F5, Inc. (FFIV) Q2 2014 Earnings Report, Transcript and Summary

Good afternoon, and welcome to the F5 Networks’ Second Quarter 2014 Financial Results Conference Call (Operator Instructions) Also, today's conference is being recorded. If have objections, please disconnect at this time. I would now like to turn the call over to Mr. John Eldridge, Director of Investor Relations. Sir, you may begin.

Thank you Brian, and welcome all of our listeners to our conference call for the second quarter fiscal 2014. John McAdam, President and CEO and Andy Reinland, Exec VP and Chief Financial Officer will be the speakers on today's call. Other members of our executive team are also on hand to answer questions following our prepared comments. If you have any questions after the call, please direct them to me at (206) 272-6571. A copy of today's press release is available on our website at f5.com. In addition, you can access an archive version of today's live webcast from the Events Calendar page of our website, through July 23. From 4:30 p.m. today until 5:00 Pacific time, April 24, you can also listen to a telephone replay at (866) 400-9641 or (203) 369-0546. During today's call, our discussion will contain forward-looking statements, which include 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 our quarterly release, and described in detail on our SEC filings. Please note that F5 has no duty to update any information presented in this call. Now, I'll turn the call over to Andy Reinland.

Thank you, John. Fiscal Q2 of 2014 was a quarter of solid execution as customers continue to embrace our solution increased adoption of our new tired pricing model good better best and continued momentum with our security and service provider business. Revenue of $420 million was above our guided range of $408 million to $418 million, an increase of 3% from the prior quarter and 20% year-over-year. GAAP EPS of $0.91 per share was above our $0.87 to $0.90 guidance. Non-GAAP EPS of $1.27 per share also exceeded our guided range of $1.23 to $1.26 per share. Product revenue of $225.1 million grew 3% sequentially and 22% year-over-year representing 54% of total revenue. Service revenue of $194.9 million increase 4% sequentially 18% year-over-year and accounted for 46% of total revenue. Revenue from the America is accounted for 56% of total revenue during the quarter. EMEA contributed 24%, APAC 14%, and Japan 6%. On a year-over-year basis America’s revenue grew 25%; EMEA revenue grew 23%; Japan revenue 17%; APAC revenue was essentially flat. Enterprise customers represent 65% of total sales during the quarter. Service providers accounted for 23% and government sales were 13% including 5% of total sales from U.S. Federal. In Q2, we have three greater than 10% distributors; Ingram Micro, which represented 16.9% of total revenue; Avnet, which accounted for 14.4%; and Westcon, which accounted for 12.3%. Our GAAP gross margin in Q2 was 82%. Our non-GAAP gross margin was 83.4%. GAAP operating expenses were $233.5 million, slightly above our guided range of $226 million to $233 million, a result of strong hiring as we continue to invest in our expanding market opportunities. Non-GAAP operating expenses were $201.5 million. GAAP operating margin was 26.4%. Our non-GAAP operating margin was 35.4%. Our GAAP effective tax rate for Q2 was 37.2%.…

Thanks, Andy. Good afternoon, everyone. I was very pleased with our performance in Q2. We experienced good year-over-year growth across most of our major focused business areas and the most pleasing metric in the quarter was the 22% year-over-year growth in product revenues. From a sales perspective the Americas, EMEA and Japan all recorded double-digit year-over-year sales booking sales bookings growth. However, sale in Asia Pacific region were flat over last year due mainly to a drop in sales in China. Our services business delivered another solid quarter with 18% year-over-year revenue growth, and added a healthy increase to our deferred revenue balance, which now stands at $588 million. If you recall we introduced our new pricing and tiering strategy Good, Better, Best, in the middle of last quarter. And we were very happy with the customer adoption especially in the Best category. Q2 was our first dual quarter with the GBB go-to-market model. GBB sales were up 83% quarter-on-quarter in Q2 with over 78% buying Best. This is significantly above the original modeling assumptions and this trend, combined with good sales execution with software module sales, resulted in our software revenues reaching a record high in the quarter with software sales in the high percentage of overall revenues ever. We had another solid quarter with sales of our security solutions. Security continues to be the major growth driver of our business was strong sales across the securities solutions portfolio including ASM, APM and AFM. We had two multi million dollars sales wins the quarter for the F5 solutions replaced existing competitors’ solutions. In the financial market, we replaced the incumbent with a very large APM access sales win. And in the service provider vertical a Tier 1 service provider purchased our AFM firewalls to replace their existing traditional data…

(Operator Instructions) First question comes from Jeff Kvaal, Northaland. Your line is open.

Hi, can you hear me?

Yes.

Great. Thanks for allow [ph] for the question. I was wondering two things. Number one, you commented a little bit in the press release about the very few surprises in the second quarter. I was wondering if that were the same set of assumptions that you were using towards – well, first, if you could comment on that; and then, secondly, if that was the same set of assumptions that you were using in the second quarter? And then my second question may be for Andy, and that is on the gross margins: if software is as high as it's ever been as a percentage of the mix, should we not have expected a little bit more on the gross margin side or what are the variables involved in that? Thank you.

Yes. On the first one, very few surprises Linearity was as expected pretty solid and normal we didn’t see any significant change in win rates. The business drivers were as expected in other words, security, we we’re very happy with that. We we’re happy with Traffix. We we’re happy with the possibility in enterprise replacing Cisco ACE areas. So, generally it was as expected, hence the no surprise comment.

And then to the gross margin, I mean one of the dynamics we have right now is the rollout of our new product line. And whenever you do that, a number of variables come into play around your margin, warranty – many indirect costs. And so we’re just seeing that dynamic, which is muting the benefits there. But overall, what we are happy with is that we’re managing the gross margin consistently with the last couple of quarters.

Okay, so John and does that mean you applied the same set of assumptions for the June quarter when setting that guidance, is that a way to think of that?

Pretty much, I mean that’s reasonably accurate, I mean obviously one of the things we are excited about is you are going to see things like Versafe, the anti-fraud capability start to com into play, you’re going to see – we’re going to start introduce a storefront, with the LineRate, so there is other incremental thing, but generally I think that’s a valid assumption.

Okay, I’ll pass it on. Thank you gentlemen.

Thank you, next question from Rod Hall with JPMorgan. Your line is open.

Hi, it is Greg Schuck for Rod Hall. Thanks for taking my question, with regards to securities. Can you guys possibly split out enterprise versus telecom and then also kind of to what extent you guys see yourself in that datacenter implementations at this point? Thanks.

Yes, regarding security, we don't really split out enterprise with telco. I mean I mentioned a couple of times in my introduction that we had that we had a fairly large security deal with our firewall AFM solutions in telco, but we don’t really split it out. What I have said in the past, and I think it's still the situation, is that when you look at service provider, in particular, security is definitely a very, very big opportunity. But it is in the enterprise, as well, so – but we don't split it out by numbers.

Okay. And I guess my follow-up would be – with June guidance, is it possible to kind of put some color around the Good, Better, Best framework, as to what percent of customers would be kind of on the new pricing versus old? Do you guys have a general sense of that, or is it?

No, I think more we are focused on the trend, which – this was really the first full quarter. And it exceeded our expectations, so we are very happy with that. And I think we will see that continue. But as for breaking it out specifically, we are not going to do that.

I mean it was Good, Better, Best apart from the obvious benefits of, been easier to package the solutions together for the customer; giving them some incentive to add more modules; what it really gives us is a really easy entry point for the salespeople to start to talk to our customers about that added value. We could easily introduce Good, Better, Best, and then they decide to buy just a vanilla system with maybe one module, but they are thinking about the other modules because we have had the opportunity to talk to them.

Thanks guys.

Next question comes from Jason Ader, William Blair. Your line is open.

Thanks. A couple of quick ones here. The operating margin was a little lower than I had expected, Andy. And it sounds like you had a good hiring quarter. But you talked about some improvements in the back half. What's the right side of near-term target for operating margins, let's say over the next 6 months to 12 months? That's the first question. And then I'm just a little confused on the GBB comment, John. So when you said GBB sales were up 82% sequentially, what does that mean? What percentage of your customers are actually buying in this way? And how can we even think about that?

Yes. Let me answer it. So we had about half the quarter when the introduced it in the previous quarter, in Q1. Q2 is our first dual quarter, and the amount of revenue that we saw with GBB sales was up 82% from that half quarter sale. That's fundamentally what it is. We are not going to split out the actual numbers in terms of the revenue, but we are very happy with the results. And we are especially happy with the split – the percentage that went towards the Best of the GBB.

I'm going to answer that – the operating margin. The way we are looking at it now, we think we are in a great spot. We have good revenue growth going. We are generating strong cash, increasing EPS; and at the same time, we see some opportunities that we want to invest in. So I stand behind my comments. We are going to see profitability ramping in the back half, but we are going to be looking at opportunities to invest that we think will drive the top line. That's how we are going to approach it.

So you are not going to give any specific number for the next, whatever, sort of near-term operating model kind of number, like you gave in the past?

Yes. Well, you know, we generally in specific hard numbers really are quarter out. So you can look at our guidance and kind of lay it out, and with the ranges that we gave see where we are going to land. And then when we get beyond that, it's usually directionally – usually not beyond the fiscal year. So I'm kind of sticking to those comments. So we are going to see a ramp through the back half of the year. And then come October, we will address to in a general direction for next year at that time.

Thanks.

Next question Ehud Gelblum, Citi Research. Your line is open.

Hi. Thanks, everyone. It's Stan Kovler in for Ehud. I just wanted to cover some of the demand areas. Do you feel like demand is really coming from replacements and current customers with higher mix? You mentioned the GBB; 70% of those are coming in at the higher end or is it just the overall demand in the market is increasing? If you could specifically touch on the area of cloud and how some of those customers are doing, and what they are deploying in the context of your competitors, as well. There are some competitors in that space for either virtual or some of the platform products that they have. And then the final question for Andy, just a housekeeping on OpEx. It came in a little higher; just following up on the last question there. Do you expect to hire at the same pace for the rest of the year? Thanks a lot.

Yes and this is John and I’ll talk about it, and I think Manny can talk about some of the cloud things and then Andy will give the answer to his question. Its interesting when you say demand, one of the things that I’m very about at the moment is that over a fairly short space of time, we really have expanded our addressable markets. The acquisition of Traffix is a good example of that. We feel very good about what we are seeing with the Versafe subscription service. We think we have an opportunity there. We are going to be getting more active with the LineRate solution for web developers. Security, the demand there that we see for our module sales, and all three of them. Clearly, the traditional firewall is a greenfield opportunity for us and we are starting to see some real good success there. So from that perspective and then I think Good, Better, Best, the product refresh and the ACE opportunity are all big opportunities. That's why we’ve been hiring, we're hiring because we are seeing demand overall as an opportunity. And Andy will give you more details in your specific question, but I think you will see us doing that in the future, because it would be crazy not to do that. And then as part of that, if you look at the technology changes that are happening with the cloud that Manny can comment in a second; the pricing structures that are buying capabilities of the customer. We think we are in really good shape when we look at our current portfolio of products with software and BIG-IQ, and areas like that. So we think we are in a real sweet spot of a lot of these very significant changes.

And just – Stan just to add some comments – this is Manny – on the cloud side. So on the cloud side; what we are seeing is a massive adoption from our customer base around hybrid clouds, both on-prem, off-prem type solutions. . And there is a couple of metrics I will share with you, or data points I will share with you, just to give you an indication of the success we are having on that. One is that our Virtual Edition, which is our software version supported across a magnitude of hypervisors, has seen both significant quarter-on-quarter and year-on-year growth. We continue to see that every single quarter, and we are very happy with that. In addition to that, just this quarter we also launched a $95 Virtual Lab Edition, so customers can try that edition in the market segment. And that, again, has had an incredible ramp-up rate, because people are trying smaller workloads out in the cloud and making sure those solutions work. So we saw great, great momentum with that. And then, third, we are launching some new licensing programs also for the cloud. They make it a little simpler for users to buy cloud-based services and for cloud providers to package solutions to the market segment. And we are seeing that take off in the market segment, as well as the number of cloud partners. Our philosophy is pretty simply to make sure that our solutions are available in the cloud in addition to be enterprise, and enable customers to have this hybrid solutions set.

Stan and then, as far as hiring goes, I said that we are going to add above 100 for the current quarter. And I think we will continue that pace through the rest of the fiscal year.

Thanks. That's very helpful. If I could just follow up on one more question. If I add up all the indirect sales that you mentioned in the top three indirect sales channels, it looked like sequentially from those three folks the revenue declined slightly. And, obviously, overall revenue grew. Can you just help us understand what's going on with direct versus indirect there?

That the numbers that we give there are distributors, right, but then go through resellers. So it's a little bit to look at – it is just dependent on how sales break down and who the customers want to work through and resellers want to work through. We are required to disclose it. But there's nothing I'd read into that from one quarter to the next.

Thanks a lot.

Next question from Pierre Ferragu, Bernstein. Your line is open.

Thank you for taking my question. I have, actually, one very specific question on China. You mentioned sales there were clearly below the trend of other regions in the world. If you could give us some color on how things are developing there that would be very useful. And then, more broadly, about a year ago you had, like, a slowdown in sales, and that was mostly driven by the service provider segment, where orders can be lumpy. And so I was wondering in your performance today and your revenues in this quarter could you give us some sense of whether your numbers are being supported by actually very large orders from these very large cloud-type customers, or very large operators? And if we – there is a bit of a risk of lumpiness in your revenues because of that in, I don't know, in the next 12 months or something like that. Thank you.

Okay. Regarding China, I think I've said – certainly I said it on the last call, I may have said it on the call before, it is a tough environment. We've seen that when we have looked at some of our peers' results as well. I think that’s going to continue for a while. We have probably bottomed out in terms of the opportunity there. I don’t think there's much risk of it being worse. However, it's not an area that we are putting any big expectations in when we get guidance. As I say, I think that's pretty much across the technology board right now. Regarding our lumpiness, unfortunately, there's always the opportunity for lumpiness in the service provider business. I think our portfolio has increased dramatically that will in some way mitigate against that lumpiness. I'm not saying we have totally mitigated; we have not, but certainly, with the security operation we’ve got opportunity we have there, with Traffix opportunities with LTE rollout with mobile traffic steering to some degree, we have a bigger portfolio there, but there always that opportunity. In terms of the specifics, I think you were asking, where there any really massive orders? Not really I mean, we had good orders, million dollar plus-type orders, but nothing way of the ordinary. Overall, the number of million dollar orders was actually quite solid, but that includes enterprise as well as service provider.

Thanks, very much.

Next question from Catharine Trebnick with Dougherty & Co. Your line is open.

Thank you very much for taking my question. Could either – one of the questions I had is you – so you had a few wins for security in the service provider area. Could you give us some more color on was it more datacenter? Have you sold into any of the mobile Internet aspects of it? And then the follow-on question is well, take that one first. Thank you.

So, hey Catharine, its Manny, how are you? Real quick, just on the service provider, I’ll give you one. Tier-1 operator. It was a data center solution set. Basically, it was a pretty significant data center solution set, protecting their applications for both DDoS mitigation all the way up to Layer 7 firewall security, application security, as well as traffic steering functionality for their data center. That was one of many footprints that service provider has. And that was a significant deal. That was predominantly midrange product in our portfolio, but significant in the sense that it was lots of units that are going out there. So we feel pretty fortunate with that. That's a data center solution. In addition to that, that same service provider has a Gi solution that we are right now in proof-of-concept with. So we are pretty excited about that opportunity, which we think is equal, if not much larger, than the current opportunity ahead. And that applies to stuff across the world . I'm just giving you one example.

No, no. I understand that totally. And then the other question is on Traffix. You did say that that was up quarter-over-quarter. Are the deals more for LTE roaming, or are they any specific area that you are getting more traction with than others? And are you replacing Tekelec in some of these deals?

Yes. This is Manny, again. So, yes, it is LTE roaming. We are seeing a lot of that. We are seeing some basic just DRA load-balancing functionality for the signals that are out there. And then we have done in certain situations replaced Tekelec out there. Again, we are seeing a lot of good momentum in that environment. And we are talking to a lot of the service providers that are out there. There's no question Tekelec had early entry into the market been in the market longer than we were. But we feel pretty comfortable that from a technology perspective, our solution is comparable to anything the market and really superior to all. That’s out there.

All right, thank you very much.

Next question comes from Sanjiv Wadhwani with Stifel Nicolaus. Your line is open.

Thanks, two questions. John, the enterprise vertical did really well this quarter. I was wondering if there was any granularity you could give on certain areas that might have exceeded expectations, like financial services, etc. And then for Andy on the Good, Better, Best pricing, I know you have talked a little bit about the gross margin puts and takes around – with your software, sort of percentage going higher. But over time, as you see more and more deals queuing towards the best categories, should we be seeing a positive impact on gross margins over the next 12, 18 months?

Yes. On the enterprise vertical or the enterprise business, yes, it was very solid. The finance, by the way, is always a good one for us. It is like security. It is – like, new architectures, including hybrid clouds and if we are really in the great spot for that so I expect that to continue, but it was pretty solid. And I just see the last quarter that from a sales perspective that was also solid last quarter as well.

I mentioned the Good, Better, Best I've answered that I think yes, in theory, adding more modules that are purely software to increase sorter size should help the margin, but we are careful not to guide that for a lot of reasons. A lot of it is strategic, that we want to keep that close in case we want to use that with our channel partners or in other ways. So, but in theory, your question is right. It gives us flexibility.

Got it. Helpful. Thanks.

Matt Robison, Wunderlich Securities. Your line is open.

Hey, thanks for taking the question. On the Versafe, do you envision that activity ever becoming material to CapEx?

In terms of spend support?

Yes, spend to support.

Yes. I think it could add somewhat, but as we model it out and look at growth, we think it will be in line. Nothing that we think would accelerate CapEx abnormally.

We’ve already done—we didn't have a Seattle security operations center up until we introduced it just recently. And I mentioned that in the call. And that I didn’t have a massive effect on the CapEx.

So do you think that your model in terms of – as it matures and starts to hit its business plan, you won't see an increase in CapEx to revenue from it?

I think we could a little bit, but I don't think anything that would draw attention. I think we would manage it in the broader business.

I mean we are much more excited in terms of the fact it's subscription-based service, and as we add more wins that revenue number goes up, I think that’s the goal. Obviously, there will be some investments in doing that, but I think the prominent thing is the revenue and the contribution to earnings.

Yes. I get that. And we are kind of seeing a bit of a trend amongst companies that come with technology that they are trying – they are managing it a bit more, whereas they used to just sell it. That's why I bring it up.

Thanks. Okay, Brian, this is John Eldridge we’re going to take two more questions and then wrap it up.

Okay. Next question comes from Paul – from Paul Silverstein with Cowen and Company. Your line is open.

Guys, I was wondering if you just – I want to revisit a couple of questions and just some clarifications. First off, John, I heard your comment about the million dollar deals, in general. Can you give us the average deal size, is there any change?

Yes, actually the average order size that which is the metric we give, it had been pretty steady right at the $100,000 but we saw that increase last quarter 200%. So about a 10% increase.

Andy, was there also an increase in the large deals? I think historically you have shared with us million-dollar-plus deals.

There was my commented on the last end of we did see a nice increase in the number of – on the revenues total revenue to be go from $1 million deal plus.

So there was general increase. And then going back to your comment earlier about the increase in software content will help, but you may choose to be strategic in terms of passing on benefits, potentially. And I thought I heard you say that new product introductions had somewhat of a muting impact on the benefit you otherwise would have seen from software. Was there anything extraordinary about this new product introduction? Or was this – all things being equal, if you don't pass on the benefits going forward, we would see the benefits show up in gross margin? I mean, really focusing just on that new product introduction piece. Anything extraordinary about this go-around?

Now this really nothing extraordinary we generally see when we come out with new products systems were working through managing the supply chain as we are managing warranty reserve, manufacturing costs. We see those increased costs I think to some extent you kind of merging two questions together work the Good, Better, Best pricing which add software modules over longer period of time, in theory could improve the gross margin. The short-run question that was asked was: why this specific quarter? John made the comment that our software tax rates were at an all-time level; why we didn't see that in the gross margin and I was saying that was offset in the short-run by in fact that we are in the stage of new product introduction.

Understood. And then China as a percent of your Asia-Pac revenue – what is the issue, John? Obviously, we have all seen the reports about economic activity in China subsiding. There's the U.S. issue in terms of the technology concerns. Can you identify – are you able to identify what the particular issue is? If it's general, with respect to perception of risk, or something else? Is China roughly consistent with being 50% of Asia-Pac economy? Would that be about right for your impact on you?

No it’s lower than that. And there is tough one because as I say, it's not we are not – we are doing business there, but we have defiantly over the last probably 12 months and 9 months, 12 month we definitely seen its just tough environment in terms of getting orders from customers et cetera. Whether that’s that's endemic or not, who knows? I guess it is what it is.

One last one. U.S. Fed – any insight you could share with us, what you are seeing there?

I’m sorry.

U.S. Federal.

Yes. I mean we are pretty comfortable with U.S. Federal; we really like the team that was got in place. By definition we tend to expect a very solid quarter come September and I think we‘ll see that. If you are selling solutions that are based on datacenter consolidation, the cloud and the internet then you are in good share, and that’s what we do. So I think that continues to be a key market for us.

Thanks, guys.

Okay, last question at Brian Marshall, ISI Group. Your line is open.

Great. Thanks, guys. Since Paul asked three, I’ll just ask one. I think – congratulations. I mean this is the first quarter in roughly two years that we grew the top line 20% year over year. So obviously moving back in the right direction, well done. Sequentially we grew at almost $15 million. Now, I'm not expecting a complete breakout, but can you talk a little bit about how your core underlying business is growing from a dollar standpoint and versus all these new opportunities that you have in security and other things, et cetera. Just kind of curious what the underlying growth look like for the core business if you strip out all the new incremental stuff. Thanks, and well done.

This gives life to this whole discussion about what really is our core business. Remember, our definition of an ADC Application Delivery Controller is basically a platform, and that can be a software platform or a system platform or a combination of both, but it’s certainly a part of a bigger architecture. That includes on that platform the ability to expand an addressable market by adding more and more bundle solutions security being a classic example. So when we sell BIG-IP 4000 and we have our application file with a module on that, we view that as ADC market. And that's what we do and then obviously there is revenue associated with each solution, but you'll just see that continues to expand, in other words, we believe we are expanding an addressable market Brian and we don’t even look at it as what is the basic core market? We look at: what's the current expandable market that we are driving to and that’s definitely expanding aggressively.

Understood. Thanks, John.

Okay. Well, thank you all for joining us. We look forward to hooking up with you again at the end of the third quarter. And again if you have any questions, please give me a call.

Thank you.

Thank you. That does conclude the call for today. You may disconnect your phone lines at this time.