG, Research Division - Senior Analyst [17]

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So the software revenue and then the watermarks that you're starting to reach every single quarter is very commendable, but I think the one thing I just want to try to understand is on margins. It looks like, on a sequential basis, there is a little bit of a pressure now. The operating margin that you had this quarter makes sense given your aggressive hirings you commented on. But on specifically non-GAAP gross margins, can you just walk us through what exactly is happening on the cost side, just because you think that a software ramps up dramatically more, you see some margin expansion and we just want to get a better idea on what exactly is going on.

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Francis J. Pelzer, F5 Networks, Inc. - Executive VP & CFO [18]

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Sami, it's Frank. Let me start with that one. It's actually right in line with our expectations, what we said was sort of 85% to 85.5%. So we were at the lower end of that range. But it was exactly as we expected to come on board. Over a long period of time, as we scaled the software business the actual inherent margin in there in the growth side is higher than the hardware business. And so as we talked about at AIM in 2018, as we get even further into closer to Horizon 2, you should see some of the impacts of that investment start to make its way as additional component of our product revenue comes from software and is a better driver for an expansion in that gross margin side. But I'd just go back to say but this is exactly what we expected and how we talked about it in guidance last quarter.

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Ahmed Sami Badri, Crédit Suisse AG, Research Division - Senior Analyst [19]

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Got it. And then the -- I think one thing on NGINX, there is lot of commentary on bringing in NGINX and integrating it and going to market more under the NGINX umbrella and unifying the offerings. So one other kind of follow-up question to a lot of this narrative, is there -- will there be any type of cannibalistic dynamics by doing this with the existing F5 business? And just to kind of use a historical or illustrative example is, if everybody was moving from physical ADC to virtual ADC, there could be an element of cannibalism, right, to the revenue streams? Is there anything like that, that could potentially emerge by integrating NGINX and going to market with that brand and integrating all F5 services and NGINX together? Could there be potentially any type of cannibalistic dynamics to your revenue stream by doing that?

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François Locoh-Donou, F5 Networks, Inc. - President, CEO & Director [20]

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I think the short answer to that, Sami, is we don't think so. So just to be clear, NGINX does not a direct -- so if one wants to go from their current mode of deployment, of using ADC as part of their infrastructure to support multiple applications, but they want to go from a hardware ADC to a virtual ADC, we already cover that today with our Virtual Editions. And we do that very well which is why, in part, our software has been growing at the rate it has, it's because of what we're doing on Virtual Editions, the introduction of our Cloud Edition and the IQ platform that provides better centralized management and automation and orchestration, and the flexible consumption that we give people around our enterprise license agreement that allow them to have license portability. All of these things address the use case of how do you go to virtualized ADC deployment and we're doing very well there. The NGINX capability is really more of an augmentation of that than a cannibalization of that, and if you look at the use case that they're addressing, it's really dev ops folks who want to build their load balancing or ADC capabilities much closer to the application logic as part of new dev ops environment. And that isn't a cannibalization of the things we do today, it's rather a new growth area for new applications that are being built and deployed either on-prem or in public cloud.

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Operator [21]

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Your next question comes from the line of Simon Leopold from Raymond James.

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Simon Matthew Leopold, Raymond James & Associates, Inc., Research Division - Research Analyst [22]

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I have two. One is pretty simple, in the quarter you did $100 million share repurchase, but you do have this acquisition. Just want to get a revisit of your plans in terms of share buybacks, given the long-standing pattern had been around $150 million a quarter, now we see a couple of quarters at $100 million. Want to get a better understanding of how to think about it going forward? And then I have a follow up on the verticals.

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Francis J. Pelzer, F5 Networks, Inc. - Executive VP & CFO [23]

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Sure, Simon. So as we discussed on March 11 when we talked about the canceling of our automatic share repurchase program, our viewpoint really hasn't changed and so we do view our cash balance as a very strategic asset for us, and we're going to use that opportunistically. It may be for additional share repurchases we're not just going to automatically do but be opportunistic about. It may be for additional acquisitions or it may be for other activities. So for the time, we have talked about we're suspending the automatic share repurchase, but we're going to be opportunistic with additional share repurchases in the future.

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Simon Matthew Leopold, Raymond James & Associates, Inc., Research Division - Research Analyst [24]

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And François, in your prepared remarks, I had the impression that you were pleasantly surprised about the telco results this quarter kind of getting back to a trend we had observed during much of fiscal '18, just over $100 million versus $76-ish million in the prior quarter. And so I understand what you said about the outlook, but if we look at the March quarter, if you were pleasantly surprised by the telco improvement, was there an unpleasant surprise offsetting it? What was weaker than you expected in the quarter? And maybe elaborate on what trends would be in that aspect of the business mix?

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François Locoh-Donou, F5 Networks, Inc. - President, CEO & Director [25]

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Simon. The -- so I'll start with the last part of your question. What was weaker than I expected in the quarter was Europe. I thought we could have done better and I think as I said the dynamic in the last month of the quarter was weaker than we would've thought. And there was a little bit we could've done more in the Fed. But again, I think we had kind of anticipated that because of the shutdown. As it relates to service providers, I wasn't necessarily pleasantly surprised. I think what we were trying to point to is, in our first quarter, service providers were particularly weak. And I felt the interpretation of that was perhaps too strong because the service provider segment is naturally lumpy. And so I think we wanted to point out that we came back to numbers in the service provider space that are more in line with historical mix for F5. But that being said, I am still cautious about the service provider segment for the next few quarters because of the transition dynamics we've talked to.

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Simon Matthew Leopold, Raymond James & Associates, Inc., Research Division - Research Analyst [26]

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And what's your expectation for the behavior from Europe over the next few quarters?

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François Locoh-Donou, F5 Networks, Inc. - President, CEO & Director [27]

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My expectation is, I think we continue to make very good progress on our own internal execution with the changes we've made. So we've have grown very confident and Chad Whalen, our Global Head of Sales, has been very confident about the leadership team and the formation of the resources that we have in place there. I have a little bit of caution specifically around U.K. and Germany, based upon what we've seen. But overall, I think with the changes we've made and the hiring we've had in Europe, our expectation would be that we continue to grow in Europe.

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Operator [28]

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Your next question comes from the line of Michael Genovese from MKM Partners.

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Michael Edward Genovese, MKM Partners LLC, Research Division - MD and Senior Analyst [29]

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François, I wanted to check in and go back to the presentation when you acquired NGINX and gave the post-NGINX Horizon 1 guidance. And just checking and see if those guideposts are still going to be applicable after today.

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François Locoh-Donou, F5 Networks, Inc. - President, CEO & Director [30]

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Mike, yes, they are.

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Michael Edward Genovese, MKM Partners LLC, Research Division - MD and Senior Analyst [31]

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So generally speaking, post-acquisition we should model in for this year, next year a little bit faster revenue growth, but a little bit of dilution in the EPS. I just want to make sure that we're factoring in the acquisition correctly.

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François Locoh-Donou, F5 Networks, Inc. - President, CEO & Director [32]

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That's correct.

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Operator [33]

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Your next question comes from the line of Rod Hall from Goldman Sachs.

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Roderick B. Hall, Goldman Sachs Group Inc., Research Division - MD [34]

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I guess I had two. I wanted to start off with the OpEx line, particularly R&D. We continue to see R&D creeping up a little bit, especially if we look over a multiyear period, and we've just bought NGINX. So I'm just wondering how much more R&D do you think you need to spend to integrate that. And to continue to push products forward? Should we anticipate that the R&D line continues to grow as a percentage of sales for a while or does that stabilize in a few quarters? And then I have a follow-up to that.

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François Locoh-Donou, F5 Networks, Inc. - President, CEO & Director [35]

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Rod, I think you'll see the R&D line pick up a little more over the next few quarters both because of the NGINX acquisition and additional investment that we want to make to catalyze or capitalize on the opportunities in front of us, specifically in the case of NGINX, beyond the organic investment there. We want to port security capabilities into the NGINX platform fairly quickly. We want to accelerate what they've been doing in the API management space. It's a big market. There is a big opportunity there. They didn't have the resources to fully capitalize on the opportunity for us. We're going to accelerate that. Same on the application server space. So all of these things should pick up. And then in security, we also are going to continue to make more investments. We've had very strong traction in security in the first half of 2019, both for our own on-prem offerings and increasingly our managed services security offerings in civil line and our cloud services in security and software services. And as you know, the market and security is, of course, moving more to software-managed services and cloud. And so we've got some exciting offerings and we're going to press ahead with those opportunities. That being said, all of that -- all of those investments have just gone through. They were considered when we gave a revised Horizon 1 guidance of operating profit between 33% and 35% for Horizon 1. So all of that's accounted into what we should expect.

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Roderick B. Hall, Goldman Sachs Group Inc., Research Division - MD [36]

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So are you -- just to clarify that, François, you're saying that it creeps up in the next couple of quarters, then it stabilizes? Or does it creep up peak and come back off? Just can you give us some idea on trajectory, what we ought to be thinking?

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François Locoh-Donou, F5 Networks, Inc. - President, CEO & Director [37]

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I think it stabilizes. We're not giving specific guidance for next year, but essentially I think it stabilizes to get into that 33%, 35% range for Horizon 1.

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Roderick B. Hall, Goldman Sachs Group Inc., Research Division - MD [38]

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Okay. And then my follow-up was with regards to service providers, the telco revenue, I mean if our calculations are right, I guess they are, I mean you are right back to the revenue -- absolute revenue level you were at 2 quarters ago. When you guys had said last quarter after the big deterioration in that revenue line, you thought it'd take a couple of quarters to get back. And we kind of had the impression from you that, that was pretty concentrated, the deterioration of that revenue. So I just wonder, any color you could give on what happened there? Was there a project that you thought would be delayed longer that came back or did -- that 1 or 2 carriers that deteriorated in revenue terms add new projects? Just give us any color on why that snapped back so much more quickly than you thought it would.

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François Locoh-Donou, F5 Networks, Inc. - President, CEO & Director [39]

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Well, it was, Rod. It was pretty concentrated and we've had good projects this quarter around a couple of carriers where we have the specific softness. My comments overall are related to the opportunity that we see in service provider. And I think the levels where we're at today are not the levels where we would like to be 18 months down the road when we -- the 5G opportunity is truly -- would truly mainstream.

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Operator [40]

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Your next question comes from the line of Catharine Trebnick from Dougherty.

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Catharine Anne Trebnick, Dougherty & Company LLC, Research Division - VP and Senior Research Analyst of Data & Internet Protocol Networking [41]

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Back to the service provider. Any -- are -- which regions do you think are tracking faster as far as getting ready to implement 5G? And then where do you think your best position, North America, because you have such good relationships with top tier carriers, one? And how are you doing in Asia PAC versus EMEA?

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Chad Michael Whalen, F5 Networks, Inc. - EVP of Worldwide Sales [42]

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Catharine, this is Chad Whalen. I think from -- from a service provider perspective, I think that we've -- across the different theaters, we're seeing motions kind of isolated to certain countries outside of North America. And I would say that there has been a stronger movement in some of the APAC region as opposed to maybe throughout Europe. And here in North America, there is deep interest in what's going on with 5G planning both in terms of core capacity for enhanced mobile broadband, which is kind of the first service that they are launching. But more importantly for us, is the new architectures that include mac at the edge. And we're spending a lot of time and that's a forcing function for what we're doing around our virtual software offerings. So we're seeing it kind of broad based, but I would say from a concentration perspective, North America and Asia Pac are probably furthest along.

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Catharine Anne Trebnick, Dougherty & Company LLC, Research Division - VP and Senior Research Analyst of Data & Internet Protocol Networking [43]

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And are you seeing any different competitors spring up in this area, especially when it comes to the NFV piece of it, combining GNAT (sic) [CGNAT] and -- with DDoS and DPI? Are you seeing any other -- I mean who do you typically see when you're competing at that level?

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Chad Michael Whalen, F5 Networks, Inc. - EVP of Worldwide Sales [44]

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Well, from a -- in many parts of the globe, the network equipment providers are kind of the key access into the carriers. And so Nokia, Ericsson. Samsung is new and has made a pretty marketable impression in a APCJ and we're expecting that to continue in EMEA. In terms of new entrants on the software side, Affirmed Networks has been around for some time, we see them some more. But it's typically the same players that we're seeing and have seen in the 4G space that are transitioning into 5G.

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Operator [45]

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Your next question comes from the line of Ittai Kidron from Oppenheimer.

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Vinod Krish Srinivasaraghavan, Oppenheimer & Co. Inc., Research Division - Associate [46]

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This is Vinod on for Ittai. I have another NGINX question. I know it's early in the planning and integration projects, but now that you're converging NGINX with cloud native, how does your go-to-market approach change? Are you going to be adopting their approach?

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François Locoh-Donou, F5 Networks, Inc. - President, CEO & Director [47]

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Vinod, so the approach that we have around the NGINX opportunities, we are going to integrate their sales force, which has been, I would say, for the most part, an inside sales motion. We're going to integrate that organization into Chad Whalen's global sales organization. And we're going to complement that inside sales motion with the enterprise high-touch sales motion that F5 has had in place and excels at. And I think with the combination of these 2 capabilities, we're going to be able to touch both the low-end deals as well as more and more the high-end, high-touch deals, because one of the things that we think is going to accelerate as we monetize NGINX at scale is that with the acceleration of their controller capabilities with the new resources that we are putting in, NGINX is going to have access to deals of, I think, increasing size as well as larger deals in the enterprise space. And so we really think we're going to need both motions. Both motions are going to be under a single organizational umbrella under Chad Whalen, and we've already started to think about the governance and collaboration between these organizations to make that very smooth.

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Operator [48]

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And that's all the questions we have time for today. Thank you for joining. This concludes today's conference call. You may now disconnect.