Suzanne DuLong - F5 Networks, Inc. François Locoh-Donou - F5 Networks, Inc. Francis J. Pelzer - F5 Networks, Inc..

Rod Hall - Goldman Sachs & Co. LLC James E. Fish - Piper Jaffray & Co. Sami Badri - Credit Suisse Securities (USA) LLC Timothy Patrick Long - BMO Capital Markets (United States) Jason N. Ader - William Blair & Co. LLC Alex Kurtz - KeyBanc Capital Markets, Inc. Samik X.

Chatterjee - JPMorgan Securities LLC Tal Liani - Bank of America Merrill Lynch Paul Silverstein - Cowen & Co. LLC Simon M. Leopold - Raymond James & Associates, Inc..

Good afternoon, and welcome to the F5 Networks' fourth quarter and fiscal 2018 financial results conference call. At this time all parties will be able to listen-only until the question-and-answer portion. Also today's conference is being recorded if anyone has any objections please disconnect at this time. I'd now like to turn the call over to Ms.

Suzanne DuLong. You may proceed..

Hello, and welcome. I'm Suzanne DuLong, F5's Vice President of Investor Relations. François Locoh-Donou, F5's President and CEO; and Frank Pelzer, F5's Executive Vice President and CFO, will be making prepared remarks on today's call. Other members of the F5 executive team are also on hand to answer questions during the Q&A portion of the call.

A copy of today's press release is available on our website at www.F5.com where an archived version of today's call also will be available through January 23, 2019. The telephonic replay of today's discussion will be available through midnight Pacific Time on October 25 and can be accessed by dialing 866-397-1432 or 203-369-0539.

For additional information or follow-up questions, please reach out to me directly, at sdulong@F5.com. Our discussion today will contain forward-looking statements which includes words such as believe, anticipate, expect and target.

These forward-looking statements involve uncertainties and risks that may cause our actual results to differ materially from those expressed or implied by these statements. Factors that may affect our results are summarized in the press release announcing our financial results and described in detail in our SEC filings.

Please note that F5 has no duty to update any information presented in this call. With that, I'll turn the call over to François..

Thank you, Suzanne, and good afternoon, everyone. Thank you for joining us today. Overall, we executed and overachieved our 2018 plan and continued to align to our Horizon 1 and Horizon 2 goals, driving growth and strong operational results across the business during the fourth quarter.

We're seeing significant traction for the long-term vision we outlined in our March 2018 Analyst and Investor Day and furthering momentum in software and security sales. Customers continue to view our solutions as mission-critical in hybrid environments as they deploy incremental workloads, dynamically both on-premises and in cloud environments.

Our product revenue growth continued in Q4 with products delivering 3% growth led by software. Public cloud continues to be our strongest software growth area with an increasing demand for security solutions. We expect our Cloud-Native offerings will allow us to extend that growth and expand our public cloud reach in 2019.

In addition, we continued to see strong customer response to our recently-launched ELA and Virtual Edition subscription consumption models. Good initial deal closure and strong pipeline growth indicates this new consumption model will be especially important with our new cloud offerings including BIG-IP Cloud Edition.

Systems continued to show resilience with growth opportunities in certain geographies including China and Latin America and with customers that want to control and manage the end-to-end application delivery solution and certain high-performance use cases.

Rounding out the business drivers, our services business continues to perform well, delivering 6% growth in the quarter. We are seeing consistently strong attach rates on maintenance and driving continued year-over-year deferred revenue growth.

We're particularly proud of our continued world-class customer satisfaction scores reflecting our relentless commitment to our customers and their increasingly complex application deployments.

I will speak more on some of the customer wins and use cases in the quarter later in our prepared remarks, but right now I'll hand the call to Frank to review our Q4 and fiscal year 2018 results and our outlook for the first quarter of fiscal 2019.

Frank?.

Thank you, François. As François noted, we drove strong financial and operating results in Q4 and for the year. Fourth quarter revenue of $563 million, was up approximately 5% year-over-year, above the midpoint of our guided range of $555 million to $565 million. GAAP EPS of $2.18 per share was well above our guidance of $1.77 to $1.80 per share.

Non-GAAP EPS of $2.90 per share was also well above our guidance of $2.61 to $2.64 per share. The beats for GAAP and non-GAAP EPS were driven largely by strength in revenue, expense discipline and lower-than-expected effective tax rates. Q4 product revenue of $256 million was up 3% year-over-year and accounted for approximately 46% of total revenue.

Software was approximately 17% of product revenue and grew more than 19% year-over-year. Systems revenue made up approximately 83% of product revenue and grew 18 basis points year-over-year. Services revenue of $306 million grew 6% year-over-year and represented approximately 54% of total revenue.

On a regional basis in Q4, Americas grew 1% year-over-year and represented 55% of total revenue. EMEA revenue grew 8% year-over-year and accounted for 25% of overall revenue. APAC revenue grew 11% year-over-year and accounted for 15% of total revenue, while Japan grew 15% year-over-year and accounted for 5% of total revenue.

Sales to enterprise customers represented 66% of total sales during the quarter. Service providers accounted for 18% and government sales were 16%, including 7% from U.S. federal. In Q4, we had four greater than 10% distributors, Ingram Micro which accounted for 18% of total revenue, Tech Data which accounted for 11%, and Westcon and Arrow each at 10%.

Let's now turn to operating results. GAAP gross margin in Q4 was 83.4%. Non-GAAP gross margin was 84.7%. Both GAAP and non-GAAP gross margins were slightly better than our expectations, driven by strength in services margin as we continue to leverage automation to optimize our support organization.

Last quarter, we took steps to further align investment with our transformation to a leading provider of multi-cloud application services. Specifically, we are accelerating investment in our roadmap and market development efforts in the fastest-growing opportunities of our business, cloud and security.

As a result, we took $20.9 million in restructuring and facility exit charges during Q4 which are reflected in our GAAP results. GAAP operating expenses of $316 million were below our $317 million to $329 million guided range, driven largely by operating efficiency and lower-than-expected restructuring expenses.

Non-GAAP operating expenses were within our guided range at $263 million. Our GAAP operating margin in Q4 was 27.3% and non-GAAP operating margin was 38%. Our GAAP effective tax rate for the quarter was 16.6%, lower than anticipated due to tax benefits associated with our stock-based compensation expense in the quarter.

Our non-GAAP effective tax rate was 19.2%. GAAP and non-GAAP effective rates also benefited from year-end adjustments related to our domestic tax filings as well as our mix of profits in lower tax rate jurisdictions.

Turning to the balance sheet, in Q4 we generated $204 million in cash flow from operations which contributed to cash and investments totaling $1.45 billion at year-end. DSO at the end of the quarter was 47 days. Capital expenditures for the quarter were $17.4 million. Inventory at the end of the quarter was $30.6 million.

Deferred revenue increased 5.3% year-over-year to just over $1 billion. On employees, our restructuring initiative in Q4 impacted approximately 215 employees.

Executing on our plan to invest in our strategic growth initiatives, during the quarter, we hired 150 employees and ended the quarter with approximately 4,410 employees, down approximately 65 people from Q3. We continue to hire aggressively in our growth areas.

In Q4, we repurchased approximately 864,000 shares of our common stock at an average price of $173.69 per share for a total of $150 million. Quickly recapping our fiscal year results, for the full year, total revenue grew 3.4% to $2.16 billion. Product revenue of $960 million decreased 0.5% from the prior-year and accounted for 44% of total revenue.

Within product revenue, software revenue grew 23% while systems revenue declined 4% over the same period. Services revenue of $1.2 billion, grew approximately 6.7% during the year and represented 56% of the total. GAAP net income for FY 2018 was $454 million or $7.32 per share, and non-GAAP net income was $612 million or $9.87 per share.

In FY 2018, cash flow from operations totaled $761 million and capital expenditures were $53 million. Now, let me share our guidance for fiscal Q1 of FY 2019. Unless otherwise stated, please note that all of my comments reference non-GAAP operating metrics.

Overall, we remain confident in our position in the market and in the growth opportunities for the business with solid software momentum. We believe the long-term trend toward multi-cloud environment is strong and will be a fundamental growth driver for the solutions we offer today and those we will launch in 2019.

With this in mind, as well as factoring in our normal seasonality, for the first quarter of FY 2019 we are targeting revenue in the range of $542 million to $552 million. We expect gross margins at or around 85%. We estimate operating expenses of $265 million to $277 million.

We anticipate our effective tax rate for the year will be between 21% and 22% with some fluctuation quarter-to-quarter. Our Q1 earnings target is $2.51 to $2.54 per share. In the quarter, we expect share-based compensation expense of approximately $39 million and $2 million in amortization of purchased intangible assets.

Finally, as has been our practice, we want to provide you with broad modeling assumptions for FY 2019 fiscal year. As we discussed in March at our Investor Conference, we are tracking to our Horizon 1 outlook with our FY 2019 operating plan. For FY 2019, from the base of Q1, we anticipate sequential revenue growth throughout the year.

We anticipate gross margins at or around 85% for the year. We expect operating margin in the mid-30s range, in line with recent year's results, moving down slightly in Q2 and Q3 from Q1 and ending Q4 in the upper 30s. Stock-based compensation is anticipated to be in the range of $155 million to $165 million for the year.

Capital expenditures are expected to range from $110 million to $130 million for the year. This range includes approximately $70 million in costs related to our previously-announced move of our corporate headquarters to F5 Tower in Downtown Seattle as we ready the space for occupancy this year. With that, I will turn the call back over to François.

François?.

Thank you, Frank. As you can see we're making good progress. I'll spend a few minutes highlighting some customer wins and use cases from the quarter, then I'll conclude our prepared remarks with comments about drivers for fiscal 2019 and our evolution to a multi-cloud application services company.

The first customer win I'll talk to, Spotlight's F5 role in network function virtualization. During the quarter, a large Tier 1 service provider selected F5 in an initial 5G VNF deployment based on overall performance in our Virtual Edition platform's ability to consolidate various functions within the core.

Importantly, the customer expects to use this as the baseline for their future virtualized core designs.

I mentioned in my earlier remarks that we continued to see good acceptance of our new ELA and subscription consumption models which are another element of F5's multi-cloud value proposition, offering customers insurance against the uncertainties associated with cloud deployment, including providing timeline flexibility.

As an example, we secured an ELA deal in Q4 with a North American healthcare infrastructure provider who provides a software-as-a-service offering. An existing F5 customer, this customer required the same level of F5 application services they had on-prem as they moved to the public cloud.

The ELA structure was important because it provided the agility they needed as they scaled their offerings over time. An added bonus, F5's ability to provide multiple services, enabled the customer to consolidate several security elements of their existing infrastructure.

Turning to our security offerings, Advanced Web Application Firewall, or Advanced WAF, continues on a solid growth trajectory. F5's Advanced WAF provides a powerful set of security features that keep web applications safe from attack.

In one deployment during the quarter, we replaced a competitor in a Virtual Edition software environment specifically because of our bot detection and mitigation capabilities. We were also deployed by a managed care provider who is moving to the public cloud to reduce the time to turn up new customer applications.

We worked with the customer to move critical applications from shared F5 appliances to dedicated high-performance Virtual Editions, extending the same on-prem policies to their cloud deployments and replacing Application Security Manager, or ASM, with Advanced WAF on the existing F5 appliances while deploying Virtual Editions with Advanced WAF to support new applications in the public cloud.

This customer will also deploy our BIG-IP Cloud Edition to support new apps going into the public cloud. And these are just a few examples of wins the sales team is driving. Let me close our remarks today with some thoughts about fiscal 2019.

Last quarter, we spoke to our efforts to repurpose investment, to focus on growth areas and ensure our product development and sales efforts were aligned with our most significant growth opportunities. As Frank noted, we're adding resources in priority areas and expanding our software portfolio and stand-alone security products.

As a result, we've got several new drivers to look toward in fiscal 2019. One of these drivers is our BIG-IP Cloud Edition. A bundle of our BIG-IQ Centralized Manage solution and BIG-IP Virtual Edition sold on a per-app basis.

Cloud Edition helps us address a large subset of applications by reducing the total cost of ownership of providing application services while providing more applications management. We have strong conviction that Cloud Edition is addressing new use cases and will be instrumental in expanding our multi-cloud platform strategy.

While not yet a material contributor to our revenue, the platform's ability to provide a single management console for both on-prem and cloud application services is resonating strongly with customers and the regional demand we saw for the product immediately following its release in April 2018 has now turned global.

We are seeing strong interest and demand across all our territories and we expect sales activity to increase in fiscal 2019 as we build customer references. In our security portfolio, we've got a new, stand-alone version of SSL Orchestrator scheduled for release in December.

The amount of SSL traffic is growing rapidly, requiring customers to use significant resources to break and inspect for security purposes. F5's SSL Orchestrator has gained strong traction as a solution on a range of F5 platforms and we expect its availability as a stand-alone product to enable increased penetration with security buyers.

Designed to optimize customers SSL infrastructure by providing security devices with highly efficient visibility of SSL encrypted traffic, it also supports policy-based management and steering of traffic to existing security devices through service chaining.

This makes it easy to integrate into existing architectures, enabling customers to easily apply corporate security controls to all their encrypted traffic.

We're already building a strong pipeline for the stand-alone SSL Orchestrator offering, particularly with enterprise and government customers and the sales team is very excited about the opportunity to drive additional growth in new buying centers. We are also making good progress with both our F5-as-a-Service and Cloud-Native platforms.

When we spoke about F5-as-a-Service at our Analyst and Investor event in March of 2018, we said we expected to launch in 2019. At this point, I am pleased to say we are on track for first commercial availability in the first half of calendar 2019 and are starting to build pilots for lighthouse customers.

In concert, we are working internally to build the muscle that will enable us to target the expanded customer set we expect this product will appeal to. Our internal digital transformation efforts include expanding our digital touch motion to ensure frictionless procurement and service renewals.

At the March Investor event, we also highlighted the investment we're making to deliver Cloud-Native Application Services in FY 2019. This program is also on track for launch in the first half of calendar 2019.

Our innovation teams have built-up functionality that enable the intelligent traffic management services and an API-first interaction model across select private and public clouds.

I've seen the product demos and I am looking forward to sharing more as we progress with our efforts to unlock latent demand through lighter weight offerings optimized for CICD workflows. In addition to pushing forward with our multi-cloud focus solution set, we're also building our public cloud expertise.

I am pleased to announce that Barry Russell has joined F5 from AWS to succeed Chad Whalen in leading our cloud sales team. Barry is a business development, sales and operational leader who brings us 20-plus years of experience.

Most recently, Barry was General Manager of Global Business Development and sale operations for the AWS Marketplace and Service Catalog where he built the AWS Marketplace ISV ecosystem and digital software catalog.

Barry's prior leadership roles include Business Development and Service Provider, Sales leadership with Microsoft, as well as roles at Nivio and Level 3 Communications and we're very excited to have him onboard to further F5's expansion into multi-cloud opportunities globally.

Barry joins another former AWS colleague, Venu Aravamudan, who joined F5 in fiscal 2018 to lead our F5-as-a-Service business. Venu is a seasoned software executive and expert in cloud computing with leadership experience spanning product development, product management, program management and product and solutions marketing.

His leading edge experience with public cloud services and infrastructure platforms, services development, deployment and operations and enterprise IT transformation to cloud made him ideal to lead our F5-as-a-Service program.

Prior to joining F5 in 2018, Venu was General Manager in the Amazon Relational Database Services unit and previously held leadership roles at Limelight Networks, VMware and Microsoft. We're excited to have both Barry and Venu's cloud expertise at F5.

In closing, I'd reiterate that we're making meaningful progress toward our long-term vision for F5 with continued momentum in software and security solutions. My thanks to the entire F5 team and our partners for the progress we've made.

As a team, we're excited about the year ahead and we look forward to reporting on our continued progress in fiscal 2019. With that, we will now open the call to Q&A..

Hello and welcome. I'm Suzanne DuLong, F5's Vice President.

Madeline, could you open the call for Q&A please?.

Thank you, we'll now begin the question-answer session. And our first question comes from the line of Rod Hall of Goldman Sachs. You may proceed..

Yeah. Hi, guys. Thanks for the question. I just have a couple. I wanted to I guess first ask about software sales growth and I needed healthy sequential growth there, but it's kind of decelerating a little bit and not sure what we should be reading into that.

We only have a couple quarters here but we calculate year-on-year growth at 19% down from 24% last quarter so just trying to figure out what do you guys think the right growth trajectory for software is, is the first question. And then the second thing that I wanted to ask about is just tariffs and really, production.

Where are you producing product and how much of it is in China? And if there is any in China, what your plans maybe to move out of China would be? So if you could address that, it would be great. Thank you..

Hi, Rod. Thanks for the questions. I'll take your question on software and Frank will take your question on manufacturing in China. So the first thing, Rod, on software, I'll tell you, no, you should not read anything into the 19%.

I am very excited about where we're at on software generally and where we're going into 2019, but the context for the Q4 19% is first of all our software as a percentage of overall revenue is still relatively small, so as I shared last quarter it can be lumpy from quarter-to-quarter but the general trends are going to be what we said.

We specifically, for this quarter, we had a tough compare to Q4 of 2017 which was a big software quarter, and I think that's part of what you're seeing in this growth rate that's a little less than last quarter, but if you look overall, in Q4 17% was, sorry, software was 17% of product revenues were up from 15% in prior quarters and as a percentage of the mix we're on trajectory to achieve our Horizon 1 goals.

I said I'm very excited for where we're at on software and that's because of what I foresee is going to be happening in 2019. So at our analyst conference, we said we would be in Horizon 1 which was 2019 and 2020, we said we would see software growth that would be in the 30% to 35% range and I feel confident we're going to be in that range.

We've got a lot of things driving software growth in 2019. First of all, I'll point to just three of them. First of all, we're seeing really good momentum on our ELAs, these Enterprise License Agreements.

They're driving a larger deal size and they're also allowing us to expand our use cases and start to take footprint from either Cloud-Native or different open source or virtual ADC competitors with this new model of consumption so that's going to drive growth in software.

Our Cloud Edition is ramping very well from the first four months we've had in the market so we expect a meaningful contribution of Cloud Edition in 2019, and then as you probably heard from the script, we also have new products that are coming now in the first half of 2019, both F5-as-a-Service and our Cloud-Native App Services platform.

So we've got very good drivers in 2019 and I expect we're going to be in the range that we discussed for Horizon 1.

Frank, on the, China?.

Sure. So Rod, in relation to your question on tariffs, unrelated to any sort of trade war escalation, we actually had a plan to move our production manufacturing from China to Mexico which we completed that transfer in FY 2018 and so we're all done and complete with that.

We've actually taken a look at where the tariffs are today, and the impact that would have on our FY 2019 operating plan. It's approximately $1 million of additional cost based off the tariffs, but then we've already baked into our operating plan and the guidance we've given you..

Can you just follow that one up because this may be instructed for other companies as well. You guys have already made that move. Did you find it – I mean we didn't really see it in the numbers so it seems to have gone pretty smoothly.

Did you find it had any impact on your inventories or anything else in the business or did you find it pretty easy to do? I guess I'm just curious about that..

Look, Rod we started this move last year, in the early part of last year. I think the team just – kudos to our, both our supply chain and manufacturing team, they executed very well on the move and no we did not have any impact on inventories.

Frankly we made the move while staying with the same contract manufacturer and so it was the same CM that was supporting us in China, that is supporting us in Mexico and I think that made things smoother and so generally there's been no impact and we have – continue to have very high-quality of the outputs that are coming both out of the China manufacturing environment and the Mexico manufacturing environment..

Appreciate that. Thanks, François. Thanks for the answers on software too. It was very helpful..

Thank you, Rod..

Thank you. Our next question comes from the line of James Fish of Piper Jaffray. Your line is now open..

Hey guys. Good quarter and thanks for the questions here. I would say, I would like to start off on sort of the billings here and the deferred revenue. Billings were down about 1.5% year-over-year, it was actually down sequentially in a seasonally strong quarter.

The implication would be that it was on the maintenance side, given the upside on the product here.

I know, François, you talked about the strength of renewals and attach, but I guess were you having to discount more on the maintenance? And then just along with that, as we're thinking about 2019, what's the impact of adopting ASC-606 with guidance here?.

Sure. So Jim, it's Frank. I'm going to take both of those. Let me start first with the deferred question. On the deferred revenue, we actually have a very simple explanation on that.

We saw at the end of the quarter, a few customers with some larger renewals that just were trying to manage their own cash and so you're going to see that reverse itself in Q1.

And then on the ASC-606, we have a very, very small deminimus impact, frankly, from the change to – ASC-605 to ASC-606 that we've discussed in our financial statements for the past couple of years and so the guidance that we've given reflects the ASC-606 impact but it is very minimal, and we see the same attach rates and do not see any unusual discounting in the maintenance..

Okay. Great. And then just one more for me.

Any sense to how pricing changes or any more color you can give? I know we talked about it a little bit at the Analyst Day but any color between the appliance version, compared to the BIG-IP Cloud version that's coming? I get that gross margins improve as it is software but are we talking about a 20% to 30% price reduction?.

No. So James, let me make sure we're aligned here. So generally, you'll see that our average deal size hasn't changed. It's still in the 120k range and it has been for the last several quarters. What you're talking about is a sort of unit price of a Virtual Edition, a classic Virtual Edition of F5 versus the new Cloud Edition.

The new Cloud Edition on a per unit basis is a fraction of a price of the Virtual Edition, but remember that a Virtual Edition typically support anywhere between five and 10 applications and a Cloud Edition is bought on a per-application basis.

And so what we're seeing in the initial deals that we've done on Cloud Edition is that the number of apps that are supported is significant and so overall, there's no impact on the deal size. It's about the same deal size as what it's been on Virtual Edition.

It's just a different consumption model that allows more flexibility for the user to manage their infrastructure on a per-app basis..

Great. Thanks, guys..

Thank you, James..

Thank you. Our next question comes from the line of Sami Badri of Credit Suisse. Your line is now open..

Hi. Thank you for the question. I wanted to get a better idea on the multi-cloud deployments. I just wanted to get an understanding of some of your customers and their behavior.

When they decide to come back to you for more product and they decided to move into a multi-cloud architecture, on a net-net basis, are they actually buying more physical ADCs or more ADCs in general to deploy a multi-cloud architecture or is it about the same number of units when they conduct that kind of deployment?.

All right. So Sami, let's just say that in general, I would say there are a couple of scenarios in those deployments. We have a lot of customers that are buying a traditional hardware motion and are adding to that Virtual Editions on-prem. That's kind of our classic deployment model.

What we're seeing is more and more, these customers also want to deploy their infrastructure in multiple public clouds and their desire is to manage all these instances of ADCs as part of a single portfolio and ideally through a single pane of glass.

Our ELAs enable them to do that and give them the flexibility to consume as many licenses as they want, of software and whether they put these licenses on-prem or in the public cloud.

The initial – and I'm talking about software purely right now, the initial view we're seeing from the consumption of these ELAs is very strong, i.e., they signed up for a minimum amount of consumption and we're seeing in the early months of consumption that they're well on track to exceed that minimal amount of consumption which bodes well for true-up in the future.

What we've seen as it relates to hardware is that generally, customers that use us in a multi-cloud deployment scenario overall spend more with us than customers that use us just in our traditional hardware deployment models. So that's, I think, how I would frame it for you.

The overall spend for a multi-cloud customer is larger than one that is not or one that is pure hardware..

Got it. Thank you and then just as a follow-up to that.

Do you see very similar services revenue attach to those same type of deployments or is it a little bit different?.

No, it's very similar.

The only difference, Sami, is that when a customer signs up for an ELA or a subscription, their services is part of the subscription and so it will show up for us in our product revenues, whereas in a model where they bought the hardware as a perpetual license and separately they bought maintenance that services would show up in our services revenue.

So there is a difference in terms of whether services revenue is going to be accounted for, but in terms of the, if you will, total customer spend, it's the same or potentially in terms of the amount of money they're spending on services, it's the same or potentially larger if we are successful with the renewal and the expansions that we're seeing in the early days..

Got it. Thank you..

Thank you. Our next question comes from the line of Tim Long from BMO capital. Your line is now open..

Thank you..

Tim, are you still there?.

One moment please..

Hello?.

Tim, your line is now open..

Okay.

Can you hear me?.

We can, Tim. Sorry..

Sorry about that. I guess they had me muted but anyway back to the software line. François, you talked about Cloud Edition and it sounds like it's off to a pretty good start.

The sequential jump in software, it's kind of the first quarter of Cloud Edition, so can you give us a sense as to how much of the contribution was from just better virtual sales in security and did that Cloud Edition start to at least make an impact on that software line? And then related to that, we've yet to see kind of the last few quarters with software moving a little higher particularly this quarter, haven't seen much in the product gross margin.

Is that something that you would expect to start to move a little bit higher as that ramps as a percentage of sales? Thanks..

Tim, thank you. So on the first one, we said at the time we released our Cloud Edition that we did not expect material revenue contribution from Cloud Edition in FY 2018, and that is the case.

I would say the contributions to Q4 was very minimal, because there is – the time it takes to get through – go through the sales cycle, the proof-of-concepts, et cetera, and then a lot of the initial deals are initial sales, which will expand over time.

So minimal contribution in 2018, but we do expect – given the traction that we've seen so far, we do expect meaningful contribution in our fiscal 2019.

And in terms of the gross margin, yes, the answer is no different than what we've said at AIM that over time, we do expect as the software contribution grows to have some impact on our – positive impact on our gross margin.

If you'll recall at the end of our Horizon 2, which is 2022, we expect that our software to be about 40% of total product revenues and I think by then we would see a meaningful impact. That being said, our margins are roughly 85% right now and so the room for expansion isn't significant.

What we said is that in Horizon 2, our margins would be in the 85% to 87% range. So....

Okay..

...it's incremental but small in the big scheme of things..

We're tracking, Tim, to the Horizon 1 and Horizon 2 guidance in that regard..

Okay. And then just a quick follow-up on the Cloud Edition. Could you just talk a little bit about are you seeing kind of new customers added to F5 by these new offerings and do you expect that with the next software offerings in the first half of next year? And then I'm done. Thank you..

Yes. Thank you, Tim. So I would say we continue – as a company, we continue to win new logos every quarter and that's not really driven just by Cloud Edition. We're winning new use cases in security, in public cloud, and even I mentioned last quarter a number of new customers coming in for hardware.

So new customer, new mobile position is going to continue. What we're seeing with Cloud Edition is within our existing customers, we are unlocking new footprint that we didn't have before. There are a couple of use cases that we could not address before.

One is when customers want to really deploy on a per-app basis we couldn't touch those types of deployments. We now can.

Two is the ability to scale rapidly the infrastructure under an application that sort of flexibility is a new use case for us and it's expanding our footprint and touching new applications, specifically applications that are in test and development.

We didn't have the opportunity before to intercept these applications at their inception and we now can.

And the third aspect of that is we are also now, for the first time, giving application developers direct visibility into their virtual instance of F5 and they're seeing analytics and the performance of their applications and so we're building a relationship with app developers that we didn't have before and that's driving new deployments into new applications.

So I would characterize it right now as largely addressing the long tail of applications you've heard us talk about, inside of existing customers, more than focusing on going and looking out for new customers.

I do think though we will address new customer segments as we introduce in the first half of 2019 F5-as-a-Service and our Cloud-Native App Services platform..

Okay. Thank you..

Thanks Tim..

Thank you. Our next question comes from the line of Jason Ader from William Blair. Your line is now open..

Yeah. Thank you. Frank, could you talk about linearity in the quarter and just give a sense of how that's similar or different than what you've seen in the past in Q4? And then, François, on the systems side, it looks like that's recovered a bit, flat year-over-year which I think is an improvement of what you've seen over the last several quarters.

Can you talk about what's driving that?.

Sure. So Jason, thanks for your question. I'll start and turn it over to François. The linearity one is fairly straightforward. It was almost identical to what we seen in the past Q4s and so we were, if anything, saw even a little bit better in month one and month one, but we're talking a percentage point, nothing dramatic..

And Jason, in terms of the systems, if you'll recall in March, we said that we expected the overall market for hardware ADCs to decline at mid-single-digits going forward, but we also expected that we would do better than that.

That we expected to be in the low single-digit decline to flat going forward and I think what we've seen over the last three quarters is we've done exactly that. This quarter, we were flat.

We still expect quarterly fluctuations on the hardware number, but overall we're executing for deployment and I think we're getting share and there are a couple of reasons for that.

One driver of the stability is security use cases driving spend in ADC for us, but not all ADC vendors have access to it, because they don't have the security capabilities things like SSL orchestration or Web Application Firewall or Access Manager consolidated on ADC. That's driving stability for us in ADC.

There are new use cases such as flips in the federal sector or IoT that are driving demand for our hardware products, there are geographies where there's significant demand for new hardware, specifically in emerging markets, places like China and Latin America, and so all of these factors are driving stability in the hardware business, along the lines of what we had said would happen at the investor meeting..

Great. Thank you..

Thank you. Our next question comes from the line of Alex Kurtz of KeyBanc Capital Markets your line is now open..

Yeah, thanks. Just a couple quick questions here. I just want to follow-up on the new customer question from earlier around, Cloud Edition.

I think there's a broader view of a lot of traditional on-premise software companies that they won't be able to capture the Cloud-Native Application or the company that maybe just starts fresh in the cloud and I think there's been some talk of companies like yourself that are building software in the cloud platforms, find the customer, then maybe there is even an opportunity on-prem, down the road, so could you just double-click on that a little bit more? I know you briefly touched on it but I just wanted to have you seen cases like that or it's just too soon to know?.

Well, Alex, if that's what you're referring to, we have seen cases and I wouldn't say we're seeing them by the hundreds, but we have seen cases of companies that were born in the cloud. And essentially never bought or owned a piece of infrastructure.

And as they grow and start to worry a bit more about their profit, they start worrying about how they control their cost and we have seen some of them, almost graduate from this born-in-the-cloud environment and come back and run co-location capabilities and actually come back to us for hardware ADCs. So we have seen those cases.

I don't know if this was a trend that's going to be much stronger in the future than it is today but we are seeing that.

But as it relates to acquiring customers directly in the cloud for companies that were historically on-prem like us, we think it's an opportunity that largely for us is on top today because you're right we don't play in that market today, but that's why we're quite excited about F5-as-a-Service coming in the first half of 2019, because that's going to allow us to really intercept these born-in-the-cloud applications in a native cloud consumption experience for those who are building their app in the public cloud's platform environment.

And so we're pretty excited about our opportunity to play there and intercept these applications. And then down the road as these applications grow, if they too have multi-cloud requirements, it will make it that much easier for us to contribute to their requirements beyond the single public cloud.

And so F5-as-a-Service essentially will be our leading entry into the relationship which we will expand from..

That's very helpful. And just back on the current environment with tariffs, higher interest rates. Very strong calendar 2018 for IT spend, I think there's a lot of concern heading into 2019 that things may not be sustainable.

I think when you talk to your larger enterprise customers, what's been sort of the initial feedback on how they feel about spend over, say, maybe the next six months or so?.

I would describe it, Alex, as generally the spending environment, you're right, has been healthy in 2018. We continue to think overall that it's healthy, specifically for the enterprise market.

In North America, in particular, we've seen some softness in the Tier 1 service providers in the last quarter, and we're cautious about the upcoming quarters with Tier 1 service providers.

There hasn't been a sign of significant change in behavior from our enterprise customers, but like everybody else, we are a little cautious going into 2019 given what we've seen over the last three, four weeks..

Okay. Thank you very much..

Thank you. Our next question comes from the line of Samik Chatterjee of JPMorgan. Your line is now open..

Hi, François. Hi, Frank. Thanks for taking my question. I just wanted to start off with the growth that you're seeing in the cloud. You mentioned you're seeing strong growth there.

Can you remind us within – amongst kind of the Tier 1 and Tier 2 cloud providers who do you have existing partnerships with and how should we think about kind of have you seen any interest from additional cloud providers and how should we think of that as an enabler of stronger growth in software?.

Yeah. Samik, so we have relationship with the major public cloud providers, so AWS obviously is a partner for us, Microsoft Azure is a partner, we have integration going into Google Cloud, and international cloud providers as well.

And the relationships aren't just technical integration, certainly in terms of the top 2 or 3, they're significant co-marketing activity between us and them helps customers leverage their clouds and migrate applications over to the cloud.

And so in the software, we don't break out, by the way, as you know, Samik, we don't break out our public cloud revenues, but we have said before and I can reiterate this that within software, software in the public cloud is the fastest-growing part of our software business, and that has been the case throughout 2018..

All right, all right. And then if I can just maybe this is more for Frank, but if I kind of look at your guidance, I think you mentioned that coming off the 1Q base you expect sequential improvement in the revenues through 2019. That seems like more visibility than you've had typically.

And correct me if I'm wrong on that, and seems like more confidence about the pace of improvement there.

Is there something more specific that's contributing to that? Is it more about kind of sequential illustration (00:51:12) in the software revenues, anything else that's contributing to that higher visibility even on the quarterly cadence of revenues?.

Samik, honestly, I think it's fairly consistent with what we've said in the past in terms of our sequential improvement. It's the cadence in which our quarters generally fall.

I think we're obviously happy about the traction that we've seen in software and continue to see in the software and visibility that we've got that actually – that's got nice predictability for us.

And so that gives a base in and of itself, but in terms of the specific qualitative guidance for the broader FY 2019, that's fairly consistent to where we've been in the past..

Got it, got it. Great. Thank you..

Thank you. Our next question comes from the line of Tal Liani of Bank of America. Your line is now open..

Hi, guys. I'd like to ask a question on security. First, what's the level of security revenues right now? I know you didn't disclose security as a percentage of sales revenues in the past.

Do you have any kind of disclosure? And if not, what needs to happen for you or what level of revenues need to happen or need to materialize for you to disclose security? Second is when you look at 2019, what's the roadmap for addressable markets for security? Meaning, what are you going after and if you can give us also snapshot of the current offerings of security, where do you see success and where do you still need to work on – what do you still need to work on within the security portfolio? And then I have a follow-up question.

Thanks..

Hey, Tal. Thank you. That's three question in one. We'll address them in that order, Tal. So in terms of disclosure of security revenues, as you know, we don't break that out.

I would say that the percentage of our ADC sales that are driven by security use cases or that include a component of security in the overall bundle has steadily increased, and today it's a meaningful percentage of our ADC sales. We don't break it out.

It's not just a question around the size of the revenue, but it has to do with, in a number of cases, it's very subjective to determine whether a sale was driven by security or ADC or both. And so that's the reason that we don't break it out today and there's not a clear trigger of when we will.

In terms of your – I'll take the third part of your question then the second one.

Where we have been seeing very strong success today historically, and Tal, I'd say that would be up until kind of the middle of 2018, was really in this consolidated use case where we – it's very convenient for a lot of our enterprise customers to consolidate on to an ADC, Application Firewall, identity and access capability, some encryption/decryption capabilities.

And so this use case of consolidation in the ADC and the enterprise has been extremely successful and will continue to be. That is also true in the service provider world, where our capabilities around CGNAT, TCP optimization (00:54:59) firewalls, consolidated into an ADC capability is very appealing to service providers.

So I would say, if you look historically, the consolidation of multiple security modules and function that allows one to reduce CapEx and reduce complexity has played out in the enterprise and service providers. Going forward in 2019, we're very excited about two stand-alone security use cases.

The first one is our Advanced Web Application Firewall, where we've already released that product and we're seeing great initial traction. We're really differentiated relative to other players because of our Layer 7 capabilities, but also bot mitigation capabilities and that differentiation today is on-prem.

But we're going to bring our WAF capabilities into F5-as-a-Service and we think that's going to be a big differentiator for us.

And then the second one we're very excited about is our SSL orchestration capabilities, a massive use case because all enterprise customers are dealing with – the vast majority of their traffic is encrypted and we provide a very efficient solution to encrypt and decrypt the traffic, do what we call break and inspect and then chain multiple security services together, which saves very significant dollars to enterprise customers.

So these two areas, Tal, we expect them to be two meaningful growth drivers for us in stand-alone security next year. And if you recall, that was one of our growth pillars from the conversation at AIM in March..

So what are the other things you need to do with your business in order to address the opportunities? Meaning, launching product is great. It's one aspect. How about dedicated sales team need or you don't need dedicated sales engineers.

Marketing around security branding, different branding or is it part of the ADC branding? So can you discuss the outer activities outside of product innovation?.

Yeah, Tal. It's a great question. So there are other activities but we have been doing them already for several years. So if you look at our sales organization, in a lot of cases, a lot of our accounting, specifically major accounts, are already facing the CECL community and the SecOps buyer.

So it's not like our sales team isn't capable today of selling security solutions because they've been selling them in a consolidated ADC fashion. And so they are very conversant in these solutions, but they are addressing new use cases with the SecOps buyer.

In terms of marketing and thought leadership, most of our customers see us today as a security company, we have a significant muscle in security and threat research of an organization called F5 Labs that publishes research on security issues on a regular basis and that is very well read within our customer and partner community.

So there are tons of things that we don't necessarily talk about because they've been in the go-to-market motion of F5 now for already several years..

Great. Thank you..

Thank you, Tal..

Thank you. Our next question comes from Simon Leopold of Raymond James. Your line is now open. Kindly check if you are on mute, Mr. Simon Leopold..

Madeline, why don't we move on to the next one and maybe go back to Simon?.

Okay. That will be noted. So our next question comes from the line of Paul Silverstein of Cowen & Company. Your line is now open..

Thank you. And I'll ask you the questions that Simon probably should have asked. François, first a clarification, I heard your response on the end demand question with respect to – I think, I heard you say that U.S. service provider weakened in the last three to four weeks.

My question on that is within enterprise, what are you seeing from an end demand perspective? And if we look regionally, I think you've now posted high-single-digit growth in the EMEA region for a fifth straight quarter. The Americas were flat and they've been flat to slow single-digit in the region for the last several quarters.

Asia Pac was 11% following 8% growth in the preceding quarter and Japan was 11% following 4% in Q3. Some of that may be easy comps in the latter two, but my question to you is looking at the regions, what accounts for the differences? Is that you would think from an economic perspective with the U.S.

having perked up and EMEA much less so, it's only counterintuitive but is this a reflection of ongoing service provider weakness? What is that regional information? What should it be telling us in terms of the strength and weaknesses of your business? And then I have a follow-up question..

Hi, Paul. I'll clarify first. I didn't say service provider had weakened in the last three to four weeks, I said we were seeing in the last quarter or so softness in Tier 1s in North America.

And as you know, service provider business can be lumpy, but if you look at – that also is, I think, the majority of the explanation on why North America has, in relative terms, is more flattish than other regions. A, it's largely driven by the softness we've seen in the Tier 1 service providers in North America..

So François, to be clear, if we looked at your – if we saw the numbers for your North America enterprise business, we would see something mid-to-high single-digit growth consistent with EMEA and the other regions, is that the case?.

We don't break that out, Paul, but you would see....

I recognize you don't..

...a number that would be higher than the aggregate number that you're seeing here..

All right. Let me ask you one other question if I may. François, to what extent, historically, if we go back to the dawn of what was then load balancing back in the late-90s, which you guys pioneered along with couple of others, and we fast forward to today, historically you all sold to the networking side of the IT organization within enterprise.

And over time – and it's still ongoing, but the locus of purchasing power seems to be shifting, seems to be in progress.

To what extent do you all have an issue? And if you do, to what extent are you addressing it and separate from Tal's security question, in terms of addressing the application developers who have increasing power in that equation in terms of making the purchasing decisions, you already have the mindshare or do you need to do meaningful work in terms of gaining the mindshare among that community?.

Yeah. Paul, that's a great question. So you are correct that both application developers and their close cousins DevOps people are gaining mindshare and influencing in large enterprise organizations. That's resulting into two things.

First, for our traditional buyers, network infrastructure buyers, typically in central IT, they want to offer a better SLA to app developers and DevOps people. And so part of our portfolio strategy, our multi-cloud strategy, is to enable our current buyers to offer that better SLA. Cloud Edition, I just discussed earlier, does exactly that.

It offers this per-app capability which means an app developer doesn't have to wait for a maintenance window for five weeks so that all applications can align to an upgrade. They can do their thing on their part on their infrastructure.

They also get more analytics and got more visibility in their application, but that Cloud Edition is typically purchased by a network operations person and they use that new technology to offer a different SLA to app developers. So that's kind of motion one.

The solutions we're releasing in 2019, both F5-as-a-Service and our Cloud-Native Application platform, those will appeal directly to the DevOps buyer and they will allow them to essentially procure their own technology on their terms.

And so associated with that, we have significant efforts around digital marketing, digital sales, a tech touch for these buyers that essentially allow them to procure – explore trial and procure the technology in the way they want to do it, which is very different than our traditional buyers currently.

So that's how we will address that community as well, but that journey starts in 2019..

Appreciate it. Thank you..

Thank you. Our last question comes from the line of Simon Leopold of Raymond James. Your line is now open..

Thanks.

Can you guys hear me okay this time?.

Yeah, Simon.

How are you?.

Great. Yes. Doing well. Paul did ask great questions, but fortunately not the ones I was going to ask. So I wanted to go back to the cloud, guys. Given that AWS and Azure offered load balancing, yet you talk about them as partners.

Could you maybe compare and contrast how you might be competing with them at times and using them as a way to go-to-market? Where does it make sense for an enterprise to engage the solution offered by an AWS or an Azure versus engaging F5 for the functionality? Thank you..

All right. Great, Simon. So let's start. So today, there are applications we don't support, there are typically applications that are born-in-the-cloud either in test or development or even production and that, I would say, have relatively simple load balancing requirements.

Those applications are largely addressed by the native load balances offered by the large public cloud providers. Now, so that's where they play and today, we largely play in enterprises that have either on-prem requirements or multi-cloud deployment requirements.

So if somebody wants to deploy an application or a portfolio of applications in multiple public clouds, typically, we're going to have a play there because we are cloud agnostic.

We will, in that scenario, partner with the public cloud providers to help the customers migrate their applications to these environments and when F5 is supporting an application on-prem and it migrates, in the vast, vast, vast majority of the cases, we will stay with our application and they will stay with us.

Now, so that's kind of the lay of the land today. In 2019, as we introduce our new platforms in F5-as-a-Service, we will also play in born-in-the-cloud applications, but the value add that we bring beyond the Cloud-Native load balances is the feature depth and breadth that a lot of these applications want.

When they want global server load balancing, some security capabilities, and our partners in this case, public cloud providers are actually interested in partnering with us to enable these capabilities in their environment in a seamless way for these applications.

And that's actually one of the reasons that I mentioned in the script earlier that Barry and Venu had joined us from AWS.

One of the reasons for that is they have deep insights both into the economics of application deployment in public cloud and the technology associated with these deployments and they are very interested in this multi-cloud strategy and how we're going to deploy our business in these environments..

And maybe just a quick follow-up to that. It seems as if Google Cloud has really been trying to catalyze multi-cloud, given that they are the third player they've got the most gain, I believe.

Where are you in terms of relationship with Google?.

Well, we have a relationship with them as well. I would say, just for clarity though, Simon, when we talk about multi-cloud, we mean by that multiple public clouds co-location, on-premise private data centers and on-premise private clouds, and we're seeing all of these deployment models happen within our customer base..

Great. Thanks for taking the questions..

Thank you, Simon..

Thank you and that concludes today's conference. Thank you for participating. You may now disconnect..