FFIV - NASDAQ

Good afternoon, and welcome to F5 Inc.'s Third Quarter Fiscal 2025 Financial Results Conference Call. [Operator Instructions] Also, today's conference call is being recorded. If anyone has any objections, please disconnect at this time. I will now turn the call over to your host, Ms. Suzanne DuLong. Thank you. You may begin.

[Operator Instructions] Our first question comes from Tim Long with Barclays.

Sure. Yes. Thanks. So I'll speak a little bit to the software dynamics that we're seeing. So we talked about that we had a large renewal base that was coming up in the second half of the year, and that gave us really good visibility. And what we saw again in this quarter was very healthy expansion against that renewal base. And so that's really coming in 2 forms. One, it's increased consumption that customers have been driving over the course of their prior subscription term. And then at that time of renewal, that consumption then comes through at a higher contract value at the renewal as well as additional expansion across the portfolio. So we're seeing new use cases built in at that time of renewal. And so that's really where we're seeing the growth in the software. On the new, when we reference new, we're talking about either net new customers or net new software projects where the customer wasn't previously consuming in software. That business is up year-to-date, but it was down a little bit in Q3. And some of that kind of goes back to what Francois was referencing around an appetite from customers to support their applications in an environment where regulatory concerns are more prevalent, resiliency is more kind of at the forefront and just generally a bias for more performance. And so at the margins, we -- there were a couple of opportunities that actually closed in hardware where previously the customer might have chosen to go with software. And so that's really kind of what's behind the business, coming from new projects coming through more in hardware than software. And so we feel good about the year. We have, again, a strong base in Q4. And just based on the expansion trends that we've seen and continue to see, we feel pretty good about our view into Q4.

Our next question comes from Meta Marshall with Morgan Stanley.

This is Mary on for Meta. I had a question on gross margins. Are there any reasons for why gross margins came in at the lower end of the range despite the upside on revenue?

Yes. So it was pretty slightly at the low end of the range. That was really driven more by some of the high-performance use cases on the systems business. We had some deals that had FIPS compliance demands, which tend to have a slightly lower gross margin profile. And then just broadly, the strength in the systems business, in general. Of course, hardware has still a very high gross margin profile, but it's not quite as high as software. And so that was the other dynamic that really was behind our gross margins. But as you see from our guidance for Q4, we expect gross margins to improve in the current quarter.

Our next question comes from Michael Ng with Goldman Sachs.

And then on the software side, it's a little bit early. We wouldn't guide software for next year, but I'll kind of give you just a few dynamics for consideration is kind of what's a reasonable estimate from where we sit today. So I'll start with just a way to think about FY '26 in terms of growth rates and then I'll get into some of the dynamics that we're looking at. I think it's reasonable to assume software would grow in the mid-single digits for next year and then reaccelerate in the following year. And just to kind of walk through some of the things to consider. So first, we're still seeing really strong consumption in that renewal motion. So as I said earlier, that's increased performance and consumption along with new use cases that are part of that renewal motion. And just as a point of emphasis, the growth comes from -- over time is coming from new use cases and that increased consumption that's embedded in the renew and expand motion. So it's not simply repeat business. Then a second dynamic, and we talked about this a little bit on the last call in April, is that the subscription base that comes up for renewal in FY '26, that base largely comes from our software revenue from FY '23 because of that 3-year renewal cycle. And so our FY '23 software sales were roughly flat over FY '22. So that represents a bit of a math headwind on that subscription base where we do that renew and expand motion. And then that same dynamic becomes a tailwind into FY '27, and it's why we would expect the growth rate to reinflect from there. And then the last dynamic, we touched on it a little bit is just some of the evolving customer preferences around deployment models. And this is really one of the big strengths around our ADSP platform is that we do give customers a choice in how they want to deploy. And so when we talk about hardware and software, something to keep in mind is that those are not products, they're delivery models. BIG-IP is a product. And some customers are choosing to deploy BIG-IP in that hardware form factor just because of the evolving needs for more performance. And so those are all just things that we consider as we look ahead to next year, and then we'll see how that plays out.

Our next question comes from Samik Chatterjee with JPMorgan.

This is Priyanka Thapa on for Samik. Great job this quarter. I got a couple of questions. First of all, on the concept of software next year, what does the new business pipeline for software look like next year? And is that kind of incremental to your expectations of mid-single-digit software growth? And I have a follow-up.

Sure. Thank you, Priyanka. So yes, our pipeline right now, it's healthy. So it's early again. I mean, our pipeline gives you really good visibility into the current quarter and then decent visibility into the next quarter. And so as you get beyond that, that's going to be business that we are surfacing now as we're engaging with our customers. But generally, I would say that as we do our planning for next year, we feel good about new opportunities for software. And again, these are either net new customers or customers that are consuming for the first time in software. So that's kind of factored into some of our thinking around the growth rate for next year. But of course, the majority of our software revenue now comes through that renew and expand motion, which is great for visibility, and that's where we would expect the majority of the growth to come from next year.

All right. And on to my second question, you anticipate hardware to grow strongly in 2026. How much of that strength is this newfound shift where people are using systems instead of software that you would otherwise expect for them to use software like you saw in this particular quarter? Was there -- was this unexpected? And is this a trend that you think might continue?

Yes. So we would expect hardware to grow, albeit it will be at a more modest growth rate than what we're seeing this current year because clearly, we're well into the 20% growth rate year-to-date for the current year, but we expect continued growth next year. I would say that there is a portion of it that is coming from customer preferences to moving into a hardware model. I don't think that's the main driver. It's really both tech refresh and some of the dynamics where customers really need more performance and they're trying to scale out their data center capacity to support those performance needs. And then at the margin, there are cases where customers may choose a hardware deployment model in lieu of what previously they may have been thinking software for the deployment model.

Our next question comes from George Notter with Wolfe Research.

Our next question comes from Matthew Hedberg with RBC Capital Markets.

This is Mike Richards on for Matt. Two quick ones for me. Just first, anything to call out on Fed? I know you guys were expecting there might be some pull-in in Q3 and anything to call out as we're 1 month into the Fed fiscal year-end? And then secondly, any guardrails you put around free cash flow looking into next year as we think about the R&D credits?

Yes. So I'd say Fed has been right at kind of at our plan for the year. Q3 was a little bit softer. I think there were a couple of projects that pushed out or were downsized kind of related to some of the government efficiency initiatives. But broadly, the pipeline is still healthy for federal, so nothing else that we would really call out. And then can you remind me the question on free cash flow?

Yes. Just as we're thinking about the tax changes around the R&D credits, just anything around free cash flow as we look to next year?

No, there wouldn't be a big impact from what we see in our business right now. There are certain elections that you have the discretion to take. So that's something we're evaluating right now, but no material change from where we sit today.

Our next question comes from James Fish with Piper Sandler.

Understood. And maybe if I could follow up there. Appreciate that added color. How are you thinking about maybe the magnitude of customers that on tech refresh could actually become more virtual or even DCS given nearly -- and given the nearly 40% growth here, and we've talked about this in a piece we did earlier this week, but what inning of refresh do you think we're actually in?

Yes. So Jim, we're pretty early in terms of the refresh opportunity for the iSeries and VIPRION product families. Well over half of the base is still on those families. And as Francois said that every customer is different in terms of their timelines, we would expect that base to get refreshed really over the next 2-plus years. So we think that it's a good growth opportunity for FY '26 and into '27. And then you would expect that to start to tail off in FY '28. Where we -- we're also -- we're not seeing a lot of migration from those legacy systems into software form factors. I think the dynamic that we're actually seeing right now is where customers are really giving more consideration to their performance needs as they evaluate between hardware and software.

Our next question comes from Simon Leopold with Raymond James.

And then I want to see if you could talk a little bit more about how to think about the longer-term trends or fiscal '26 expectations for services in that I would have thought we'd see some correlation to the stronger hardware business, but maybe there's a lag effect. And I'm assuming there's very little correlation to your software stand-alone business. So how should we think about services trending?

Yes. So you're actually right. There is a lag effect on product. And so we would expect to see the growth rate kind of come up from where -- what we just reported with the 1%. I think there's kind of an outlier dynamic that's behind the deceleration in the last couple of quarters, which is really around the kind of the last of the refresh from the prior product family, those laggard customers that have finally retired some of those end of technical support units. And so those came out of the maintenance base that drives our services revenue. That's now behind us. And so what we do expect is to see the services revenue start to grow now from that lag effect on the strength of the product revenue. And you can see that in the deferred revenue, which is up 10% year-over-year. The short-term deferred revenue, which is really kind of a proxy for the maintenance revenue growth, that's up 5% year-over-year. And so we do expect to see the services growth rates to be a little bit better into FY '26.

Our next question comes from Tal Liani with Bank of America.

It's Tomer

Our next question comes from Ryan Koontz with Needham & Company.

First, just a clarification on when you talk about tech refresh, I assume you're talking about F5 to F5 legacy to modern product. Second question I have is regarding your modest price increase you've talked about phasing in. Kind of where are you in terms of that making its way through the model? And what's been the customer feedback on that relative to some of your competitors' moves?

Sure. Yes. When we talk about tech refresh, we're talking about refreshing F5. We also have had good success displacing competitors. So there is a kind of a separate refresh motion around competitive installed base, but that's not part of that dynamic when we're speaking specifically to tech refresh. And then in terms of the price increases, so yes, we announced a price increase in January that -- so we're starting to see that come through in the numbers. I think that customer reception has been reasonable. We've seen other peers in the space that have had much more aggressive pricing practices that have frankly turned off a lot of customers, and that's driving some business our way. We want to make sure that we're delivering value commensurate with the price increases that we introduced in January. So we feel pretty good about where we sit from that perspective.