Greetings, and welcome to the F5, Inc. First Quarter Fiscal Year 2023 Financial Results Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Suzanne DuLong. Thank you, Suzanne. You may begin.

Hello, and welcome. I am 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 session. A copy of today's press release is available on our website at f5.com, or an archived version of today's audio will be available through April 24, 2023. Visuals accompanying today's discussion are viewable on the webcast and will be posted to our IR site at the conclusion of our call. To access the replay of today's webcast by phone, dial (877) 660-6853 or (201) 612-7415, and use meeting ID 13735357. A telephonic replay will be available through midnight Pacific Time, January 25, 2023. 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 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 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 François. François Locoh-Donou: Thank you, Suzanne, and hello, everyone. Thank you for joining us today. Against the backdrop of a continued tough environment, our team delivered first quarter revenue at the midpoint of our guidance range and earnings per share above the high end of our range. We came into Q1, expecting we would see deteriorating close rates and that the dynamics concentrated in EMEA and APAC in Q4 would spread to North America. In Q1, we experienced heightened budget scrutiny and more pervasive deal delays across all geographies. The dynamics are particularly challenging on larger transformational-type projects, which for us tend to be software focused. Like last quarter, new multiyear subscriptions were most affected. We noted last quarter that we were not planning on year-over-year growth from new software business this year. However, in Q1, it was down a double-digit percentage year-over-year. Based on customer feedback, we believe we are seeing the impact of financial decisions resulting from broader economic uncertainty, pervasive budget scrutiny and spending caution as opposed to technological, competitive or architectural decisions. In contrast to what we saw on new software business, software renewals performed largely as expected in the quarter. At the same time, improving supply chain conditions aided our hardware revenue, making it possible for us to ship systems to waiting customers. In addition, our Q1 maintenance renewals were particularly strong, which in the past, has correlated with customers' sweating assets. Despite the environment, we continue to expect 9% to 11% revenue growth for the year, albeit with a different mix than we initially forecasted. Given the demand trends of the last quarter, it is challenging to call our revenue mix with precision. However, with supply chain improvements and the benefit of our system redesign efforts coming to fruition, we continue to see a second half acceleration in our systems revenue. In addition, based on the solid maintenance renewals we experienced in Q1 and our forecast for Q2, we expect global services revenue will be stronger than we initially anticipated for the year. As a result, we expect the combination of stronger systems revenue and global services revenue to offset software headwinds in the year. We also continue to expect non-GAAP earnings growth in the low to mid-teens for FY '23. We remain to maintaining double-digit non-GAAP earnings growth this year and on an annual basis going forward, and we will continue to evaluate our cost base and take further action as needed to achieve this goal. In the current environment, customers are focused on minimizing their spend and optimizing their existing investments while also continuing to drive revenue. We are confident that we are well positioned to help them do exactly that. For instance, during Q1, we closed a significant multi-cloud networking win with a Tier 1 North American service provider. The customer selected F5 Distributed Cloud Services as the core for its next-generation managed service offering based on the platform's ability to deliver a scalable, agile and dynamic infrastructure. This is the second such win for the platform. F5 Distributed Cloud Services makes it possible for service providers to monetize their substantial network investment, including investments in 5G. The platform enables a managed service offering that solves critical challenges for enterprise customers like simplifying the deployment and operations of applications across multi-cloud and edge environments. Customers also remain focused on application security and F5 Distributed Cloud Services is also winning security use cases. In Q1, a healthcare customer selected our managed web application firewall and API protection solution after a proof-of-concept evaluation against both their incumbent CDN provider and a cloud-native solution. The customer selected FI Distributed Cloud Services because it proved more effective against threats while also being easier to manage. Our solution also met the customer's stringent regulatory requirements. Finally, customers are focused on total cost of ownership. As a result, we continue to drive good traction with our next-generation hardware platforms, rSeries and VELOS. These next-generation platforms can dramatically reduce customers' total cost of ownership by offering cloud-like benefits for on-premises systems. Clearly, the enterprise spending environment has changed from six months ago. That said, the breadth of our portfolio positions us well. The number of applications continues to grow, and those applications and the infrastructure needed to deliver, secure and manage them continue to get more complex. Customers need a partner like F5 who can help them simplify, reduce our cost of ownership and make the most of the budgets they have. Our broad solutions portfolio, combined with the consumption model flexibility we offer, squarely addresses these requirements. Now I will turn the call to Frank. Frank?

Thank you, François, and good afternoon, everyone. I will review our Q1 results before I speak to our second quarter outlook and provide some additional color on our FY '23 expectations. We delivered first quarter revenue of $700 million, reflecting 2% growth year-over-year. Global services revenue of $360 million grew a strong 5% in part due to the high maintenance renewals François mentioned and also reflecting previously announced price increases. Our revenue remained roughly split between global services and product, with product revenue down slightly year-over-year reflecting softer demand across all geographies and representing 49% of total revenue in the quarter. Continued supply chain improvements enabled systems revenue of $173 million, down 4% year-over-year. Q1 software revenue grew 3% to $168 million, against a tough comp last year. Let's take a closer look at our overall software growth. Our software revenue is comprised of subscription-based and perpetual license sales. Subscription-based revenue, which includes term subscriptions, our SaaS offerings and utility-based revenue totaled $129 million or 77% of Q1's total software revenue. Perpetual license sales of $38 million represented 23% of Q1 software revenue. Within our subscription business, as François noted, new multiyear subscriptions performed significantly below plan in Q1, while renewals performed largely as expected. Revenue from recurring sources contributed 68% of Q1's revenue. This includes revenue from term subscription, SaaS and utility-based revenue as well as the maintenance portion of our services revenue. On a regional basis, revenue from Americas was flat year-over-year, representing 57% of total revenue. EMEA grew 14%, representing 26% of revenue and APAC declined 7%, representing 16% of revenue. Enterprise customers represented 62% of product bookings in the quarter, service providers represented 21% and government customers represented 17%, including 6% from U.S. Federal. I will now share our Q1 operating results. GAAP gross margin was 77.9%. Non-GAAP gross margin was 80.4%, in line with our guidance for the quarter and below where we expect to be for the year. GAAP operating expenses were $454 million. Non-GAAP operating expenses were $378 million, in line with our guided range. Our GAAP operating margin was 13%. Our non-GAAP operating margin was 26.5%. Our GAAP effective tax rate for the quarter was 24.5%. Our non-GAAP effective tax rate was 21.4%. GAAP net income for the quarter was $72 million or $1.20 per share. Non-GAAP net income was $149 million or $2.47 per share, above the top end of our guided range of $2.25 to $2.37 per share. EPS was aided in part by currency gains related to a weaker U.S. dollar in the quarter. I will now turn to cash flow and the balance sheet. We generated $158 million in cash flow from operations in Q1. Capital expenditures for the quarter were $13 million. DSO for the quarter was 62 days. This is up from historical levels, primarily due to strong service maintenance contract renewals in the quarter and, to a lesser degree, back-end shipping linearity resulting from ongoing supply chain challenges. Cash and investments totaled approximately $668 million at quarter end, reflecting the paydown of approximately $350 million in term debt remaining from our Shape acquisition. During the quarter, we repurchased approximately $40 million worth of F5 shares or approximately 263,000 shares at an average price of $152 per share. Deferred revenue increased 12% year-over-year to $1.76 billion, which is up from $1.69 billion in Q4. This increase was largely driven by particularly strong service maintenance renewal sales reflecting the trend of customers sweating their existing infrastructure while recalibrating budgets. Finally, we ended the quarter with approximately 7,050 employees. I will now share our outlook for Q2. Unless otherwise stated, my guidance comments reference non-GAAP operating metrics. We expect Q2 revenue in the range of $690 million to $710 million, with gross margins of approximately 80%. We continue to expect our gross margin will improve in the second half of the year for two main reasons. First, we expect some of the ancillary supply chain-related costs like expedite fees will begin to abate; second, with our engineering efforts to redesign around some of the more challenged components nearing completion, we expect to be less dependent on the broker market where cost for critical parts has been exorbitant. We estimate Q2 operating expenses of $368 million to $380 million, and our Q2 non-GAAP earnings target is $2.36 to $2.48 per share. We expect Q2 share-based compensation expense of approximately $64 million to $66 million. Given our Q1 results and our Q2 expectations, I also want to elaborate on our FY '23 outlook. We continue to expect revenue growth of 9% to 11% for the year. Given the demand trends we have seen in the last four months, we expect our FY '23 revenue mix will reflect revenue contribution weighted more towards hardware and services and less towards software than we expected a quarter ago. Our FY '23 software growth is likely to be lower than the 15% to 20% we initially expected due to budget scrutiny and project delays, pressuring new software contracts. This is offset by the probability of stronger systems growth given supply chain improvements and the benefit of our system redesign efforts coming to fruition. In addition, based on the strong maintenance and forecast for Q2, we now expect Global Services growth of mid-single digits, which is up from low to mid-single digits growth we forecasted previously. As François noted, we continue to expect non-GAAP earnings growth in the low to mid-teens for FY '23. We remain committed to maintaining double-digit earnings growth this year and on an annual basis going forward. We will continue to evaluate our cost base and take further action as needed to achieve this goal. I will now turn the call back over to François. François? François Locoh-Donou: Thank you, Frank. In closing, I would ask you to take away three things from this call: Number one, that despite the environment, we remain committed to delivering double-digit earnings per share growth this year and on an annual basis going forward; number two, while we believe 9% to 11% revenue growth for the year is achievable, if we get demand signals that tell us it is not, we will exercise operating discipline and adjust our cost base in order to achieve our earnings goals; and number three, we have built a strong business model with nearly 70% recurring revenue, product revenue that is split 50-50 between hardware and software and global services revenue that has proven durable. The result is a diversified and resilient revenue base, which when combined with operating discipline enables us to drive revenue and earnings growth in this environment. Operator, please open the call to questions.

[Operator Instructions] Our first question is from Sami Badri with Credit Suisse.

All right. Thank you very much for the question or at least opportunity to ask questions. I have two. First one is, could we just decompose the services revenue growth? You mentioned price increases and then maintenance renewals. Could you kind of split that reported number into each -- like what was stronger? Was it more renewals, et cetera, if you can just decompose that? The other question I have is, clearly, the IT landscape has shifted. And I think the big question myself and other investors are asking ourselves is if there is incremental risk through the year as far as demand or demand signals changing unless just say they get worse, how will those signals manifest themselves into F5's business and results? And a good example, a question we get is, if things decay or deteriorates, does that mean that product orders sitting on your backlog get canceled? Is that the -- is that kind of the deterioration that would yield that kind of output? I mean to get your comments on those two questions.

Sure, Sami. So I'm going to start with your first question, and then I'll let François take the second. It's Frank. So we didn't give an exact split out, but I would say it's roughly even between the two. I think the renewal rates continue to go up, particularly on those services business, and we've seen less discounting, given the environment that we see of people continuing to sweat assets putting focus on that and taking the price increases that were put in place a couple of quarters ago, and we're starting to see the benefits of that come through to the services revenue. So I'm not going to give you the exact split, but I would think of them as roughly equal between the two, and I'll let François refer to your second question. . François Locoh-Donou: I mean in terms of the overall environment, yes, the overall IT spending environment has deteriorated quite meaningfully over the last six months. And we're seeing that mainly in terms of softer demand than clearly what we were seeing six months ago. Now the way you would see that in our results, it's not in order cancellations because the appliances that our customers buy from us are typically mission-critical to deliver on applications that actually need the capacity. So we haven't seen any trend in order cancellations nor do we expect to see any of that. In fact, our customers have been pressing us to ship to them the backlog that we have built over the last couple of years and a lot of the orders that displaced that we haven't delivered on. And so we continue to work hard on our improvements in supply chain in order to be able to meet that. Where you are seeing this different environment in our results, and clearly, we're seeing a number of software projects that have been delayed, a lot more scrutiny on deals and that is actually affecting our software growth rate and you're seeing that in the results. And we've seen it, frankly, across the board in terms of softer demand in software, but also softer demand in hardware this quarter than we had a quarter a year ago.

Our next question is from Tim Long with Barclays.

Two, if I could, sorry. Could you talk a little bit about the software businesses, kind of which pieces of it you're maybe seeing more of an impact than others? Is it some of the SaaS businesses or it sounds like a lot of the term deals? But anything you can split apart there to let us know on that. And then related to that, what -- why are we still talking about the distinction between hardware and software? I don't think you guys really sell the solutions that way. So could you just give us an update why we still need to look at that distinction? François Locoh-Donou: Thank you, Tim. I will take your two questions. So let me start on the question on what -- where are we seeing the softer demand on software. I think if we split the software between existing contracts that have renewals or to forward or expansion versus new contracts, the renewal business on existing contracts largely performed as expected and where we saw most of the softer demand was on new contracts and new projects, which we had said, we expected this year in the past three years, new software business had grown pretty significantly year-on-year. We expect it coming in the year that new software project would be flat year-on-year. And what we saw in the first quarter was more of a -- it was down double digits relative to last Q1. So this is where we saw more of the pressure. Whether it affected more of the SaaS business or the term subscription business, I would say, it was quite indiscriminate across product lines, what we saw. But of course, the most significant impact in terms of in-quarter revenue was really in this multiyear term subscription deals. That's really what was a bigger impact on Q1 revenue. In terms of the hardware software distinction, Tim, it's a good question. Look, I think this year, certainly, and there was also that effect last year that there is a dynamic around hardware where last year we had a lot of demand that we couldn’t really ship because of supply chain issues and this year we are looking to improve on our supply chain and be able to ship all the orders that we've had in our backlog. And we've made a lot of progress on the supply chain to be able to do that. But it's true that a lot of our customers consume both hardware and software. We think that's going to continue to be a trend from our customers towards more software-first environment. And that's because of the way they want to consume the technology ultimately. But when we look at the total performance of the company, we focus less on that distinction than driving earnings growth and specifically double-digit earnings growth, and we're absolutely committed to driving that regardless of the dynamics between hardware and software.

Our next question is from Alex Henderson with Needham.

Great. helping you address a little bit about what your backlog in systems looks like. I think it was running 40% to 50% of four-quarter product sales in systems. And I was hoping you could give us some insights there in terms of what the backlog is at? And then second, obviously, getting the rSeries out in March of last year was an important milestone, but there was a lot of application functionality that you needed to get built into it in order to solve individual customers' needs in order to replace the iSeries. And I was hoping you could give us an update on where you are on that? And do you think that, that then creates post, say, the June quarter, a refresh cycle on the large installed base of iSeries?

Yes. Alex, let me start with the backlog question. I'm going to turn it over to François for your second question. So on backlog, what we've talked about is that we will disclose that once a year if it's material, meaning more than 10%, but we weren't going to talk specifics in any one given quarter. I will say similar to Q1 last year, where we talked about percent move up, we were down a bit more than 10% this quarter in backlog from where we ended in Q4, and that was largely a result of our ability to ship based off of some of the product redesigns that we were able to achieve. And so we were quite happy with seeing that reduction in backlog from a customer satisfaction standpoint. And then François, I think we'll talk to your second question. François Locoh-Donou: So Alex, on the rSeries, there were -- there have been two factors that have sort of gated the ramp and growth of the rSeries over the last several quarters since we launched it. First is what you mentioned, the number of use cases and applications that rSeries could cover relative to the iSeries. And second was our ability to build and ship rSeries, which has been significantly constrained with some of the components. The good news is both of these factors are going away over the next couple of quarters. So on the supply chain factors, we are seeing better component availability and also access to broker markets where we are still constrained. We still have constraints on rSeries. We still had in Q1, and [we're still having] but a lot of the redesigned efforts that we have already done will be complete by the end of our second quarter. And so we are seeing lead times on rSeries will be improving in our second quarter and beyond. And then the second aspect in terms of the application, the number of use case that rSeries can cover will pretty much be at parity with iSeries, if not in the June quarter, in the September quarter. So in both cases, there's a lot of progress. There is a lot of demand for rSeries. And I think you should expect that rSeries will certainly grow into FY '24 to become the vast majority of what we ship in terms of appliances.

Our next question is from Samik Chatterjee with JPMorgan.

I guess for the first one, if I can, François, ask you to sort of share a bit more color on in terms of budget scrutiny, which regions as well as customer...

Samik, we're having a hard time hearing you. You may want to speak up.

Can you hear me now?

Yes, much better.

Yes. So first question was really more about sort of François' comments on the budget scrutiny that you're seeing, which regions and maybe customer verticals as well, are you seeing the most sort of scrutiny from? And where do you stand in relation to like as you sort of are in the early days of fiscal 2Q in terms of either quantifying it in terms of a sales cycle or conversion cycle? Are you continuing to see those sort of conversion cycles get extended or time line get extended? Or are you starting to find a sort of levels set to a longer duration in terms of the conversion cycle? And I have a follow-up. François Locoh-Donou: Thank you, Samik. So in terms of where we saw softer demand in software, it was across the board in terms of verticals and geographies. So if you remember in Q4, I said the international EMEA and Asia Pacific, in particular, were quite affected we actually did see that clearly in North America as well this quarter. And it was also, I would say, across most of our verticals. I think it was more pronounced in the technology sector, large tech companies going through substantial revisions of their budget and to some extent, I would say, financial services. These are perhaps where the effects were more pronounced. In terms of the rest of the year, it's too early to have full visibility on the rest of the year. I would say our expectation is that the dynamics that we have seen in our first fiscal quarter as it relates to software will largely continue in our second fiscal quarter. But beyond that, it's too early to speak to the visibility.

Got it. Thanks for that, François. And for the follow-up, I mean, you mentioned customers are sweating the assets a bit more, which is sort of you are recapturing some of that on the services side. But in terms of the systems demand, and there is obviously a supply chain piece here. But what -- how are you thinking about sort of the upside to system demand as some of the maybe software transformation projects get delayed and drives some level of sort of utilization of hardware appliances, which always had sort of great performance? So how are you sort of looking at the upside on the system side from that delay as well? What -- how would you quantify that? François Locoh-Donou: I think, Samik, the -- in terms of the system demand, as we said earlier, we also saw softness in systems demand this quarter. So this effect on budgets and scrutiny from our customers at large affected both the software and the hardware demand to an extent. The upside in demand, frankly, is -- sorry, in in hardware revenue for the year is we said at the beginning of the year, we felt our hardware revenue forecast was really a shipping forecast. And the upside and the stronger second half that we see in hardware is really driven by ability to ship more hardware. So you should see a step increase in our hardware revenue in Q3 and Q4 from the first half of the year because of the improvements we've made on supply chain. In terms of demand specifically, I don't think the pressures on software would necessarily create stronger demand on hardware at this point in time in the environment because I think our customers are really trying to sweat their assets and try and limit the utilization to not exceed the capacity that they already have in place to the extent they can. I think that can only go on for so long, at which point they will have to buy and add capacity. But I do think that -- the improvement in supply chains and as lead times improve, we will see some demand that is latent that has been gated by the fact that we're not able to ship. So a lot of customers because we haven't been able to ship orders that they place two, three, four, five months ago, and they haven't been able to project or implement our solution or not able to place the next order. And I think as we resolve that, we should see some improvement there in demand from these customers.

Our next question is from Amit Daryani with Evercore.

I guess I have two as well. François, maybe just going back to this product systems discussion a little bit. Yes, the risk of the fear folks would have is listen, if the macro remains soft and IT budgets remain under pressure, why wouldn't customers push out or sweat the appliances more. And so then maybe just about how do you have confidence that this appliance or systems business recovers in the back half if the macro remains challenging and the backlog can remain strong. François Locoh-Donou: Well, I would say, look, where we have strong visibility is for us to achieve the revenue forecast we have in hardware, we don't necessarily need a very strong fundamental recovery in hardware demand than we have today because of the visibility we have on revenue and our ability to ship, including our backlog. In terms of what I think -- there's a real question as to when do I think this recovers and demand picks up again. It's difficult to predict. But what I can tell you is that the fundamental drivers of what gets customers to buy hardware or software are still there. They are tied to the growth in applications and applications continue to grow the complexity of these applications. And the deployment models, the fact that these applications increasingly live in hybrid and multi-cloud environments. All of these drivers are fundamentally there. So demand can be suppressed for a period of time, a couple of quarters, three quarters, four quarters. But where we have a ton of confidence is that it is going to come back because the fundamental drivers of our business and what our customer is doing are still there and will continue, including, I should say, attacks on applications that drive demand for security for applications. So all of those things are part of what gives us a lot of confidence that it's going to come back. In this current environment, the fact that we've built the flexibility that we have built around our consumption models and our deployment models, plays very well because some customers have pressures on CapEx, others on OpEx and our ability to serve them one way or the other is one mitigant, if you will. And it's one of the aspects that we think provides the resilience that you're seeing in our business and operating model.

Got it. That's really helpful. And then if I just touch on the software side. I know you folks talked about in the ability -- the growth will be sub the 15% to 20% range that you talked about previously. Is there anything about what the new range would be? Or what does the trajectory of software look through fiscal '23? And then does this alter at all what you're seeing your longer-term expectations you've had from the software business beyond just this year? François Locoh-Donou: Let me start with the last part. It does not alter our long-term view, Amit, because of the drivers that I've just taking you through. We think our customers will continue to deploy software in -- sorry, we'll continue to deploy our software in cloud and hybrid cloud environment. We think that the architectures are evolving to be multi-cloud architectures, and that absolutely favors that if I go back to where we were five years ago when we were hearing customers and why everything is going to go to a single cloud location, and we're not sure we're going to need an F5 ADC. Today, we are positioned where the architectures are going. They're going to multi-cloud. We're very well positioned in these architectural conversations. And so what we're not seeing is the shift away from F5 from an architecture perspective, we're seeing just financial decisions and pressure. So we're very confident that the drivers of long-term software growth for F5, security, modern applications and multi-cloud environment are going to be there and drive the 20% plus growth that we've talked about in the long term -- in the shorter term. Yes, we have said it's less likely that we will be in the 15% to 20% range we've mentioned. There is a path to get there. It's a narrower path than it was a quarter ago because it would imply a change in the second half in terms of the demand patterns that we have seen on software. And so whether things would rebound this quickly for us to be able to see that. That's unclear, and that's why we're saying that it's less likely that we would deliver 15% to 20% growth. You will note, however, Amit, that the -- I mentioned our business and operating model earlier. Part of the benefit of the balanced model that we have built is you're seeing the improvements we've made on supply chain allow us to have perhaps upside on the hardware revenue and also upside on the services revenue. So on balance, we feel our 9% to 11% revenue range is still achievable.

Our next question is from Meta Marshall with Morgan Stanley.

Maybe two questions for me. One, if you could just kind of lay out maybe most often what some of these larger new software deals are associated with, are they tied to kind of cloud migrations or security upgrades or kind of thinking about hybrid architectures, that would just be helpful to kind of figure out what other indicators we could be looking at when thinking about the software -- new software growth coming back? And then maybe just on the second question. Product gross margins are staying depressed for a little bit longer. Just how are you guys thinking about kind of the progression of getting rid of some of these supply chain costs or broker fees throughout the year just to the time that it might take to get back to some of the product gross margins we've seen in the past? François Locoh-Donou: Thanks, Meta. I'll take the first one. Frank will take the second one on gross margins. The -- so the large software projects that are tied to all of the factors you mentioned, but typically infrastructure modernization or application modernization. So these would be companies that are -- that have had, say, our hardware in their environment, and they're deciding to move in a partially or wholly to a software-first environment. This could be a private cloud or it could be a public cloud implementation with lift and shift. More often than not, they are actually setting up the software environment whilst keeping part of their application estates on hardware. So they will pick a set of applications that we really want to modernize and move to an environment that's more automated, whether it's in a public cloud or even in their own private cloud whether it's higher levels of the automation that gives them faster time to market, better deployment time frames and cetera, et cetera. So that's the type of project for the large kind of multiyear subscription. We have also a number of other projects that are now with NGINX. There are just typically new applications, new modern applications that have been in test and development, and they're moving into production. And when they move into production, there is a need for strong networking and security capabilities that NGINX brings as a complement to, for example, Kubernetes orchestration. So we're seeing a lot of these projects. And now with our Distributed Cloud offerings, we're also offering SaaS solution, and that is, I would say, a missing part of our business, but it's a different model of deployment where typically, a long tail of applications that would not have had a traditional ADC in front of them in the past, customers are choosing to protect them with a SaaS security solution for F5. So those are, I would say, the three types of implementations. But of course, the multiyear sort of subscription are more anchored on the first model that I mentioned.

Meta, in relation to gross margins, particularly product gross margins, our view of that for the year has not changed. And we talked about the supply chain improvements starting to benefit our product gross margins really in the latter half of this year, even all the way up into Q4. But the real benefit that we're going to see is going to be in FY '24 in terms of product gross margin improvement. We still had the purchase price variance and expedite fees that we're working through the components that make up our box builds through this year, and we still have got a few critical components where we are having to go in the broker market. So largely, we will start to see improvement in Q4, but more of it you will see in FY '24.

Our next question is from James Fish with Piper Sandler.

On the software number, I don't get the reluctance to not give a number at this point. I get -- we're kind of missing the 15% to 20%, but it's the main question we're getting after hours. So any clarity on that would be helpful, Frank. And should we be assuming the kind of net new business, double-digit decline in new recurring software should continue for the remainder of the year? Or are you expecting this to kind of improve as that new business comp gets easier in the second half of the year? And just I have a quick follow-up after.

Sure. And I appreciate the question, Jim. We -- again, as François mentioned, a second ago, we are not updating our 15% to 20% guidance because we do still see a path to get there. Again, it's harder path. I think that we're not necessarily expecting to change in environment. And part of the reason why we're not updating the back half is because the visibility is cloudy right now in terms of demand. And with -- when we came into the year, we talked about over 50% of the revenue that we expected as part of that 15% to 20% growth was going to come from new business activity. And that we didn't expect that to grow, but we didn't expect to see the types of percentage declines that we saw in Q1. And so just with the lack of visibility that we've got right now, we don't have a new range to offer to you today. But we do feel like it's less likely that we will be in that range.

Okay. And then François, I'm surprised no one's asked about it at this point, but on the strategy side with this Lilac deal. Why Lilac? What's the competitive advantage? And is it hope more to align with product overlap against some of your kind of newer competitors like an Akamai or Cloudflare is it more to be able to offer that SaaS-like experience inside a customers' environment? And just trying to understand why couldn't this get done with NGINX and Volterra already? François Locoh-Donou: Thank you, Jim. So Yes. On the Lilac, let me start with -- we acquired Volterra a couple of years ago. and really launched the platform with our security offering about a year ago. And we've seen a very, very good traction with Distributed Cloud Services over the last 10 months. And so we want to build on that traction. We recently started with a CDN offering in the Distributed Cloud Services platform. That was based on an OEM agreement with Lilac. And this was essentially a talked acquisition to in-source that technology and the team, in order to be able to secure the offering for the longer term. And also work with this team to continue to improve on the offering and deliver increasingly innovative edge services on the Volterra platform. So we're pretty excited about the team joining us and being able to accelerate our innovation on that front. And it completes our offering in terms of web application firewalls, API security, DDoS protection, anti-bot and now CDN into the bouquet of services that we offer on Distributed Cloud.

Our next question is from Simon Leopold with Raymond James.

This is Victor Chiu in for Simon Leopold. You noted that the fundamental demand around F5 software is still largely intact. But are there specific factors that you can point to that gives you confidence that the slowing isn't a reflection of more secular headwinds like cloud migration versus the cyclical slowing that you're noting? François Locoh-Donou: Yes, Victor, I think it's interesting because I would say that migrations to the public cloud, if you want to call them like lift and shift tech migrations, we have seen that to be more of a tailwind to F5 than a headwind. But even more than that, what we have seen over the last couple of years is that customers are not migrating applications to a single cloud. Increasingly, customers are leveraging multiple different environments for their applications, multiple public clouds, private cloud and on-premise. And that actually is an architectural model that is ideally suited for the portfolio that we have built, which is essentially an infrastructure agnostic portfolio of application security and delivery services. And so we feel very strongly that as that trend accelerates in large enterprises and that multi-cloud and hybrid cloud becomes more and more the mainstream deployment way of that enterprises deploy their application portfolio. It is going to drive growth for F5 and specifically, for F5 software and SaaS services. So that's where our confidence comes and I mentioned those drivers earlier, multi-cloud environments, security, modern applications. All three will contribute to the long-term growth of our software, which is why we feel our views on that are absolutely intact. What we are seeing right now, again, it's not an architectural or a competitive issue. It is it is largely a macro-driven very cautious spending environment that is kind of indiscriminate across product lines.

Well, I mean so prior to the kind of macro headwinds that we started seeing, do you see -- did you observe any of those trends that you mentioned regarding multi-hybrid cloud trends and did you see -- you observed those trends and that kind of gives you the confidence that, that will resume when things normalize? François Locoh-Donou: Yes, Victor. I mean, we saw them, which is why if you look at our software growth in 2021, I think it was around 37%. And if you look at our software growth in 2022, the first three quarters of '22 prior to the change in the environment, our software growth was also close to 40%. So we -- and it came from these three drivers, more deployment of modern applications that we serve with NGINX now with Distributed Cloud Services, more need for security in front of applications that we serve with all security solutions, Shape Distributed Cloud, BIG-IP and more deployments in multi-cloud environments with our large customers.

Our next question is from Tom Blakey with KeyBanc Capital Markets.

I guess my first question is also -- or both questions are on software as well. The numbers you've given for us are -- you can kind of back into, I believe, strong double-digit growth in the renewal, kind of true-up business in the quarter. Is there anything onetime in that number? Or anything that kind of would lead us to believe that, that can't -- you don't have any visibility into that -- into fiscal '23, that growth kind of remaining?

Yes. We did not experience any sort of onetime benefits, I think the -- however you want to think about the perpetual business versus the subscription business, but there was nothing unusual in the quarter.

Yes. I'm sorry, I'm just focusing on the subscription business with regard to renewals and true-ups. And then as you mentioned -- sorry, Frank, go ahead.

No, no, no. Absolutely, Tom.

Okay. And then just on the perpetual side, you've been a little bit above trend line in the last couple of years -- the trend line over the last couple of years, where -- what kind of visibility do you have into this perpetual business line, in the pipeline there? Comments from François, maybe. And maybe if you could juxtapose that with your comments about pause and a slowdown in spending just doesn't really jive with your kind of like beating the last couple of quarters pretty handily from a perpetual license perspective, that would be helpful.

Yes. Tom, let me start with that, and François wants to add, he certainly can. Again, we think some of the power of our model is the flexibility of the way customers want to consume. And in some cases, people have OpEx budgets and in other cases, they have CapEx budgets. And so in certain instances, I think they'd rather consume on a CapEx basis, and some of that will come through perpetual. It's not something that we try to spend a ton of time forecasting the split between the two. We're happy when revenue falls in either. And so for the last couple of quarters, you may have seen that tick up from what was sort of a low $30-ish million a quarter business to the upper $30 million, low $40 million. But generally, those are customer preferences and how they want to consume our solutions.

Our next question is from Jim Suva with Citigroup.

Your commentary about the hardware being stronger especially with your outlook and such and the mix shift to more towards that, which will impact things. I understand it all, but the question is, is that impacted at all due to the supply chain issues during the past year or two in that maybe customers are absorbing some of the orders that they did and then this is going to face a headwind? Because normally, I would think about customers buying both the hardware and software kind of together.

Jim, is it affected by the supply chain? The answer to that is yes, because we have a lot of orders that we were not able to ship last year, and we have made a lot of improvements in supply chain, both from our suppliers in the general environment and our own redesign of our platforms that give us better visibility on what we're going to be able to ship to customers over the next three quarters. And we've always said we wanted to be able to get all this these orders to our customers as soon as possible and reduce our lead times, which we believe actually will be a tailwind to demand when we're sale to reduce our demand. So yes, it is affected by that. But it is -- that's part of why we see the soft side in the hardware for the year. It's because our view today of what we'll be able to ship has actually improved from where it was three months ago.

Okay. That makes a lot of sense. And then just given the macro cautiousness, how should we think about capital deployment, stock buyback, M&A, any changes there? Are you kind of holding, not holding up, reserving a little more for organic functions? Or how should we think about capital deployment versus maybe six, 12 months ago?

Yes, Jim. So it really hasn't -- our outlook on capital deployment has not changed. We still expect to spend 50% of our free cash flow on share repurchase this year. And as you -- as we mentioned earlier, we did pay down the term loan debt associated with the Shape acquisition, which was a little over $350 million use of cash in the quarter. And so that reflects the change in our cash balance and the $40 million share repurchase we did in Q1. And we obviously announced Lilac, which was an undisclosed sum. It was a small acquisition that we did today. And so the balance of the activities and how we said we're going to use our capital has not changed, and we don't anticipate that it will change going forward.

Our next question is from Fahad Najam with Loop Capital.

I want to revisit the software issues again. If you look at perpetual, it's growing fairly steadily. So can you maybe help us understand in terms of the renewals, what the net retention rate saw maybe anything cohort analysis that you said it was in line? So maybe if you can just elaborate a little bit more? And then furthermore, I guess the question also is how should we be thinking about your exposure to legacy applications versus new modern applications? And if there's anything you can share with us on how that mix is trending. François Locoh-Donou: All right. Let me start with the legacy and modern applications and how the mix is trending. I would say it's actually trending in line with the population of applications overall, which is that legacy applications are growing, I would say, in the single-digit percentage range in terms of the number of these applications out there deployed in the world. Whereas modern applications, we think are growing in the 30% range in terms of the number of them that are going into production on an annual basis. And so over time, there will be a lot more of the more than applications than the legacy applications. But where this gets blurred though, is that we're also seeing a number of legacy applications get modernized where folks are adding modern component to an application that is already in production has already been generating revenue. And this is where I think F5 has a specific advantage is that, yes, we play in modern applications with components like NGINX and excluding our Distributed Cloud Services. Yes, we play in legacy or traditional applications with platforms like BIG-IP. But for a lot of our customers, they want to have implementations that involve modernizing a legacy plate application and especially in an environment where customers are looking to consolidate vendors to simplify their operations, our ability to deliver on both of these requirements and actually deliver a single commercial vehicle where you can have both your modern and legacy application services is critical. And so that's one of the ways that we've positioned the company to be able to serve both needs. Over time, it will skew more towards modern applications as they grow faster.

And we're not offering any new metrics on software like net retention rates. I will say that as we mentioned for the renewal side of the business, which includes the SaaS business is the true forwards associated with the business and some of the second terms of our multiyear subscription agreements as largely came in as we expected. The shortfall that we experienced was largely due to the new software business that just didn't drive growth in the way that we would have expected it in Q1.

I have one more follow-up. François, now that you've had a few years post NGINX, Shape acquisitions under your belt. Can you maybe give us an update on how the progress is in integrating these acquisitions into F5? Is it -- are you able to sell and integrate these acquisitions and upsell your solutions? Any update on how the integration of these assets have gone? And how do we think about next year -- sorry, fiscal '23? François Locoh-Donou: Yes, absolutely. So let me take them quickly in order. I would say on NGINX and Shape integrations are largely complete. And so on NGINX, you've already -- so they're complete both from a, if you will, product perspective in terms of capabilities, we have ported from F5 or BIG-IP onto NGINX, so we can offer, for example, security on NGINX. And increasingly, we're offering our customers a single pane of glass to be able to get visibility on both NGINX and BIG-IP deployments. And they're also complete from a go-to-market perspective whereby we have now enabled our mainstream go-to-market, marketing and sales resources to be able to promote and engage customers on NGINX. We've done the large thing on Shape, we're a little behind that, but I would say almost 80% there where we now have the integration complete. Shape is available in BIG-IP. Our customers who have BIG-IP can turn on Shape and tie more capabilities quickly. Shape is also available in our Distributed Cloud platform as a standard anti-bot defense offering. And we've also done a lot of the go-to-market integration. By the way, those integrations from -- when I say from a go-to-market, they are quite critical because they have allowed us to continue to drive better operating leverage from a sales and marketing perspective. So if you look at our sales and marketing expense, I think it was 31% or so of revenue in 2020, and it's 29% in 2022 despite the revenue pressures we had because of supply chain. So you see operating leverage there. And you look at our overall OpEx as a percentage of revenue has gone from roughly 54.5% in 2020, down to 50% to 51% implied in our FY '23 guidance. So the integrations have also enabled us to drive the right synergies and operating leverage. And then in terms of the -- I don't know if you asked about Volterra, of course, is newer. And so we're still going through that, but we've already done a chunk of the integrations by deploying all of our security capabilities onto that platform that we call now Distributed Cloud, and we're getting quite a bit of traction where all of that is going, is that ultimately, we are going to offer our customers a single console and a single pane of glass from which they can manage all their security policies from which they can get visibility to all their deployment with F5, whether it's hardware, software or SaaS and whether it's in legacy or modern environment. And in that regard, we're positioning to be quite a unique player that can cover all these models in a way that's agnostic to the underlying infrastructure.

Due to time constraints, we will be taking our last question from Ray McDonough with Guggenheim.

Just two if I could. I understand you're not giving any new software metrics right now. But can you talk about how contract duration trended on renewals? I understand you were selling three-year term license deals in that cohort. It's really the first cohort of renewals that you're seeing this year. Are you seeing any contraction of contract duration? And then the second question would be I appreciate the comment around double-digit EPS growth and the commitment there. But how should we think about cash flow growth and cash flow margins normalizing as you kind of lap the change towards more annual invoicing terms this year?

Sure. Ray, why don't I take both of those? The first in terms of changes in duration of the contracts, we are certainly sensitive in monitoring that, but we have not seen any discernible change in contract duration on the second term renewals or on the primary contracts that we are putting in place. And so that has not impacted us at this stage. In terms of the commitment to our double-digit EPS growth and cash flow, we are -- we will see the benefits of some of the slowdown in the new flexible consumption programs that will then yield more actual cash in the back half because we're not adding on as much of the upfront revenue recognition in relation to the cash that we are receiving. So we will start to see the benefit of that and see that normalize out a bit. Part of the other benefit that we're going to see for cash flow is that the supply chain issues that we've had and the extra purchase price variance and expedite fees those will largely come out, and those will help our cash flow from operations. So both of those, I think, will start to see a normalization. But it is one of the more difficult areas to predict in the model going forward.

Thank you. This concludes today's question-and-answer session. This is the end of today's conference. You may disconnect your lines at this time. Thank you for your participation.