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F5 Networks, Inc. (NASDAQ:FFIV)

F4Q08 Earnings Call

October 22, 2008 4:30 pm ET

Executives

John McAdam - President and CEO

Andy Reinland - Senior Vice President and Chief Financial Officer

John Rodriguez - Senior VP and Chief Accounting Officer

Mark Anderson - Senior VP of Worldwide Sales

Edward Eames - Senior VP of Business Operations of Global Services

Chris Lynch - Senior VP of Data Solutions

Dan Matte - Senior VP of Marketing

Karl Triebes - Senior VP of Product Development and CTO

Mr. John Eldridge - Director of Investor Relations

Analysts

Ittai Kidron - Oppenheimer & Co.

Ehud Gelblum - JP Morgan

Erik Suppiger - Signal Hill Group, LLC

Troy Jensen - Piper Jaffray

Ryan Hutchinson - Lazard Capital Markets, LLC

Mark Sue - RBC Capital Markets

Jeff Kvaal - Barclays Capital

Samuel Wilson - JMP Securities

Cobb Sadler - Deutsche Bank Securities

Matthew Robison - Pacific Growth Equities

Bill Choi - Jefferies & Co.

Jason Eider - William Blair & Co.

Jeff Evans - Sanford Bernstein

Tim Long - Banc of America Securities

Rohit Chopra - Wedbush Morgan Securities

Presentation

Operator

Good afternoon and welcome to the F5 fourth quarter financial results conference call. (Operator Instructions) I would now like to turn the call over to Mr. John Eldridge, Director of Investor Relations. Sir, you may begin.

John Eldridge

Thank you, Brian and welcome all of you to our conference call for the fourth quarter and fiscal year 2008. Speakers on today's call are John McAdam, President and CEO and Andy Reinland, Senior Vice President and Chief Financial Officer, John Rodriguez, Senior VP and Chief Accounting Officer; Mark Anderson, Senior VP of Worldwide Sales; Edward Eames, Senior VP of Business Operations of Global Services; Chris Lynch, Senior VP of Data Solutions; Dan Matte, Senior VP of Marketing and Karl Triebes, Senior VP of Product Development and CTO are also with us to answer questions following our prepared comments.

If you have any follow up questions after the call, please direct them to me at 206-272-6571. A copy of today's press release is available on our website, f5.com. In addition, you can access an archived version of today's live webcast from the event's calendar page of our website till January 21. From 4:30 pm today until 5 pm Pacific Time, October 23, you can also listen to a telephone replay at 800-879-7966 or 402-220-5346.

During today's call, our discussion will contain forward-looking statements that include words such as believe, anticipate, expect and target. These forward-looking statements involve risks and uncertainties that may cause our actual results to differ materially from those expressed or implied by these statements. Factors that may affect our results are summarized in our quarterly press release. Our quarterly release is described in detail in our SEC filings. Please note that F5 has no duty to update any information presented in this call.

One final note, if you are planning to attend our Analysts/Investors Meeting in Seattle on November 4 and have not registered, you can register online at F5.com/analyst-meeting or call Darlene Henderson at 206-272-6170.

Now, I will turn the call over to Andy Reinland.

Andrew Reinland

Thank you, John. Capping another year of growth against the backdrop of a very challenging economic environment, F5's fourth quarter for fiscal year 2008 ended on a relatively positive note. Q4 was our 23rd consecutive quarter of revenue growth. We saw continued improvement in our non GAAP operating margin. We exceeded our GAAP and non GAAP earnings guidance and we generated record cash flow from operations of $59 million for the quarter.

Following my review of results for the fourth quarter in fiscal year 2008, I will provide guidance for Q1 and briefly discuss our goals and outlook for fiscal year 2009. Revenue for our fiscal fourth quarter was $171.3 million, up 18% over the same quarter last year and just over 3% from Q3. Our book-to-bill was greater than one. As we stated on our October 7 call, bookings for our newly released BIG-IP 3600 exceeded our forecast and we are unable to shift all orders for the product by quarter end. If we have been able to shift these orders, revenue would have been within our guided range of $172 million to $174 million and our book-to-bill would have still being greater than one.

Revenue from our core application delivery and networking business was $160.2 million compared to $153 million in Q3 and represented 94% of total revenue. ARX revenue was $4.7 million, down from $5.1 million in the prior quarter and represented 3% of total revenue. Higher past revenue was 4% of total revenue or $6.3 million, down from $7.5 million in Q3. From a geographic perspective, the America has represented 60% of revenue, EMEA accounted for 20%, APAC 12% and Japan 8%.

Results in EMEA reflected a drop-off in sales during the last weeks of the quarter and were below our expectations. By vertical, Telco represented 23% of revenue during the quarter. Technology, including largely internet content providers was 22% and the financial sector accounted for 16%. US Federal government generated 8% of revenue and totaled government was 12%. During Q4, we had one greater than 10% distributor, Avnet Technologies which accounted for 15.8%.

Product revenue of $115.8 million represented 68% of total revenue. Service revenue of $55.5 million was 32%. Continuing down the income statement, gross margin in Q4 was 77.3% including $1.2 million of stock-based compensation. Excluding stock-base compensation, non GAAP gross margin was 78%. Operating expenses were $106.7 million including $13.6 million of stock-base compensation expense and the one-time charge of $5.3 million related to office consolidation at our corporate headquarters.

GAAP operating margin was 15%. Our non GAAP operating margin was 26.7% reflecting marked improvement versus our Q3 non GAAP operating margin of 25.4%. Our effective tax rate for the quarter was 32.4%, our non GAAP effective tax rate was 32.2%. GAAP net income for the quarter was $19.7 million or $0.24 per diluted share, above our guided range of $0.19 to $0.20.

Non GAAP net income was $33.4 million or $0.41 per diluted share, also above our guided range of $0.38 to $0.39. Revenue for fiscal year 2008 was $650 million, an increase of 24% over fiscal 2007. Product revenue of $453 million was 70% of total revenue and service revenue of $197 million was 30%. GAAP net income for fiscal 2008 was $74 million or $0.89 per diluted share. Non GAAP net income was $121 million or $1.45 per diluted share.

Turning to the balance sheet, in Q4 we generated $59 million in cash flow from operations contributing to cash and investments totaling $451 million at yearend. For all of fiscal 2008, cash flow from operations totaled $194 million. Accounts receivable DSO was 51 days, down from 53 days in the prior quarter. Inventory of $10.1 million was up slightly from $9.7 million in the prior quarter. Deferred revenue increased $6 million from Q3 to $145 million. Capital expenditures for the fourth quarter were $4.7 million and depreciation and amortization expense was $6.3 million. We ended the year with approximately 1,695 full time employees, an increase of approximately 30 over Q3.

During Q4, we repurchased 50 million of our common stock representing approximately 1.6 million shares. This completes the 200 million repurchased plan approved by the Board last January. In total, we repurchased approximately 7.7 million shares of F5 common stock. In addition, we announced today that the Board of Directors has approved the repurchase of up to an additional $200 million of the Company's outstanding common stock beginning in Q1.

Moving on to the outlook, for the first quarter of fiscal 2009 ending December 31, we continue to believe that a robust pipeline, strong demand for Viprion and continued momentum from our ongoing product refresh will drive our top line revenue during the quarter. At the same time, there is a measure of uncertainty regarding sell cycles and close rates within the current economic environment and with that in mind, we are targeting Q1 revenue in a range of $172 million to $174 million.

We expect over our gross margins in the range of 77% to 78% including approximately 1 million of stock base compensation expense. Our operating expense targets are $104 million to $107 million including approximately $15.5 million in stock-based compensation expense. Our effective tax rate for the quarter is expected to be 31%. Excluding stock-based compensation, our non GAAP effective tax rate is expected to be 30%. These Q1 expected tax rates are significantly lower than our anticipated annual effective tax rate reflecting a one-time retroactive impact of the extension of the R&D tax credit.

Our Q1 GAAP earnings target is $0.26 to $0.27 per share. Our non GAAP earnings target is $0.41 to $0.42 per share. We expect to maintain DSOs in the low to mid 50-day range. We anticipate ending inventories in the range of $14 million to $16 million. We are targeting modest headcount growth in Q1 with an increase of 20 to 40 employees and we believe we will generate cash flow from operations in excess of $60 million. Although we do not provide specific annual guidance, I would like to share some general guidelines related to our expectations for fiscal 2009.

In previous years on the October call, we have given guidance for sequential revenue growth throughout the fiscal year. Given the strength of our primary business drivers discussed earlier, we believe we can achieve quarterly sequential revenue growth throughout fiscal 2009 and will strive to do so.

That being said in light of the volatile economy, we will update on a quarterly basis our views on sequential growth throughout the year. We expect to see gross margins in our historical 77% to 78% range. We are targeting non GAAP operating margin between 26% and 27% throughout the fiscal year and ending 2009 at or near the high end of this range. We expect stock-based compensation expense to approximate current levels until our next annual grant in August.

Capital expenditures are expected to be approximately $4 million to $6 million per quarter. We expect our effective tax rates for Q2 through Q4 to average 37% on a GAAP basis and 34% on a non GAAP basis. As previously stated, Q1'09 will be significantly less than these rates due to a one-time benefit related to the R&D tax credit extension.

And with that, I will turn the call over to John McAdam.

John McAdam

Thanks, Andy and good afternoon everyone. I will take a few minutes to summarize some of the highlights of fiscal 2008, comment on our Q4 performance and outline the opportunities for F5 as we move into fiscal 2009. Clearly, fiscal 2008 presented most businesses with some challenges given the overall state of the economy. In spite of these challenges, I was pleased with the F5 team's performance and we made a lot of progress during the year.

We grew our revenue by 24% over fiscal 2007. We made progress on non GAAP operating margins finishing the year with the operating margin of 26.7% in Q4. We continue to maintain a solid balance sheet with $451 million cash and investments and no debt and that was after our purchase of Acopia for $210 million cash as well as buying back 200 million worth of F5 stock.

Our overall customer satisfaction levels remain very high due to our continued focus on product quality and the industry leading to customer service. Our latest quarterly customer satisfaction surveys up of these scores above 9 out of 10 in overall satisfaction. These are world class levels. I was pleased with results from the first year of selling our ARX range of products from the Acopia acquisition. We managed to meet the revenue expectations that we set at the beginning of the year in spite of significant economic headwinds in a nascent market with considerable concentration on Wall Street and the financial vertical.

We strengthened our competitive position at our core application delivery controller market with the introduction of a slight shift Viprion product and new entry level BIP-IP 1600 and 3600 products. The [shortly] base Viprion port product has already produced significant revenue with some exciting sales wins in the Telco market as well as sales to large internet based organizations and last corporate enterprises. The reception to a new BIG-IP 1600 and 3600 product, which we introduced last quarter, has been excellent and demand exceeded our expectations for the quarter. We have maintained a clearly shift position in the GAAP emerging quadrant and their application ready network strategy has been embraced by a lab solutions partners like Microsoft, Oracle and SAP.

We have also made significant progress with our solutions to enable virtualization architectures including strengthening partnerships with key players such as Microsoft and VMware. We will provide more detail on our partnership strategy as well as our product roadmap during our Analyst Investor Day in a few weeks.

Andy gave specific data on our Q4 results which we also announced a couple of weeks ago so I will keep my comments fairly brief. Clearly, I was pleased that we were able to deliver solid profitability in the quarter as well as record cash flow from operations. I believe this is a testament to the tight controls that we have in our business and we are committed to continuing this approach in fiscal 2009. Although we were slightly below our revenue guidance, we continue to deliver another quarter of sequential revenue growth and we are very focused on continuing this record.

As we stated in our announcement a couple of weeks ago from our geographic perspective, overall sales bookings were consistent with or exceeded our internal expectations with the exception of our European results where we experienced delays and deal closures in the last couple of weeks of September. Overall, annual results from our media operations were excellent and from a year-over-year growth perspective, the immediate results in Q4 were actually pretty solid.

Looking forward to fiscal 2009, clearly that a significant economic challenge is facing business globally. As I mentioned earlier, we will continue to manage our business on a tightly controlled and conservative basis as business conditions develop. Andy already provided our projected revenue range for Q1. We are very focused on continuing our track record of delivering sequential revenue growth as we have done for almost six years now. I believe our Q1 guidance is conservative but also realistic in this uncertain economic time.

Let me reiterate why I feel positive about F5 future's opportunities as we move into fiscal 2009. We enjoyed our zone balance sheet and expect to continue to deliver solid results with cash from operations during the year. Hopefully you picked up from a press release that our Board of Directors agreed to maintain a stock buyback program. As Andy mentioned earlier in his summary, we also expect to maintain healthy non GAAP operating margins during 2009 and we will balance improvements and operating margins with investments and technology and sales development.

Our cash position is as strong as ever and we expect to increase our competitiveness with a solid product roadmap of deliverables during the year. Also, we have a very strong services business with our substantial deferred revenue backlog that should be a significant growth driver throughout 2009. Finally, we had a market leader and a key strategic real estate within the data center. Internet traffic and file base data continue to grow very high rates. We continue to see customers and solution partners embrace the concept of pushing application intelligence into the application lead of the network.

Global consolidation of data centers and trends such as virtualization required the application network intelligence delivered by F5 for capability such as traffic control, policy meeting and resource provisioning. The other way that can begin by deploying our solutions can be very significant in areas like bandwidth reduction, several capacity savings and reduction and head trend resources of quiet to manage the data. In addition, this otherwise can be obtained while making efficiencies and performance availability and security. In summary, although we expect 2009 to have real challenges given the global economic problems that we all face in 2009, I remain very excited about the future heads for F5. I would like to take this opportunity to thank the entire F5 team and their partners for their efforts in 2008 and I look forward to the continued support in 2009.

We will now hand the call over for Q&A.

Question-and-Answer Session

Operator

(Operator's instruction) Your first question comes from Ittai Kidron - Oppenheimer & Co.

Ittai Kidron - Oppenheimer & Co.

John, can you give us a little bit more color on Europe, specifically, what you are seeing out there? First of all, what would be the typical customer that you have in yours? Was that typically a smaller relative to or average bigger and is there any geographical color within Europe that you can give us some strength that we can assume over there?

John McAdam

Yes, absolutely. First of all, from a customer profile, our customer profiles are actually very exciting in Europe. I mean whether you are in the UK, Germany, France, Scandinavia, actually in the Middle East and Africa, we are seeing large fortune or [3.10] 200 type customer so we are very, very confident in there. And we obviously had a misstep last quarter but we had a great year. We have actually spent a lot of time since we did the preannouncement, face to face meetings with sales management, not just conference calls and we think we have got pretty good handle in the business. If you dissect Europe and you look at this coming quarter, we feel very good about our opportunities in the Middle East and Africa.

We feel very good in Southern Europe. We feel very good in Germany and Eastern Europe and we expect the UK to see some rebound as well. So, overall we feel pretty good about it.

Ittai Kidron - Oppenheimer & Co.

Okay, so this was just two weeks of… you are cutting a headline here and…?

John McAdam

No, we expect the economy continue to be tough but what we have done we hope and we spent a lot of time in this because I think we have taken up pretty conservative approach. I think the conservative approach has come in terms of both to mark some sales and then we will take in that at the management level.

Ittai Kidron - Oppenheimer & Co.

Very good and second question is more of a strategic one with regards to your hiring plans for the year. Can you give us some color around that and some would argue that in challenge times like this. You might look into more strategic opportunities to displace your competition even more and be willing to make steps that otherwise in an ongoing business might not be the best to do right now but as far as continuing to invest in your business and doing it in a way that in this timeframe could put you in a much better position when exiting the market something for example there has been talked about Cisco doing that a lot and do you see opportunities like that or do you think that at this point, given the fact that the market is more of a duopoly or just kind of seeing the business and you are going to scale it to how worth that the money is going to come?

John McAdam

Okay, first of all in head turns, just to be really, really clear. We are going to be investing behind revenue. We have done that every year except for 2007. We are back doing it and expect us to continue doing that so, very conservative, looking at the revenue and making decisions as the headcount behind that. So, that pro by definition tells you we are going to be pretty conservative there.

In terms of strategic opportunities, we are viewing 2009 as a tactical year more than anything. I do not see us making any very strategic moves. We do not think it is appropriate right now. We think we have got a great market in terms of the application delivery controller market, strategic real estate. We think we have got a great opportunity in the file virtualization market. We see both of those extending in terms of the requirements that the customers need and that is an up for us. So, you never say, never, just so that is on record but I think it is more unlikely than likely.

Operator

Your next question comes from Ehud Gelblum - JP Morgan.

Ehud Gelblum - JP Morgan

A couple of things, first Andy you gave your gross margin guidance saying 77% to 78% including the stock comp?

Andrew Reinland

Yes.

Ehud Gelblum - JP Morgan

Is that, am I raising it right that it is up 100 basis points from the usual guidance that you have given the last couple of quarters in 76% to 77% or is it a changed basis?

Andrew Reinland

No. We are getting back to our historical levels which at the beginning of the fiscal year, we have said with Acopia we might see a 100 basis points drop and that would have affect our guidance but we were going to work through that and yes, we did not take it up and you are seeing us deliver on what we thought we said we would do it at the end of the year.

Ehud Gelblum - JP Morgan

And that primarily because Acopia has contributing less than you anticipated at this point?

Andrew Reinland

No, I think there is a lot of drivers in the overall gross margin and we talk a lot about how we manage gross margin, very focused task force internally, cross functional, addressing a lot of different areas there and I think we are seeing the outcome of that as well as improvement in Acopia's overall gross margin.

Ehud Gelblum - JP Morgan

Okay. On the Telecom vertical, I think you have said it was 27% of revenue which I calculated…

Andrew Reinland

Ehud, that was 23% this quarter.

Ehud Gelblum - JP Morgan

Okay because I calculated that and would have jumped up a lot. By the way, I have 21% in June and so it was up about $5 million sequentially and this is something that we set up before but of that $5 million sequential, was most of that sales are different or how should we look at that or something else going on there?

John McAdam

This is John. I do not know if most, to be honest, I do not know if most of that were sales of Viprion and Viprion is very, very important in the telco vertical. So, yes let us go with that. I definitely am clear in terms of the growth. I guess more importantly, we expect it to be a continued player in Telco. I say that a couple of times actually that we did some pretty reasonable opportunities out there in Telco with Viprion and we hope to close them more in the next few quarters.

Ehud Gelblum - JP Morgan

So, that number should probably continue to go up?

John McAdam

Yes, we have not given specific guidance. That is the statement we have made in Viprion.

Ehud Gelblum - JP Morgan

Okay and if we assume that for the Viprion is in the order of $2 million, $3 million to $4 million being roughly halfish of that $5 million sequential increase, is that in the right ball park for this quarter?

Andrew Reinland

We do not comment at that level in detail, you know that.

Ehud Gelblum - JP Morgan

Okay, I thought I would just try. Finally, cash flow is strong this quarter and getting even stronger in the next quarter. You said revenue growth is sequentially of they shall try to raise revenue for each quarter during the fiscal year 2009, how do you see cash flow? Do you see it staying roughly flat or do you see that connection grow with revenue over that fall as you fluctuate with investment?

Andrew Reinland

That would be our intent for it to grow. The thing I would remind you is, I think Q2, historically, and we have seen Q2 kind of drop for cash flow from operations because of timing with tax payment. But overall we would expect to see growth in cash flow from operations.

Operator

Your next question comes from Erik Suppiger - Signal Hill Group, LLC.

Erik Suppiger - Signal Hill Group, LLC

Can you give us a little color in terms of how your low end products are performing? You have talked about very good adoption of the 3600 and 1600 but how are you seeing that, the broader impact for the low end products because that has been a drag for a little while? Are you seeing the new product generate incremental business or you are seeing it more as a replacement to this point?

John McAdam

We had been seeing a decline, this is John, a decline in the low end entry level product and we saw that percent of decline stopping last quarter. So, we saw an improvement. In other words, the 3600 and the 1600 definitely had an effect positively and we expect that to continue into the point, I think we said a couple of times that we were actually surprised by the 3600. Now, the interesting thing is as well is where we have seen most of the 3600 business come from, and this is positive, is mainly replacements of the 3400.

So, we saw the 3400 reducing and the 3600 gone up which is really good news. So, yes we would expect that to continue.

Erik Suppiger - Signal Hill Group, LLC

Just to be clear, your low end products in aggregate, they were flat sequentially or did you say that the decline slow down?

John McAdam

Well, it had been actually up sequentially.

Erik Suppiger - Signal Hill Group, LLC

The aggregate of the low end product actually grew sequentially.

John McAdam

That is correct. That is for the 1500, the 1600, the 3400 and the 3600 combined.

Erik Suppiger - Signal Hill Group, LLC

Okay, the ARX was down again. Last quarter, you had diversified away from the financial services sector. Any comments as to why it was weak again this quarter?

John McAdam

It is a very small amount, by the way, that was down. So, it was not…it was almost flat to be frank. Not really, we are still focused on making sure that they were not just in the vertical finance and that we can go into other verticals and I think we are making very good progress with that. I think we are making good progress, slow but sure progress in terms of the integration of the product coming from the older F5 SalesForce of only selling BIG-IP. I mentioned that we have just done a whole bunch of face-to-face meetings and we are definitely seeing a pipeline growing there and more of an interest definitely growing in the core channel of the F5 SalesForce I should say.

So, I think overall it is going to be a driver and a good one in fiscal 2009, it is probably a bit tough in the first half given the comparisons but we feel very good about it.

Erik Suppiger - Signal Hill Group, LLC

Do you think you will start seeing sequential growth in the first quarter?

John McAdam

We do not get it by product, by the way. We are very, very focused on making sequential progress with our product line.

Erik Suppiger - Signal Hill Group, LLC

Okay, lastly, Andy just to clarify, did you say the tax rate for fiscal 2009 would be 34% or did you say the last three quarters would be 34%?

Andrew Reinland

The last three quarters.

Operator

Your next question comes from Troy Jensen - Piper Jaffray.

Troy Jensen - Piper Jaffray

I have a couple of questions here for Andy. Could you talk about the gross margin profile and the two low end products, the 1600 and the 3600? Do they have higher gross margins on their replacements given that they have got more software content?

Andrew Reinland

Yes, they have slightly higher gross margins but not it so much driven by the software. We just look at them at the standalone platforms comparing them straight up. It is a little bit higher but still in that range that we target, Troy.

Troy Jensen - Piper Jaffray

Okay and then I know in the 10-K, I guess you are going to have to reveal your backlog was exiting the fiscal year, any chance that you could share that with us here in the call?

Andrew Reinland

No. We will leave that for the 10-K.

Troy Jensen - Piper Jaffray

Alright, we will stay tuned. Keep up the good works guys.

Operator

Your next question comes from Ryan Hutchinson - Lazard Capital Markets.

Ryan Hutchinson - Lazard Capital Markets, LLC

Just want to dig a little bit more maybe into the product and services split. It looks like product revenue was up 8%. When you back out Acopia, it was up about 6%. So, I am just trying to get a sense in terms of modeling here for core product revenue next year. I know you are not going to give much in the wave color on Acopia but maybe perhaps that at a high level would be helpful in terms of just how we should think about the break out between the product and service for the full year.

And then for John, just in terms of your expectations, I mean would you be disappointed if you did not grow at 15%+ next year.

John McAdam

Let me answer that first of all. I am not going to give you a direct answer to that. You had the saying that “where we sit today we think we can grow sequentially each quarter but we also made a caveat that we are going to update that every quarter because of the situation we face.” I mean frankly when we go back a couple of months ago before the Lehman, before all the other things have happened; we felt that they are more positive so we are clearly taking a more conservative approach.

I am not going to give an answer on the 15…you are going to have to live with the data that Andy gave you but as I said, we are very focused in growing sequentially and then we will see what happens.

Ryan Hutchinson - Lazard Capital Markets, LLC

Okay and then maybe Andy, if you could just help us understand the split there between product and service for next quarter.

Andrew Reinland

Yes, I think we looked at our deferred revenue number and obviously we feel very good about the service growth and in terms of product, we look at those key drivers that we talked about; Viprion and the product refresh and also the pipeline as we have reviewed that with the SalesForce and we feel good about product as well. So, we do not guide specifics for product and service but that is where we sit.

John McAdam

I think another point on that, Troy, is one of the things that you may have noticed, obviously, how far past business was doing a little bit again. I think that is very much related to the economic situation where it is not a must have type capability but remember given the half end, of course, that means our core BIG-IP/Viprion business actually was up.

Ryan Hutchinson - Lazard Capital Markets, LLC

Okay, maybe give it one more shot if I may, just in terms of looking at it between product and service, would you be disappointed that the product piece was down sequentially in any given quarter given the strength that we have witnessed in the services business over the last several quarters, any expectations for growth moving forward?

John McAdam

Yes, I am not going to give a direct answer on that either, sorry. The reason being is if you dissect our business and you look at our forecast and you look at deferred revenue and service that gives you a pretty good clue about what we consider to be conservative and that is why we are doing that anytime. We are very, product growth is obviously a key engine and that is what we are focused in doing but we are not going to give you specific statement on it by quarter at the moment.

Operator

Your next question comes from Mark Sue - RBC Capital Markets.

Mark Sue - RBC Capital Markets

John, did you say you are comfortable with 14% revenue growth next year?

John McAdam

No, I said that we are not going to give a number. We are very focused on that sequential growth and we are sticking with that.

Mark Sue - RBC Capital Markets

So, maybe you can give us your thoughts on which verticals of customers where you need closer rates to get better, which ones are lagging and where have things snapped back to somewhat normal levels just from a vertical or customer point of view?

John McAdam

It is interesting. If you take our financial, it is probably pretty normal across the board. I mean, we had a good Telco quarter. Most of the drop was that 20% to 15% overall in financial. Obviously we see some slowliness in Europe last quarter particularly the UK but generally I would not say there has been a marked change. I think the other thing that is almost done save is that we have a pretty big sales force at the end territories and clearly, few of territories got lot of financial in it. You are going to be looking elsewhere. You are not going to be ignoring financial but you are going to be starting to look elsewhere and that has been happening over the last year.

That is what we have done with ARX and that is what we done actually with BIG-IP so apart from financial, I would not say there are any massive differences.

Mark Sue - RBC Capital Markets

Okay, got it. Then how should we look at the upgrade from the 3400 to the 3600? Should we count what is out there? Do you have a sense of how many 3400s are out there and should each unit be ripe for an upgrade?

John McAdam

I do not think in the short term you will see that. I think it is more substitution. In other words, people live with and bought a 3400 would buy a 3600 and we saw that. We saw that dramatically last quarter and we expect that to be almost a done deal most when we moved into this quarter which is much faster than any product transition. In terms of upgrade, that tends to take a year or two, sometimes three years to happen.

Now, what we do expect to see is that the 1600 and the 3600 replacing maybe older products that are right there. Certainly, the ones before [Timos] where we are still about 20% of the customer service base there. So, that is more of an opportunity than the coming 3400.

Mark Sue - RBC Capital Markets

Got it. Lastly, Andy tax rate after the current quarter, is 31% a new number going forward?

Andrew Reinland

No, for Q2 through Q4, we said we will use 34%.

Operator

Your next question comes from Jeff Kvaal - Barclays Capital.

Jeff Kvaal - Barclays Capital

Andy, I was wondering if you would not mind thinking about your guidance for the fourth quarter. Is there someway that you can help us understand the level of conservatism that you are embedding there talking about perhaps the difference in close rate assumptions that you have or the type of book to bill that you usually enter a quarter with and anything on the slice a bit would be very helpful.

John McAdam

This is John actually. Yes, basically we have a pretty tried and proven technique in terms of looking at our pipeline, looking at our frontline pipeline, looking like a corporate data like that. More importantly, in my opinion is the face to face reviews that we do that [Marcan] does with his team which is to say we have completed, where we basically take their forecast. They know what is going on so hopefully they are being conservative and I have set the feeling we get from them and then to be frank, we add some conservatism to that.

So, that is exactly how we do it. There is an up to it. It is not all signs but I think it is something that we have proved that we have good tried record with.

Jeff Kvaal - Barclays Capital

Okay, thanks John. Would it be fair to say that there is an extra dose of conservatism in this particular measure than the typical?

John McAdam

It would be absolutely be fair to say.

Operator

Your next question comes from Samuel Wilson - JMP Securities.

Samuel Wilson - JMP Securities

Couple of small questions for you. First, R&D spending it looks like it has been generally flat the last few quarters. I am just wondering have you scaled that back at all just because of the nature, do you feel like that those projects will get the more time just talking in R&D spending first?

Andrew Reinland

Yes, I think it has more to do with the timing of projects and the coming with completion on the development of the new hardware platforms, having had Viprion come out earlier in the year. It is just more of timing thing but not a purposeful scale back in spending.

John McAdam

I mean, just to be really clear on that, we are religious on the fact that we need technology leadership especially in our market where we have a great company like Cisco there as our competitor. So, technology leadership is always going to be important to us. So no, there is no change in direction.

Samuel Wilson - JMP Securities

No, I was not implying that. I was only implying that just whatever timing or just conservative of what it was. Second, the office consolidation of $5 million charge, was that a sense for you thought the Company would grow a little bit more here over the next couple of years you are using a little bit more conservative?

Andrew Reinland

Yes, on the many. We locked up some space that we wanted to have available to us but obviously with the environment and being conservative, we just made the call to go ahead and list that out.

Samuel Wilson - JMP Securities

And then lastly and I am not trying to poke you in the eye here. This one actually is a little bit poking in the eye, on Acopia, you paid $210 million cash for it. It is a sense here that customers are just pulling in their horns on these new technologies given the macro environment. Has the computation in competitive picture changed because the revenues are sort of decelerating on or is it just the customers are blowing up? I am just trying to get a sense to what you think is going on there.

John McAdam

I think two things. First of all, it is not concentration of financial and you are effectively spreading up in that because it was very significant. I mean when we made the acquisition, the first quarter after that was 65% with financial which a huge amount of that was actually Wall Street so some of those customers have gone away. That is first thing. Second thing is nascent market issue. I mean definitely in a nascent market, even with an incredibly strong ROI, it is not so easy to sell.

I really want to be clear that we still feel incredibly excited about the opportunity here. It is interesting if we look internally, our IT, our CIO, I think I mentioned this before, I met with him a month ago and we reckon we had more ROI from that product than any other product we use right now in terms of high availability, not by as much as distillates from players like Netcop. So, we feel really good about and we are investing the roadmap in a pretty big way. I think overtime, I think it could be as big as BIG-IP. We are talking like 10 years out so not tomorrow.

But definitely nascent market, financial vertical, the fight that we need to evangelize, the fight that we need to [Evile] and I do not think it was a poke in the eye either. I think it was a good…

Samuel Wilson - JMP Securities

So, that is my question and I will make a note the reason of that is missing numbers is because you are ordering less than you are supposed to.

John McAdam

Any more questions?

Operator

Your next question comes from Cobb Sadler - Deutsche Bank Securities.

Cobb Sadler - Deutsche Bank Securities

You are trying a get an idea on how the economy if it does continue to slow, will it affect several parts of your businesses. So, do you think the low end, refresh and Viprion, I mean those are, could they not grow in a really bad economy? I guess is the question and then also if you could talk about how the 8000 series might be affected.

John McAdam

Yes, I mean if IT budget went completely frozen then all technology companies will have an issue. You cannot deny that. Are we in a space where the internet continues to grow? Absolutely. We had an example of a purchase last week where basically, it is a financial organization, I am not going to say who, but basically the reasonably big purchase, came very, very quickly because their website was being overran by internet traffic more than normal. That is an example.

So, on the one hand, I think we are very high up in the radar screen, on the other hand we do need to look at the economy and I think we are in very, very good shape in terms of the packing order and we just watch revenue daily. Linearity is absolutely key for us and as we have had said earlier, invest behind revenue.

Cobb Sadler - Deutsche Bank Securities

Got it. So, IT spending were flat, the 1600, 3600 and Viprion; would be able to hit your internal targets if over IT spending were flat?

John McAdam

It is very hard to generalize that. IT spending probably is flat, probably at that right now. So, that is sort of assumptions we are making when we give guidance.

Operator

Your next question comes from Matt Robison - Pacific Growth Equities.

Matthew Robison - Pacific Growth Equities

My usual question is to start with the digital central users, if you have that data?

Dan Matte

Sure, Matt. This is Dan. We talked out at the end of last quarter at 3200 with 3600 business at the central and one interesting thing too is we did launch digital central a Japanese version and that run up to number two in terms of contributing countries for content. So, year on year, we are going pretty well. It is up about 67% or so.

Matthew Robison - Pacific Growth Equities

Speaking of Japan, I think you said on the pre-announcement conference call that the new products will head and start to register in Japan. Is there a new dynamic in Japan with the channel or anything in particular that we should be seeing as a factor and change there?

John McAdam

No, not at all. That is extremely normal. When we introduced Timos as an example in 2004 with the law of new product, it was almost nine months before it started to really run pop in Japan. It tends to be very conservative with new products and I do not think that the 1600 and 3600 will be much different. Then having said that, it is same operating system. We have seen amazing quality by the way with both these products, both quality and almost less issues that these products we have seen in any product range we have ever introduced. We think that should definitely accelerate that one step of that experience that happens in Japan.

And then overtime, as we have said, we think given the profile of Japan's business, they are going to benefit more from the 1600 and 3600 than any other job. We will say we are pretty sure about over a reasonable period of time and then hopefully the 3600 will get more and the more dividing software and then bringing the curves up the range in Japan and that is very much the strategy we have embarked upon.

Matthew Robison - Pacific Growth Equities

Of the three modules you are going to run on your low end and refresh, pretty one of them particularly strong in driving the sale?

John McAdam

We probably need to get back to you. I know [ASM], the application file module was that it had some pretty solid tax rate but I do not specifically if it was the top one.

Matthew Robison - Pacific Growth Equities

Andy, on the cash flow, how is the facilities charge flow through the cash flow statement? Is it already been a factor or is it something that is going to happen overtime going forward?

Andrew Reinland

Well I think as a charge, upfront it is non cash. You are not really going to see it but overtime what you will see is we will just lower operating expenses and we will flow through that way.

Operator

Your next question comes from Bill Choi - Jefferies & Co.

Bill Choi - Jefferies & Co.

Several questions here. First, Andy would you explain why inventory you expect to be up to $14 million to $16 million? I think it is typically a decline in the December quarter.

Andrew Reinland

Yes, that is pretty much directly tied to our product transition rise. So, being ready to meet the demand that we expect to see out there and then also in this environment a little bit, our overall inventory is pretty low and we want to make sure we have certain products and some parts and pieces that we want to make sure we have on hand and so we do some vice there.

John McAdam

A couple of weeks ago, the preannouncement call, I mentioned about the product refresh and that there is some eminent announcements coming that we are going to update you on the Analyst Day on November 4 but that is also we are getting upfront on some announcements in that area as well.

Bill Choi - Jefferies & Co.

Okay and also just in terms of visibility into the inventory of your distributors and also in Japan where it is two tiered, can you talk about inventory there? Is everything looking fairly clean too?

Andrew Reinland

Yes and just to be clear, Japan is actually the only dealer where we have an inventory. So, in our other dealers where we are sell through so it does not matter on the inventory level or where we sell in. We do not carry inventory. So, in Japan in particular and we usually do not disclose this but actually we have worked that inventory down in Japan. So, that is pretty much.

Bill Choi - Jefferies & Co.

And then John, I want to step back a little bit and look at one of the key drivers of your business which is the deployment of new servers whether it is for consolidation of data centers or just build out a new data centers in general. Obviously you guys are still performing quite well. The server guys have taken a big hit starting in the September month whether you look at IBM or Sun Micro. How do you feel about the tie between your products and ultimate pulse of demand of the servers and if server shipments continue to weaken and should necessarily expect your product to have a bit of a slowdown maybe couple quarter later?

John McAdam

No, I do not. Actually, let me explain why. Our business is absolutely as if the BIG-IP and Viprion business is related to that. However, it is related to server consolidation and virtualization pipeline, I have brought that out in my script. You should really think of the fact that you can have scenario where you are building a new data center and this is very common. You are effectively building up commodity building blocks and you are virtualizing them with VMware or with Microsoft products or whatever.

Our products in that environment have a massive value add. So you actually maybe reducing the number of servers but you are actually increasing the value add from F5 solution. And the reason you are doing that is with all the value add that we do, the actual physical server we do it a virtual server space as well but even the quite more than that, the comp value add for physical servers plus the fact that you have got more complexity in terms of managing virtual servers. You have got provisioning requirements, series like that, and we have a tremendous play. In fact, we are actually a real key building block there.

So no, I do not think there is a direct correlation at all because the way architectures have moved on.

Bill Choi - Jefferies & Co.

Right, but even when you virtualized, you typically deal with new servers whether it is systems from IBM or instead, but there is typically a new server involved because they tend to have a better performance, better power consumptions. So, you are saying there is no real link between new server shipments and the level business you would ultimately expect?

John McAdam

No, I am actually saying, I think the opposite from what you are asking which is when we get an opportunity where we receive data consolidation, we see our adoption in servers maybe moving because of virtualization, it is the most common way of doing that. That is an opportunity that the F5 Sales Force see to sell our products because if we do more value add in that space.

Bill Choi - Jefferies & Co.

Okay. One final question, you talk about where average deal sizes have gone since you guys really have moved up here in your new products into the higher end and new products also have higher SPT than the mid and low end.

Andrew Reinland

Yes, we met our average deal sizes had been just above 200,000. We saw it pretty comparable quarter over quarter. But yes, I think that was driven early on to the year by Viprion and then with the strengthening of a 3600 and 1600 this last quarter, I think it kind of balanced that out.

John McAdam

One of the things we will do just at the Analyst Day, we are going to talk about the profile, the number of the codes where we sell above $200,000 number of deal size. You will get more of visibility and I know that is on Mark Anderson’s presentation that is coming up.

Operator

Your next question comes from Jason [Eider] - William Blair & Co.

Jason Eider - William Blair & Co.

Just two quick questions, guys. First one of your suppliers, [Cavion] noted some concern over demand for high end boxes in networking. So, I was just wondering whether you are seeing any lengthening of sale cycles for some of the higher end boxes like the 8000 series.

John McAdam

Yes and no. I mean we have had actually had a different issue. So, we have seen Viprion very, very strong. We have seen our high end boxes very, very strong and obviously we have been focused on the opposite which is we are seeing a decline in the entry level product and that is why we introduced the 1600 and 3600 so we really have not seen that.

Jason Eider - William Blair & Co.

I know the Viprion was strong but I think we are thinking more in terms of the 8400 and some of the other…Okay, alright and then second question is in terms of your cautious guidance. Is that kind of spread across the world at this point? Is it in every region where you are going somewhat cautious right now? Could you maybe comment on each of your major geographies and how you are feeling relative to the guidance?

John McAdam

It is pretty much every region. I mean there is no question at each of these similar facts on the region. Obviously, we pay more attention than ever to the media given what we saw at the end of last quarter but pretty much across the board.

Jason Eider - William Blair & Co.

Lovely.

Operator

Your next question comes from Jeff Evans - Sanford Bernstein.

Jeff Evans - Sanford Bernstein

As you look forward the fiscal year 2009, I can imagine that you have gone through an exercise and talked about R&D headcounts that is needed given your product development priorities, sales force addition, etc. How flexible or how much uncertainty is there in your spending plan for fiscal year 2009 in light of the economy?

John McAdam

Well, I think it goes back to the comments that we made that we are going to approach our investments very conservatively and we start out where in this quarter we said we thought we would have 40 to 60 employees then came in more at 30 because we are just being very tactical and very careful about how we will invest and we will be doing that through the year.

Operator

Your next question comes from Tim Long - Banc of America Securities.

Tim Long - Banc of America Securities

Just two quick ones if I could. First, just talk a little bit about the pricing and competitive environment, obviously good product cycle for you but other concerns that our competitors might see some slowing and kind of change the dynamic out there as you look out a quarter or two and have you seen any of that yet? And second, as we look out 6 to 12 months, how long does over tail do you think we have with both Viprion and the lower end products that are new? At what point do you think we need to see yet another new wave of products basically, another product cycle that would help keep that flat rate going on sequential basis? Thank you.

John McAdam

Just to go towards the end of the question. So, 3,600 Viprion all through '09, we think they are going to be growth drivers and beyond probably 2010 as well. One of the things we are going to talk about in a couple of weeks, in November 4 is the product roadmap and some detail. But you are going to see a product refresh of the other products happening in 2009, and as I was saying earlier you are going to see some of that stuffing eminently as well and we will talk a bit on that in a couple of weeks. So, we have a pretty strong refresher, in terms of the competitive environment.

Dan Matte

Yes, Tim this is Dan. As far as the competition goes and when we are seeing pricing wise, really there is always to be occasional practical thing going on from competitors. But overall, I think as reflected in our gross margins that we have not seen any big tectonic plates shift out there in terms of what is going on in the competitive environment. So, I think with the refresh that we got, with Viprion, we were really in a very, very strong position.

John Eldridge

Yes, and Brian we will take some more question and we will be done.

Andrew Reinland

Yes, just a wrap up on that. We have seen pricing remain very stable, you see that on our product margins, watching the deals come across, we really seen no change I mean deal profiles from discount perspective or either, so I think that is important to know.

John Eldridge

Yet again, one more question Bryan, and we will wrap up the call.

Operator

Our last question comes from Rohit Chopra - Wedbush Morgan Securities.

Rohit Chopra - Wedbush Morgan Securities

Just wanted to know if things got really, really bad out there and everyone sort of predicting that, are there certain areas where you think you could actually cut cost as other than not adding headcount for certain areas where you guys are thinking that you can cut cost?

John McAdam

You mean what was in next size in the Company? There is always a case you can do that actually in 2000 we had to do that. In 2000, we made some pretty significant cost cutting. I do not think when the space at all right now. I really do not. Having said that, it is just that the economy is very, very difficult but what we are going to do is tight control, invest behind revenue.

Rohit Chopra - Wedbush Morgan Securities

There is another question I have so back to Europe really quickly as you saw things slow down, did you analyze it and as far as say whether it is just a complete freeze on spending or was it anything to do with the credit market that is freezing up where the customers could naturally pay you or provide advances, did you guys look at that?

John McAdam

Oh, yes. We looked at that pretty tightly. We did it by deal. I mean that is the way you do that. In other words, what was forecast, why it did not close? Most of what we saw was not that system. Most of what we saw was crisis. So, the great majority of the mixes that we saw was pushed out. Some of that went in this quarter, some would be delayed. Very few went away and then you have to basically do your sales judgment, your sales forecasting and your sales execution to see what you think at that. But it was pretty deal oriented.

Rohit Chopra - Wedbush Morgan Securities

And the last question is why could not service revenue begin to slowdown? The customers started to pullback and not do multi-year service contracts or they just go to one year or maybe not, maybe they just forget about renewing for a certain period or something like that. Why could not that happen?

John McAdam

Well, the vast majority about contracts of one year, we only have a few multi-year one. So, that is one part of the answer and the other piece is one that say using our products where it exist in the networks. That is a big risk to go and saying either when they have to go for our baits, either when they get help and we do not have a problem renewing. We always have to go to the debates and negations but we have very high renewal rates.

John Eldridge

Okay, thank you very much for joining us and again, if you have any follow up questions give me a call and we will make sure we answer.

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Source: F5 Networks, Inc. F4Q08 (Qtr End 9/30/08) Earnings Call Transcript
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