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F5 Networks, Inc. (NASDAQ:FFIV)

F1Q13 Earnings Call

January 23, 2013, 4:30 p.m. ET

Executives

John Eldridge - Director, IR

Andy Reinland - EVP and CFO

John McAdam - President and CEO

Karl Triebes - EVP, Product Development and CTO

Dan Matte - EVP, Marketing and Business Development

Manny Rivelo - EVP, Security and Strategic Solutions

Analysts

Brent Bracelin – Pacific Crest Securities

Matt Robison – Wunderlich Securities

Ehud Gelblum - Morgan Stanley

Jess Lubert – Wells Fargo Securities. LLC

Mark Sue – RBC Capital Markets

Jayson Noland – Robert W. Baird

Alex Kurtz – Sterne Agee

Rod Hall – JP Morgan

Simon Leopold – Raymond James

Kent Schofield – Goldman Sachs

(Toa Leone) – Merrill Lynch

Operator

Operator

Ladies and gentlemen, thank you for standing by and welcome to the F5 Networks' first quarter results conference call. (Operator Instructions).

I'd now like to turn the call over to Mr. John Eldridge, Director of Investor Relations. Sir, you may begin.

John Eldridge

Thank you, Angie, and welcome everyone to our conference call for the first quarter of 2013. The speakers on today's call are John McAdam, President and Chief Executive Officer and Andy Reinland, Chief Financial Officer. Other members of our exec team are also with us to answer questions following their prepared comments.

If you have questions following today's call, please direct them to me at 206-272-6571. If you don’t have a copy of today's press release, you can get one from our website, F5.com. In addition, you can access an archived version of today's live webcast in the investor relations events calendar page of our website through April 24th. From 4:30 p.m. today until midnight Pacific Time, January 24th, you can also listen to a telephone replay at 800-695-3640 or 402-220-0318.

During today's call, the 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 release described in detail in our SEC filings.

Before we begin, I want to remind you that F5 has no duty to update any information presented in this call. Now I'll turn the call over to Andy Reinland.

Andy Reinland

Thank you, John.

Q1 marked a quarter of focused execution within a challenging macro-economic environment. Against the backdrop of our typical fiscal Q1 seasonality, we delivered our 15th consecutive quarter of sequential revenue growth reporting revenue and earnings results within our guided range.

Before I discuss specific results for the quarter and our outlook for the second quarter, I would like to remind you that non-GAAP numbers exclude stock-based compensation expense and amortization of purchased and tangible assets. A reconciliation of GAAP to non-GAAP results is included in our press release.

For the first quarter of fiscal 2013, revenue of $365.5 million was within our guided range of $363 to $370 million, an increase of 1% from the prior quarter and 13% year-over-year. GAAP EPS of $0.88 per diluted share and non-GAAP EPS of $1.14 per diluted share were within our guided ranges.

Product revenue of $204.7 million grew 4% year-over-year and represented 56% of total revenue. Service revenue of $160.7 million grew 28% year-over-year and accounted for 44%.

Q1 revenue from our Application Delivery Networking business was $359.9 million. And revenue from our ARX File Virtualization business was $5.5 million. Book-to-bill for the quarter was less than 1.

Accounting for 58% of the total, revenue from the Americas grew 12% from the first quarter of 2012. EMEA, which represented 23% of revenue grew 22% from the first quarter of last year.

APEC accounted for 14% of revenue and grew 16% year-over-year. Japan revenue declined 11% from a year ago and represented 5% of total revenue for the quarter.

Representing 23% of sales during the quarter, Telco was our strongest vertical followed by financial at 20%, technology 13%, and total government was 11% including U.S. Federal, which accounted for 5% of the total.

In Q1, we had three greater than 10% distributors, Avnet, which represented 16.9% of total revenue, Ingram Micro, which accounted for 15.2%, and Wescon, which accounted for 11%.

Reflecting a record contribution from software sales, our GAAP gross margin in Q1 was 83.3%. Our non-GAAP gross margin was 84.4%.

GAAP operating expenses of $195.5 million were within our target range of $193.5 to $198.5 million. Non-GAAP operating expenses were $171.7 million. GAAP operating margin was 29.8%. Our non-GAAP operating margin was 37.4%. Our GAAP effective tax rate for Q1 was 37.2%. And our non-GAAP effective tax rate was 34.5%.

Turning to the balance sheet, cash flow from operations was $145 million contributing to total cash in investments of $1.29 billion at quarter end. ESO at the end of Q1 was 51 days. Inventories were $18.7 million. Capital expenditures for the quarter were $7.8 million. Deferred revenue increased 26% year-over-year to $480.6 million.

We ended the quarter with 3,125 employees, an increase of 95 from the prior quarter.

In Q1, we repurchased approximately 555,000 shares of our common stock at an average price of $90.02 per share for a total of $50 million. Approximately $131 million remains authorized under the current share repurchase program.

Now for the Q2 outlook. At the end of Q1, we began shipping several of the new hardware and software products we will be announcing over the next several weeks. We believe these new additions to our product portfolio will have a positive impact on our business as demand for the new products builds throughout fiscal year 2013.

In addition, we have continued to gain momentum with our security and service provider solutions. And we anticipate continued solid growth from our services business. As a result, we believe that we will achieve sequential revenue growth for the remainder of the fiscal year and reaccelerate product revenue growth in the second half of the year.

For the second quarter of fiscal 2013, our revenue target is $370 to $380 million. We expect GAAP gross margin in the 83% range including approximately $3 million of stock based compensation expense and $1 million in amortization of purchased and tangible assets. We anticipate GAAP operating expenses in the range of $198 to $205 million. This includes approximately $25.5 million of stock based compensation expense.

The recent extension of the R&D tax credit by Congress will have a favorable impact to our tax rates in Q2 driven by a one-time retroactive catch-up for fiscal 2012.

For Q2, we are forecasting a GAAP effective tax rate of 32.5% and a non-GAAP effective tax rate of 31%. We anticipate tax rates for the remainder of fiscal '13 to normalize closer to 36% for GAAP and 34% for non-GAAP.

Our GAAP EPS target is $0.93 to $0.96 per diluted share. Our non-GAAP EPS target is $1.21 to $1.24 per diluted share.

We plan to increase our head count by approximately 100 employees in the quarter.

We estimate DSO will be in the upper 40 day range.

We expect inventory levels within a range of $18 to $20 million.

And we believe our cash flow from operations will be in excess of $95 million reflecting the large sequential increase in our federal tax payments that is normal in our fiscal second quarter.

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

John McAdam

Thanks, Andy, and good afternoon everyone.

I was very pleased with the F5 team performance in Q1. We delivered year-over-year growth of 30%, continued to strengthen our balance sheet with strong cash generation under an increase in deferred revenue. And made significant progress in product development by introducing a range of new products with the goal of reaccelerating product revenue growth as well as increasing our solution portfolio in the addressable market for our products.

From a geographic perspective, we experienced mixed results in our major regions. Business in the Americas region excluding U.S. Federal delivered solid sequential sales bookings growth over Q4. However, we saw significant sequential decline in sales in U.S. Federal business. The U.S. Federal sales in Q1 were below our normal seasonal trends and below our internal forecast. We believe the reason for this decline was directly linked to the uncertainty caused by the Fiscal Cliff discussions. The sales pipeline in our federal business remains very strong. And we feel very confident about our future opportunities in this market.

Both EMEA and Asia-Pacific also delivered sequential sales bookings growth over Q4 with several large winds in each of these regions. In Japan, we experienced a significant year-over-year sequential growth in sales bookings. The booking forecast was reduced during the quarter as a well-publicized fiscal situation in Japan deteriorated. Japan in particular still has a large percentage of sales fulfilled by the mid to lower end of our appliance range of products. We believe Japan should benefit substantially from the product refresh I will talk about in a moment.

We had some really good sales in the last quarter when we replaced existing Cisco ACE products with F5 solutions including three ACE replacement winds in Fortune 50 companies. Our percentage of new business in Q1 was up 6% to 46% last quarter driven by ACE replacement winds globally.

We set another record for software sales in the quarter. Software module sales continued a strong growth. And sales of our software only virtual edition products set a new record high with some $1 million orders in the quarter.

Once again, our security solutions produced strong year-over-year growth driven by continued strength in the security module sales especially with our application firewall ESM module.

We also made good progress with our diameter solutions from the traffic systems acquisition with some good comparative LPE project winds. Service providers are moving to LP architectures on a global basis. And we believe this trend gives F5 the opportunity to increase our strategic footprint with these operators.

We have come to expect stellar results in our services business. And these results were again delivered in Q1 with 28% year-over-year growth and a 26% increase in deferred revenue compared to Q1 last year.

We talked in some detail at our analyst investor meeting in November of the large array of new products and software solutions, which we will be shipping during fiscal 2013. Our development team made fantastic progress last quarter in meeting their development milestones to deliver a significant new release of TMOS referred to internally as Solar, as well as delivering a number of new ADC platforms. The Solar release ships with approximately 76 new areas of functionality for TMOS including the debut of our advanced application delivery firewall solution. Enhanced virtual solutions with the industry brought us high provider's support, deployment options to support physical, virtual, and hybrid environments, and a new service provider solutions that carry a great network address translation, and policy enforcement module with deep pocket inspections.

Our policy enforcement module allows bigger IT to inspect and classify application and protocol traffic and dynamically enforce service provider policies. For example, our policy enforcement module supports a GX interface enabling inter-operability with a broad set of PCRX and our own traffic signaling delivery controller.

Development has also made great progress on the platform effect of delivering a range of new products. You may recall that we started shipping the first of these new platforms last quarter when we announced the BIG-IP 4200v platform. Our goal is to refresh the current product lines, a new range of products that provide significant price performance advantages with increased functionality. We were very pleased with the initial demand for the 4200v in Q1, which was above our original forecast. We believe this bodes well for the new range of products now available this quarter. The additional new products now available include the new eight blade VIPRION 1400 chassis, which handles performance levels well above any other products in the industry.

Also introduced are the new VIPRION blades, our new FPGA hardware based security capabilities that significantly increase the performance of VIPRION to defend against specific types of the [inaudible] service or DDoS attacks while allowing the system to maintain an extremely high level of through put.

The new seas of the big IT platform introduces industry leading performance as well as first such as 10-gigabit interfaces on the low end and 40-gig interfaces on the high end of the lineup. These new ADC platforms enable the dynamic use of IT resources through F5's innovative scale end technology. ScaleN allows customers to elegantly enhance their application delivery infrastructures by adding capabilities as business needs grow. Unlike comparative approaches, ScaleN does not require extra hardware or customers to disable features to use it. This enables organizations to simplify their IT infrastructures and make their technology investments more efficient and cost effective.

As far as the outlook is concerned, Andy indicated that we expect to see sequential growth this quarter. As I mentioned earlier, we saw a very cautious spending environment last quarter especially in our Japan and U.S. Federal business. However, looking forward, we believe that we have significant revenue growth opportunities starting this quarter. And these opportunities should increase our momentum as we enter the second half of fiscal 2013.

We are now at the initial phase of one of the most significant product line refresh opportunities that we have had in several years. Product training is underway and will continue over the next few weeks to ensure our sales force and channel partners maximize the advantage of these new products.

Also as mentioned earlier, we're seeing good momentum with sales of our software only and hybrid software system solutions. We expect this momentum to continue with the expansion of our industry leading range of high provider's support. These solutions can now support customer's bases and [inaudible] environments with unprecedented performance. Our virtual software ADCs now include closed solutions based on Amazon web services and VMware vCloud suite as well as Microsoft Hyper-V, (NYSE:ZEN), and KVN Learning.

We also believe that the new solar release of TMOS significantly expands our addressable market. In particular, the new application delivery firewall solution gives our enterprise and service provider customers the ability to integrate essential security capabilities and protect our application's data end users.

F5's application delivery firewall solution is the first in the industry to combine DDoS protection, network firewall, application security, access management, and DNS security with traffic management while maintaining industry leading performance and scalability.

We also see market expansion opportunities in the service provider market with our new Carrier-Grade NAT solution, policy enforcement modules, and our traffic systems to amateur solutions for LTE deployment.

In addition, TMOS has been engineered to operate in an SDN infrastructure dynamically enabling application level layer three to layer seven services. TMOS provides true separation of data, control, application, and management planes enabling our customers smooth migration to SDN. For example, with the introduction of new capabilities later this year to our big IP and our big IQ platforms, customers will be able to see mostly managed applications in both DX-1 and the NVGLE-enabled environments, and leverage sophisticated automation and application's control capabilities through our new iControl API extension Cloud IQ API.

Finally, we believe there's a real growth opportunity for F5 in replacing the large base of existing Cisco ACE solutions. As I mentioned earlier, we had some great ACE replacement wins last quarter and the pipeline of business for this opportunity is very strong. F5 has a unique and stellar track record of replacing Cisco ADC products in Fortune 500 accounts over the last several years. The timing of our new ADC platform availability is ideal for us to exploit this opportunity.

Clearly, I feel very optimistic for the future prospects for F5. I'd like to take this opportunity to thank the F5 team and our partners and look forward to continued support for the rest of the year. And with that, we’ll now hand the call over for Q&A.

Question-and-Answer Session

Operator

Thank you. (Operator instructions). Our first question comes from Brent Bracelin from Pacific Crest. Your line is open.

Brent Bracelin – Pacific Crest Securities

Thank you. John, I really wanted to focus in on kind of the appliance refresh. Could you kind of frame for us the volume, where the bulk of the volumes within the appliances are coming from, 4,200 was shipping in the quarter, is that the high volume product or how should we think about the two additional appliances that you’ll be shipping this quarter, the 2,000 at the low end and the 10,000 at the high end? Does that provide you move coverage as you think about the competition in that environment? Are those important products that should give you a little more cover relative to the competitors and refreshing those appliances? Any color there would be very helpful.

John McAdams – President, CEO

The 4,200 PB is the lower end of the midrange, so not quite the – so you know, it’s a [inaudible] product but it’s not quite the volume product in either actual volume of units or in revenue. It’s a very important product, I don’t want to put it down, it’s pretty important. The big volume product, certainly from a unit perspective, but also nontrivial from a revenue perspective is the entry-level product and that’s – you know, that’s been the case for many years and we think will continue. So the truth falls in the series because we’re talking about more than one model here, is very significant especially with things like 10 gig and [inaudible] like that.

I can talk about, or maybe Karl could talk about if you want some more detail there. And then of course there at the high end of appliance range, we’ve set about even higher with the 10,200 which is – so, these are really important products, very significant ones.

Brent Bracelin – Pacific Crest Securities

Very helpful, and as you think about the competition, where do you think you need the coverage – is it really the low end where you felt a little pain, kind of, over the last, you know, six to nine months, and that’s really the product that we should focus on going forward as a potential reacceleration growth?

John McAdams – President, CEO

I think with a scale and technology – with the ability to do more modules, I, quite honestly, I think all of our products are going to be pretty hot because of that price, performance change. But if you are going to ask me where – probably where our most weakest, probably at the low end, I would agree with that.

Brent Bracelin – Pacific Crest Securities

Okay, great, thank you – and then just one quick one on Cisco ACE. You had three ACE wins in Fortune 50, did you recognize revenue on those, any of those three ACE wins in the quarter, are those wins that you do expect to see revenue on in the March time frame?

John McAdams – President, CEO

It’s actually yes and yes to most of that – I don’t want to say 100% certain because it’s - the forecast needs to be careful with forecasting accounts. But we saw revenue last quarter, and given the opportunity, we’ll probably see that increasing in that – that’s the whole point of getting into the Fortune 50 accounts, or Fortune 500 for that matter.

Brent Bracelin – Pacific Crest Securities

Okay, fair enough, thank you.

Operator

Thank you, Matt Robison from Wunderlich Securities.

Matt Robison – Wunderlich Securities

Yes, Matt Robertson at Wunderlich. Can you comment if the – if you’ve got recognition yet for the policy enforcement, and maybe give us an update on DevCentral users?

John McAdams – President, CEO

Yes – so, the policy enforcement is part of the solar release that, you know, Karl’s team is basically meeting the milestones and have it ready for the end of last calendar year. So, in truth, most of that solar stuff is this quarter – I mean, it’s this quarter and beyond, and we would expect to see sales of that. I mean, it’s very new, it will take a while to ramp up, take some training, as all software does. We – oh, by the way, we expect the platforms in sales to be much [inaudible] because they can run not in just solar, but also in previous releases like the 4200 could, and the VIPRION 2400. But with software, you know, we want to be a little bit cautious with because it does take some time to bleed through the market, but we would expect to see sales win.

Karl Triebes – EVP, Product Development, CTO

Yes – and by the way, Matt, this is Karl. One thing that I would also mention with the [inaudible] module, the customers tend to have a longer sense of – search providers tend to have a much longer qualification cycle where they have to go through and run the different applications, and whatnot in their environments. So, the ramp rate of that will tend to be different than necessarily some of our other features like security, and other things in our platforms.

Matt Robison – Wunderlich Securities

If it’s probably solar, than it comes with maintenance agreements I would expect, right?

John McAdams – President, CEO

Absolutely.

Matt Robison – Wunderlich Securities

So, is there any specific hardware that needs to be in place to invoke the policy enforcement – the DPI capability that is required for that?

Karl Triebes – EVP, Product Development and CTO

Yes, with the PenModual, obviously our VIPRION platforms and our higher end platforms – right now, we don’t support it on the low end of the range yet, because it is very much focused on the surge provider market.

Matt Robison – Wunderlich Securities

Yes, so the VIPRION platforms that are available now can do it?

Karl Triebes – EVP, Product Development and CTO

That is correct.

Matt Robison – Wunderlich Securities

And update on DevCentral users?

Dan Matte – EVP, Marketing and Business Development

Yes, sure, Matt, this is Dan. So DevCentral we’ve finished up the quarter just over a 116,000 members – so, we see a great growth continuing there, and just one thing that I would highlight as well – some of the activities that we’re doing, things are guru panels, for example, to get the word out we’re seeing great traction on things like our ACE Replacement panel, and expansion into DNS services as well. So, you know, not only DevCentral user account, but participation in some of these things are growing in a great way.

Matt Robison – Wunderlich Securities

Thanks a lot, I will let somebody else’s question in.

Operator

Thank you, Ehud Gelblum from Morgan Stanley, your line is open.

Ehud Gelblum - Morgan Stanley

Hi guys, thanks, I appreciate it. A quick question on WesCon, as they are now 10% customer, were they – can you give us a sense geographically, was that mainly a US account, or were they more international, and was the growth there responsible for most of the uptick in services, or was that just coincidental?

Andy Reinland – EVO, CFO

Hey, Ehud, the first part of your question – so, WesCon has long been a distributor of ours just to not hit that 10% threshold.

Ehud Gelblum - Morgan Stanley

Right.

Andy Reinland – EVP, CFO

And then six months ago you might have recalled a press release where we named them really our first true international distributor, and so the balance of that revenue has – I don’t have the specific breakdown, but it has gone over that 10% principle driven by international revenue, and I didn’t hear the second half of his question.

Ehud Gelblum - Morgan Stanley

Well, basically it was following up on that – as they peak through the 10% mark from where they were before, and I don’t – we always knew there was significant…

Andy Reinland – EVP, CFO

Yes.

Ehud Gelblum - Morgan Stanley

But obviously they were in the 7-8% maybe range or so. Was that the difference in the quarter, or was it just coincidental that they happen to break through the 10% [inaudible]?

Andy Reinland – EVO, CFO

I say it’s more coincidental.

Ehud Gelblum - Morgan Stanley

It’s more coincidental, okay.

John McAdams – President, CEO

Yes, definitely it’s coincidental, there is no link to any specific products here [inaudible] our geography.

Ehud Gelblum - Morgan Stanley

Okay, helpful. With guidance, we booked a bill less than one, how should we be reading the product versus services split as we look at guidance for next quarter? Should we be looking for product revenue in sequential basis until again we can be sort of flat to perhaps downing – down a little bit with services making most of the difference given the book to bill, or should we be seeing products starting to move up on a sequential basis?

Andy Reinland – EVP, CFO

Yes, when we give our guidance we always assume book to bill equal to one, so I think you can look at our guidance from that perspective, and the strong message I want to reiterate here though is we really expect to see as we go into the back half of this year, Q3, Q4, that is where we’re really going to look to see reacceleration of the product revenue growth.

Ehud Gelblum - Morgan Stanley

Alright, okay, finally, on Japan, is – what’s your expectation on Japan for next quarter – you said most of the issues were in the low end, I would imagine there’s some competitive issues there. Is that now shipping and fixed to the point where you can start seeing that to start to rebound, is that an area that we can look if we don’t have much faith in the US Federal in the near term, is Japan an area that can start recovering sooner more in Q – in the next quarter, or the quarter after?

John McAdams – President, CEO

Yes – I mean, we’re being cautious on that area – this is John. So, I mean, it’s clearly in the forecast, but we’re being pretty cautious with that – Dave, do you want to comment on what we saw last quarter?

Dan Matte – EVP, Marketing and Business Development

Yes, I think we just saw, you know, pretty tough macro environment, not only from, you know, end user customer, but even with our partners as well, that we – that we, you know, just saw pretty much as the quarter went on towards the end of the quarter, really business stopped. So, you know, we’re looking at a little better quarter this quarter in Japan, but it’s still going to be a challenge.

Ehud Gelblum - Morgan Stanley

I see, it wasn’t as competitive as you think, it’s completely the macro, and then….

John McAdams – President, CEO

We really – Dave really pushed in that during the quarter [inaudible] – well, you never really can be 100% certain, but the feedback we go back to team, and by the way, we are really – we’ve got a lot funds in this Japan management, and the team was – they really saw some

Operator

Thank you. Jess Lubert from Wells Fargo Security, your line is open.

Jess Lubert - Well Fargo Security

Hi guys. Thanks for taking my question. A couple of questions. First I was hoping you could help us understand what drove the weakness in the Technology Vertical, the business has declined year-over-year and four of the last five quarters, so I’d be curious to understand. Are customers waiting for new product? Is there a competitive issue? And to what extent you believe this Vertical is likely to improve in future quarters?

Dan Matte – EVP, Marketing and Business Development

Sure Jess, this is Dan. So, on the Tech Vertical issue, you’re right. I mean, the Tech Vertical has trended down over the past several quarters for us, and we believe it’s driven really by a couple of our larger customers that are taking alternative architectural approaches in terms of how they’re building things. So, generally what (dead air) and they’re building some basic functionality into that app. And, so we’ve been seeing that going on, and obviously we’re doing something about it.

We’ve got projects going on internally that we believe will provide this type of customer with bays that will make it easier for them to integrate our functionality into the applications [inaudible] that they’ve got.

John McAdam – President and CEO

And just to be very pointed [Inaudible]competitive at all. It’s more that you know they’ve definitely seeing some architectural in-house changes.

Jess Lubert - Well Fargo Security

So, does that business kind of linger around this level the next couple of quarters, until you can implement some of these new solutions, then it ramps back up? Is that the right way to think about it?

John McAdam – President and CEO

Yes, that’s probably the assumption we’re making at the moment.

Jess Lubert - Well Fargo Security

And, you know, then they just want to touch base on the Carrier business, how you’re thinking about that going into 2013, clearly a better quarter here. Several major Q1 providers have suggested they’re going to spend more in 2013 than they did in 2012, so would love to get some of your thoughts, and what you’re hearing from some of the major service providers. If you’ve seen a change of tone, or an uptick in activity that has you more optimistic about the Carrier businesses as we work through the year?

Manny Riveldo – EVP, Security and Strategic Solutions

Hey, Jess, this is Manny, just to comment on that. So, we’re actually seeing a lot of excitement based on the solutions that we’re bringing out to the market. And it’s primarily driven by a couple of factors. As we all know, there’s huge amounts of demand today around the mobile space. So we’ve been organizing and orchestrating over the course of the last year, is really a set of solutions for a mobile and fixed operators, that really begin to deliver advanced capabilities in terms of traffic management, and being able to send to the subscribers as what the application is. And then being able to make policy decisions around that.

So, as we take these architectures out to these customers, they’re very interested in various different solutions. So, we think we’re going to have a very strong second half. But to the point that Karl make, a lot of this new technology we introduced in the market – or we’re introducing over the coming couple of weeks, is going to go into trial environments and it’s going to have to go through validation. And this will be our PAM Module, our [inaudible] Modules, our advance traffic shaping, and traffic steering capabilities, as well as continuing with our Traffix Solution set to our Diameter solutions [inaudible] market.

Jess Lubert - Well Fargo Security

Would you expect the Telco business to grow faster than the Enterprise business in fiscal 2013?

John McAdam – President and CEO

Possibly, and we’ve had this question so many times over the last couple of years. I think you’ll see quarters where it’s more lumpy than others. And if it’s lumpy on the high side, clearly you know, we’ll see it pick up a little bit. And certainly it’s a key [inaudible] we’ve got. You know, when we look at the products we’re bringing to market, especially in the software side of things with the application firewall and with RAM and with Carrier grade NAT, and Diameter, there’s more of an array of products, but there is going to be some lumpiness. So, I think over time yes, but I would like to talk about that in the next two or three quarters.

Andy Reinland –EVP and CFO

Yes, one additional comment Jess. We’re going to be at Barcelona obviously a mobile well congress, and really rolling out these solution sets broadly. And around three key tenets: One is optimization of the carriers networks. The second is really around the modernization, so they can monetize additional service offerings, and the third is around security. Security is becoming a very, very important topic for all of the mobile operators out there. So, we have some interesting solutions coming out and look forward to sharing those with you.

Jess Lubert - Well Fargo Security

Thanks guys.

Operator

Thank you. Mark Sue from RBC Capital Markets, your line is open.

Mark Sue - RBC Capital Markets

Thank you gentlemen. I was just wondering on product transition. Can you think any customers might have caused the head of the new product launch? And just any thoughts on [inaudible] and some of your lower end products that so much more performance for the price than some of your mid-ranged products from the past?

John McAdam – President and CEO

Yes on the potential [inaudible] it’s so hard to really, you know put numbers around that. You may remember Mark at the [inaudible] Day we did point out where we saw one or two [inaudible] was used as an example. We haven’t seen a lot of that anecdotally to be fair. But it’s a really difficult thing to judge, you know, because the customer may not tell you that they are waiting. Because we have been fairly public over these. So, we will see. I mean, we think we’re going to see a very good reaction given what happened with the 42 hundred, and given the fact that, you know they can run on solar or in the previous [inaudible] so they can move quite quickly.

But I wouldn’t like to make a big statement about it, because it wasn’t obvious to – what was the other?

Andy Reinland –EVP and CFO

In terms of the performance, you’re asking about performance and the impact of low end to the mid-range. I mean, one thing that we think about with these platforms is that we increased performance also to increase the ability of the platforms to run the modules. And so, we wanted to do that while byproduct of that issue increased throughput and transactional throughput as well. So that’s part of the equation that we look at as part of this.

Mark Sue – RBC Capital Markets

Got it. And then generally on security, it seems when I look at your competitors, Cisco and Juniper, the security market share seems to have stabilized. Is it getting incrementally harder for F5 to gain share in security or are you now – and are you now seeing a different class of competitors?

Manny Rivelo – EVP, Security and Strategic Solutions

Hey, Mark. This is Manny. Let me just take that, so in general no, it’s not getting incrementally harder. Obviously the competition is aggressive, and as we enter the market they’re going to continue to target not only themselves, but also us. But what we’re seeing is, we’re seeing a new set of buying patterns are developing. And there’s three predominant use cases that we’re positioning our solutions to, and this is the solution that John talked about around out application delivery firewall.

The three use cases are mobile and fixed operators, and that is really all about performance and massive expansion, and throughput connections per second, things of that nature which our platforms are well suited to accommodate.

The second is really what I would refer to as the Enterprise and service provider, IT or internet data center. This is the protection of your dub, dub, dub applications and being able to defend those from [inaudible] attacks all the way to application vulnerabilities.

And the third thing we’re seeing, which is really why we’ve expanded so aggressively with our virtual addition, is being able to protect applications as you spin them out to the cloud. Meaning the hybrid environment if you will.

So, in those three use cases, we feel very comfortable with our solution set. We’re well positioned, great performance, great scalability, and we bring unique value. So, we think we’re in a prime position to continue to grow there in the market.

Mark Sue – RBC Capital Markets

That’s helpful. Thanks Manny, thanks gentlemen.

Operator

Thank you. Jason Noland from Robert W. Baird, your line is open.

Jason Noland - Robert W. Baird

Great, thank you. Just to step back John, a question on your comment about challenging macros. Is that a reference to Federal and Japan, or were you seeing smaller deal sizes or delayed deals in US Enterprise in Europe.

John McAdam – President and CEO

It was more of a reaction to Federal and Japan because we did see improvement in the other regions, especially in North America actually. However, we could say – in previous calls we talked about the million dollar plus deals being less than we’ve previously seen. We still saw that trend last quarter, so in in fact to be more specific, we actually saw 500 to a million dollar deals up quite significantly. But the million dollar plus ones [inaudible] to similar levels to Q4 and Q3, so we’re not dismissing that macro, because we definitely believe that is a macro scenario. Where instead of spending 1.5 million, you spend 900,000, and it really was quite significant.

Jason Noland - Robert W. Baird

So some of the upside was pushed out into this year possibly?

John McAdam – President and CEO

Well possibly, and that’s an interesting question, because we are seeing the pipeline and this is obviously linked to the forecast, but we are seeing the pipeline of million dollar deals increasing. So, that’s a good sign, and we’ll see what happens, but you know, at the end of the day we’ll measure it next quarter.

Jason Noland - Robert W. Baird

Okay, last question from me on the Cisco/ACE replacement opportunity. What’s the sense of urgency out there? Are people in a hurry here, or are they just kind of sitting back waiting to see what Cisco is going to do?

John McAdam – President and CEO

I think it’s pretty reasonable. I mean, I can’t remember the last time we’ve won three Fortune 50 brand new projects in a while. I also think there’s no doubt it is linked to our new business being up more than it normally is. It’s 46%, it’s usually right about the 40%. And then we did the North America, - Americas I should say, QVR at the beginning of this week and there was a lot of discussion from all the management team of the ACE opportunities. I know we’re hearing the same, and from the customers prospective, -yes I mean I guess it depends on what the application is they’re running. But if it’s mission critical, I think if I was them, I would have some options.

Jason Noland - Robert W. Baird

Thanks, John.

Operator

Thank you. Alex Kurtz, Sterne Agee, your line is open.

Alex Kurtz – Sterne Agee

Yeah, thanks for taking the questions, guys. Andy, could you take us through gross margin in a little more detail this quarter. It looked like obviously very strong product margins but if I look at your guidance, it implies it being down sequentially. Can you just take us through that a little bit?

Andy Reinland – EVP, CFO

Yeah. The key driver that led us to really what is now an all-time high for us on product margin was a very strong quarter in software sales. So not only software modules, but sales of our virtual addition. So we see that as good.

Part of the guidance – I look at the guidance as more flattish. We do think we’ll see some pullback on the service side a little bit as we continue to hire there. Obviously, customer satisfaction is most important to us and we want to keep hiring in that area. So I see it as flattish is how I’d characterize it.

Alex Kurtz – Sterne Agee

Okay, and John, just on the U.S. Federal post or close of the quarter, have any of those deals or some of the pipeline that was getting stuck at the end of the quarter, have you seen any improvement or is it the challenges continuing here?

John McAdam – President, CEO

Normally we wouldn’t comment on that. We get asked that type of thing a lot. I mean, it’s not something that – yeah, there’s no big trend there that you should think about. We’re still being conservative on the Federal because it really was doing – especially sales bookings were doing quite substantially last quarter from the budget flush that happened in September.

Alex Kurtz – Sterne Agee

Okay. Thanks, guys.

Operator

Rod Hall from JP Morgan, your line is open.

Rod Hall – JP Morgan

Yeah, hi, guys. Thanks for taking my questions. So I just want to paraphrase what you said so far and then I had one more questions and I just wanted to make sure that this is accurate. So it sounds like you experienced Federal weakness in the quarter just [inaudible], the quarter you’re guiding, the slight revenue you’re guiding for, is that continuing Federal, underline Federal caution or are you adding to that from the Enterprise weakness? So I guess there’s a little bit of a question burred in that. And then as you look to this recovery late in the year, can you talk to us about what the main driver there is? It sounds like you think maybe the Telecom business is the primary driver for that road of recovery. And if you could quantify where you get to on growth rate as well, you know, do you get back to like a mid-teens type of growth rate by the end of the year? You know, any help you can give us there would be good.

John McAdam – President, CEO

My apologizes for starting off negative, but on the final bit, we’re not going to give the growth to you ever. We’re going to take that a quarter at a time. We do think, as Andy said, we believe that in the second half total revenue growth will excel but that’s the best that we’re saying there, Rod.

On the forecast, yeah, we’re being cautious in Japan and Federal. I think we have to be there. In terms of the Teleco as being the most exciting – it’s certainly up there. It’s very, very exciting, Manny talked about that, the wide range of portfolio now that we can sell into these Telco’s that are pretty unique in the whole mode of areas. But you know, the ACE opportunity is massive for us. We think the product refresh, if it follows any historical trends what so ever, will be significant as well. And then the rest of the [inaudible]. So there’s a bunch of stuff, you know, most of which, by the way, helps Telco, but also helps [inaudible].

Rod Hall – JP Morgan

John, it kind of sounds like you guys are – regardless of what happened in the macro, you’re kind of positioned to grow in the second half of the year is the way you feel. Is that the right way to think about it?

John McAdam – President, CEO

From a product revenue growth acceleration perspective?

Rod Hall – JP Morgan

Right.

John McAdam – President, CEO

Yes, that’s correct. That’s how we feel.

Rod Hall – JP Morgan

Yeah. And then I just – one last little thing is all. On SDN, you know, you’ve made some comments about how you’re positioned well to be integrated in the SDN. It does feel like, though, strategically you’re moving to providing [inaudible] services, the wider array of them. But if you’re not in control of the market you potentially are out of strategic disadvantage. I just wondered, you know, you guys are pretty good in software, would you ever consider moving into that controller market?

Karl Triebes – EVP, Product Development, CTO

Well, our goal. Hi, this is Karl, by the way. With SDN, I mean, the big IP platform is inheritably designed to enable SDN environments. And we’re not trying to move into the switching business with that. What that means for us is that we work with an eco-system of partners that allows our customers to implement these broad SDN-enabled applications and networks. So we’re partnered with – you know, we talked about at VM World, we demonstrated with VM Ware a service orchestration solution per V Cloud. We have open-flow partnerships. There was a press release that went out with, I think it was Big Switch that released a press release that talked about our interoperability with them. Our platform is designed to work with these different application, these different control protocols and provide that application knowledge and really help optimize, manage, secure, do whatever, but focus on the applications as well.

Rod Hall – JP Morgan

Good. Okay. Thanks a lot, guys.

Operator

Thank you. Simon Leopold from Raymond James, your line is open.

Simon Leopold – Raymond James

Great. Thank you very much. I wanted to follow up on a couple things that were touched on earlier. One is in terms of – I’d like to get a better understanding of the Telco vertical use cases. Let me share my understanding of how they’ve been used is largely in the Telco data center, historically, and not really in the network and I think you’ve talked a lot in the past about opportunities and applications in the network. Could we get really a better understanding of the timeline of your expectations of let’s say greater network participation in the Telco vertical?

Manny Rivelo – EVP, Security and Strategic Solutions

Yeah, so obviously, this is Manny, Simon. So obviously, the data center space is something that you mentioned you’re familiar with so I won’t go into that, but obviously there’s a litany of solutions inside the data center space that we provide. In the core network where our primary use case is, is really in [inaudible] core, sitting inside the [inaudible] core, analysing the traffic flow and being able to understand the application, the subscriber traffic flow. And based on that, be able to apply a set of network services to monetize if you will or to optimize that.

So let me give you an example of that. A typical example of that would be to understand who the subscriber is, what application they’re trying to access. If that application tends to be a video application, we may re-steer that traffic to a cacheting engine as an example. Or if it’s a non-premium customer, we may rate limit that traffics so that they don’t consume all the RAM bandwidth. At the same time, depending on what the flows are, we may want to provide security services or carrier-grade NAT services. So what we’re doing is, by understanding the application of the subscriber, we’re able to implement a set of services inside that infrastructure, consolidating that, reducing the cost to the operator at the same time giving them monetization strategies.

In addition to that, we’re moving very aggressively into the LTE space and we’re looking at the growth in 4G networks and how 4G networks also integrate with 3G networks and roaming across 4G networks. So the result of that, our Traffix acquisition that happened now approximately a year ago is something that we’re aggressively pursuing with all of the mobile operators as we move out there. So that footprint is also active, very active right now and we’ve seen some material wins over the last couple of quarters so we’ll continue to engage in that.

So those are two predominate uses cases above and beyond the traditional, if you will, data center solutions that we offer.

Simon Leopold – Raymond James

And have any of these use cases that you just described contributed to revenue yet or are they still on the come?

Manny Rivelo – EVP, Security and Strategic Solutions

No, they are. They’re attributing to revenue and as a matter of fact, a lot of the new modules we’ve introduced over the course of the – or we’re introducing here in the next couple of week, were being implemented in our platforms through iRules, right, because we have an open data plane and we allow our customers to program to that.

So the net of it is that we’ve been monetizing this through the classic platform for numerous years. Now that we’re doing is, we’re exposing that through our [inaudible], making it easier for the operators to manage this environment, which is really what they’re looking for. They’re looking for visibility and exposure and monitoring capabilities to be exposed natively in the product without it having to be programed if you will.

Simon Leopold – Raymond James

Great. That’s helpful. And then the second thing I wanted to ask about was, you talked about wins from displacement of ACE products. I’m just wondering two aspects of that. One is if you could characterize your win rate given that your competitors are also trying to exploit the same opportunity and displace ACE? And the second part of that is have you had to sacrifice any margin or pricing as incentives for those trade ins, whether there was any kind of trade off for those wins? Thank you.

John McAdams – President, CEO

Dan might want to comment on this as well, but we said – as I say, I mentioned we saw it through the North America – I keep saying that – the Americas. I don’t want to forget Canada and Latin America. The Americas [inaudible] on Monday and we have the better wins and I didn’t hear any losses. You know, you’re going to not win deals you don’t see, that happens. But the win rate seems to be incredibly high.

Dan Matte – EVP, Marketing and Business Development

No, we’re doing very, very well in the win rate and you know, we certainly have given incentives to our partners and certainly trade ins to the customers on, you know, to give, you know, bring the business in quicker and sooner to work. We’re not seeing any real losses to our competitors in the [inaudible] at this time.

Manny Rivelo – EVP, Seucrity and Strategic Solutions

And if I may add something, and this is Manny again. We’re not only seeing direct replacement if you will for server load balancing around ACE, but what we’re also seeing is a very rapidly evolving landscape around threats and vulnerabilities that are out there. So some of these decisions that customers are making are not just to replace the ACE functionality but they’re to bring new functionality into that environment, like IPv6, like protection for DDOS attacks, things that we natively do also in our platforms. So it’s not just an apples-for-apples replacement, it’s really upleveling their infrastructure and positioning for the future.

Simon Leopold – Raymond James

Great. Thanks for taking my questions.

John Eldridge – Director, IR

Angie, this is John Eldridge. We’re going to take two more questions and then wrap it up.

Operator

Thank you. Kent Schofield from Goldman Sachs, your line is open.

Kent Schofield – Goldman Sachs

Great. Thank you. To follow up on a couple of questions around software, you mentioned adding some performance features to the virtual additions. Can you talk a little bit about what those are and what those mean for your software business going forward? And then as a follow on as well to an earlier one, you mentioned some alternative approaches in the tech space. How does that software play of yours fit into hopefully addressing those alternative approaches?

Karl Triebes – EVP, Productc Development and CTO

Right, so hey, Kent, this is Karl. So with the VEs, we significantly enhanced performance so now we have 3-gigabyte versions pretty much straight across all the different hypervisor types where they can allow that. So that enabled customers now in the virtual environments to run it three times faster than previously. And then with regards to – you’re referring to these customers that presume to Dan’s comments earlier about some of these environments where they’ve changed the architecture, well, in those environments, what they’ve done is they’ve gone and started leveraging some newer technology around Java Script and some technology called Node. What they’re doing there was essentially with their own development teams, kind of writing their applications to inherently understand or be a part of that framework. With our newer – some of the newer functionality coming out in the big IPs, and this is just kind of a sampling of it, we have some new APIs, these rest- based APIs, both with our new big IQ management platform. Also, we have a next-generation version of iControl that’s a part of the big IP project itself that allows it to inherently adapt better to these different Java Script or these Node or these other type of web-based environments more easily than in the past. So they can automate, manage, orchestrate their applications much easier there.

So – and there’s a lot more behind that in terms of our road map of what we’re putting down with that, you know, we have some new stuff that for the cloud-based orchestration and et cetera. But we think we have a significant offering coming that, again, helps us in these different environments.

Kent Schofield – Goldman Sachs

Great. Thank you for the detail there.

Operator

Thank you. Our last question comes from Toa Leone from Merrill Lynch. Your line is open.

Toa Leone – Merrill Lynch

Hey. Thanks, guys. Just a quick question on the risk of – the risk in launching the products. When Cisco launched or refreshed their switches, all of their switches at the same time, they [inaudible], people bought the upgraded low-end instead of buying the high end. I’ve seen the same thing with similar companies, similar launches. What’s the risk that you see or what are you doing to mitigate the risk that when you launch so many new products together, people downgrade to a lower product, but upgraded?

John McAdam – President, CEO

Yeah, and remember, we’ve done this before, Toa. Obviously, I don’t want to sound complacent about the risk because you always have to look at that type of thing. However, our platform is fairly unique in its ability to add more and more services, typically through software modules and we’ve seen from the field, a [inaudible] for the ability to do more software modules at the entry level, more capabilities with DCMP, the [inaudible] multiprocessing where we can build more and more added value to the platforms and that tends to go way far and above the cannibalization effect. We feel pretty confident – when we look at the 4,200 sales we’ve had [inaudible], that’s the way it will go. There’s more – much more [inaudible] in the terms of cannibalization.

Toa Leone – Merrill Lynch

Okay. Thank you.

John Eldridge - Director, IR

All right, thank you very much for joining us and we look forward to talking with you all again in a couple of months from now.

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