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Executives

John McAdam - President and Chief Executive Officer

Andy Reinland - Senior Vice President and Chief Financial Officer

Dan Matte - Senior Vice President of Marketing and Business Development

Karl Triebes - Senior Vice President of Product Development and Chief Technical Officer

John Eldridge - Director of Investor Relations

Analysts

Troy Jensen - Piper Jaffray

John Marchetti - Cowen and Company

Mark Sue - RBC Capital Markets

Ittai Kidron - Oppenheimer & Company

Ehud Gelblum - JP Morgan

Brian Marshall - Broadpoint AmTech

Jeffrey Kvaal - Barclays Capital

Manjal - Jefferies

Jason Ader - William Blair

Richard Sherman - MKM Partners

Nikos Theodosopoulos - UBS

F5 Networks Inc. (FFIV) F2Q09 Earnings Call April 22, 2009 4:30 PM ET

Operator

Good afternoon and welcome to the F5 second quarter financial results conference call. At this time, all parties will be able to listen only until the question-and-answer portion. Also today’s conference is being recorded. If anyone has any objections, please disconnect at this time.

I would now like to turn the call over to Mr. John Eldridge, Director of Investor Relations. Thank you, sir. You may begin.

John Eldridge

Thank you, Sarah. Welcome everybody to our conference call for the second quarter of fiscal 2009. Speakers on today’s call are John McAdam, President and CEO and Andy Reinland, Senior VP and Chief Financial Officer. Other members of our executive team are also with us to answer questions following our 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, it’s available on our website www.f5.com. In addition, you can access an archive version of today’s live webcast in the Events Calendar page of our website through July 22. 4:30 PM today until midnight Pacific Time, April 23, you can also listen to a telephone replay at 866-463-4179 or 203-369-1387.

During today’s call, our discussion will contain forward-looking statements, including 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 and described in detail on our SEC filings. Please note 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. While the economy continued to exert pressure on revenue in Q2, the cost controls we implemented during the quarter enabled us to achieve our profitability objectives and demonstrate our continued commitment to meet or exceed our operating margin targets.

As we stated in our release in conference call on April 7, revenue for the second quarter of fiscal 2009 was 154.1 million, below our guided range of 157 million to 164 million. Despite the revenue shortfall, GAAP EPS of $0.24 per diluted share exceeded our target range of $0.19 to $0.21. Non-GAAP EPS was $0.38 per diluted share, which was at the high end of our guided range.

Product revenue of 94.1 million represented 61% of total revenue. Service revenue of 60 million accounted for 39%. Book-to-bill for the quarter was below one. North America accounted for 55% of total revenue; EMEA contributed 23%, APAC 13%, and Japan 9%.

Revenue from our core application delivery controller business was 143.5 million and accounted for 93% of total revenue. ARX revenue was 4.5 million, representing just under 3% of total revenue and revenue from FirePass was 6.1 million, slightly under 4%.

During Q2, Telco represented 26% of total revenue. The financial sector represented 22%, and technology accounted for 20%. U.S. Federal government was 3% of revenue, and total government accounted for 7%.

Avnet Technologies was our only greater than 10% distributor at 15.5% of total revenue. Our GAAP gross margin for the quarter was 76.3%. Excluding stock-based compensation of 1.3 million and a 1.3 million patent-related legal settlement, our non-GAAP gross margin was 77.9%.

One additional comment on gross margin; it’s worth noting that in Q2 we recorded a charge to product COGS of approximately $2.1 million to increase our inventory reserve related to components for our legacy platforms. This charge had an impact of approximately 225 basis points to both GAAP and non-GAAP product margin.

GAAP operating expenses of 94.3 million were below our guided range of 100 million to 105 million. Non-GAAP operating expenses, which exclude 12 million in stock-based compensation expense and 4.3 million of restructuring charges, were 78 million.

Our GAAP operating margin was 15.1%. Non-GAAP operating margin which excludes stock-based compensation expense, the restructuring charge, and the patent related legal settlement improved to 27.4%, reflecting a benefit related to the deductibility of stock-based compensation in one of our international theaters. Our GAAP effective tax rate was 25.3%; our non-GAAP effective tax rate was 31.7%.

On the balance sheet, we generated $39.2 million in cash flow from operations above our $35 million target for the quarter. We ended the quarter with $499 million in cash and investments after repurchasing approximately 1.3 million shares of our common stock for $27.4 million.

DSO improved to 53 days compared to 55 days in the prior quarter. Inventories at quarter end were 15 million, deferred revenue ended of the quarter at $160.5 million, an increase of $4.5 million from the prior quarter.

Capital expenditures for the quarter were $2.6 million, and depreciation and amortization expense was $7.7 million. Headcount at quarter end was approximately 1605 employees, a 6% reduction from the prior quarter.

Turning to our outlook, we remained very confident in the strength of our business model, our market position and our technology leadership. And while we are encouraged by improved closed rates in March and the first three weeks of April, visibility remains a challenge, and we feel it is prudent to provide a broad range of revenue guidance for the current quarter.

Accordingly, we have set a revenue target in the range of $148 million to $157 million for Q3. We expect GAAP gross margin in the 77% to 78% range, including approximately 1 million of stock based compensation expense. To achieve our operating margin targets, we will continue to closely manage discretionary spending, while ensuring adequate investment in programs to maintain our technology in market leadership.

During Q3, GAAP operating expenses are expected to be in the range of $89 million to $95 million, including appropriately $12.5 million of stock based compensation expense. Our GAAP EPS target is $0.22 to $0.25 per diluted share. Excluding stock based compensation expense, our non-GAAP EPS target is $0.35 to $0.38 per diluted share.

We are forecasting an effective tax rate of 34.5%, and we expect a non-GAAP effective tax rate of 31.5%. We estimate DSO’s will be in the mid 50’s. We expect inventory levels within a range of 14 million to 16 million, and we forecast cash flow from operations will be in excess of $45 million.

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

John McAdam

Thanks Andy and good afternoon everyone. As I mentioned on our prerelease conference call on April 7, we experienced a tough business environment during the second fiscal quarter.

We believe the shortfall in revenue, which occurred across all our major geographies was directly associated with the slowdown in the economy. We continue to enjoy a very strong competitive position in our core application to other the networking market, and we do not believe competition was a factor.

Despite the revenue shortfall, I am very pleased that we produced solid operating profits and in particular delivered a non-GAAP operating margin above 27%. We also saw continued strength in cash from operations ending the quarter with almost $0.5 billion in cash and investment with new debt and that’s after repurchasing over $27 million worth of a common stock during the quarter.

Our services business continues to deliver solid sequential and year-over-year growth with another increase in the deferred revenue. I was also pleased to see a sequential increase in our file virtualization business in Q2. Our ARX file virtualization products offer our customers a very attractive ROI by optimizing the file based storage environment and significantly reducing their capital spending requirements and on going operating costs of managing the storage architectures.

As we documented in our recent press release, one of our customers was able to reduce anticipated spending on disc capacity by as much as 50% to 80%. And in an independent survey by TechValidate over half a ARX customers reported a pay back of 12 months or less.

We suspect our core ADC business of product refresh initiatives are very much on track. We are seeing good traction with the new BIG-IP 6900 system and we continue to be pleased with the customer acceptance of an entry level product the BIG-IP 1600 and 3600. Our top end VIPRION product continues to be very successful, especially with high traffic throughputs required, including the service provider market for mobile Internet traffic continues to grow dramatically and with large Internet-based applications, such as social networking.

Earlier this month, we reached a significant milestone with the introduction of the BIG-IP 8900, a new high-end appliance as well as TMOS version 10, a landmark release supporting F5’s vision of unified application and data delivery services.

TMOS version 10 includes over a 130 new features and is a more significant software release that F5 has brought to the market since our original TMOS application release in September 2004.

TMOS version 10 redefines our application services, storage, and network resources are aligned and managed that provides an agile framework to integrated emerging dynamic computing models, such as virtualization, cloud computing, and software-as-a-service without having to completely re-architect existing systems.

The implementation of V10 can drive down cost by consolidating the application delivery infrastructure on a single platform, as well as providing the benefits of content and context awareness of applications running in the data center. We believe V10 will be a major differentiator for F5, as next generation data centers continue to evolve in large enterprises and service providers.

As far as the company outlook is concerned, we continue to have limited visibility into future business and economic conditions. The weakness in the global economy is clearly making it difficult to forecast business even in the near term.

Last quarter we experienced relatively strong bookings in the month of January, a steep decline in February and although business did pick in March, it was not enough to recover from the February shortfall. This quarter has started relatively well, but it would be premature to make any major assumptions given the experiences of the last couple of quarters.

Having said that, we expect growth once again in our services business, and we remain confident in the strength of our market position and our technology leadership, which we now believe now, extends across an entire product line.

We believe that over time TMOS version 10 will prove to be a significant driver of our business, as data centers continue to adopt virtualization functionality and cloud computing architectures.

As Andy stated earlier, we are committed to maintaining our operating margins above 25%, and in spite of the formidable challenges with the global economy, I continue to remain very positive about F5’s strong position in the market and our future opportunities.

We are leaders in the core ADC market. Our balance sheet and cash position are very strong. We enjoy significant technology leadership and our solutions continue to maintain a strategic position in the data center, providing key infrastructure to optimize applications in both existing and new next generation data centers.

I’d like to thank the entire F5 team and their partners for their efforts in Q2. And with that, we’ll hand the call over for Q&A.

Question-and-Answer-Session

Operator

(Operator Instructions) Our first question comes from Troy Jensen - Piper Jaffray.

Troy Jensen - Piper Jaffray

Andy, historically March quarter you’ve always had a book-to-bill below 1, something like six or the past seven years, followed up with a book-to-bill above 1 for the June quarter. So I’m just curious if your guidance is reflecting expectations bill backlog?

Andy Reinland

When we give guidance, it’s more with the expectation of flat backlog.

Troy Jensen - Piper Jaffray

Next for you Andy, the product gross margins down a little bit here sequentially, was that mix issue, pricing pressure or just absolute revenue levels?

Andy Reinland

No, as I said in my script, we actually took a charge this quarter that was pretty significant, so affected this by 225 basis points. And then you if you add into that another 140 basis points for the patent settlement I talked about, see where our gross margin on a GAAP basis was down about 76.3%. So, those should not reoccur and we’d expect to be back in our historical range next quarter.

Troy Jensen - Piper Jaffray

One for John, John can you think about when you guys did launch Buffalo Jump? Can you give us a sense for how long it took before the new operating system really started gaining momentum with customers?

John McAdam

I mean obviously that was in September 2004 and these are different times, so I’ll talk about 2004. I’m not implying it’s going to the same in 2009, I wish it was. It was a pretty aggressive pickup. I mean in the first quarter, that means quarter after by 25% of our business was the NME got about 50% of our business, but what it did was, it did, in our opinion actually increased the market as well because market grew at the same time and I’m sure that’s not a coincidence.

Now TMOS version 9 was a very big architecture changes. This isn’t quite as much an architecture change with 10. It’s is more of a feature, with a lot of features if I could say approximately about 150. So it’s not quite seemed product to market. I don’t want expectation thinking it’s equal, but it’s definitely going in our opinion gave us significant competitive advantage.

Operator

Our next question comes from John Marchetti - Cowen and Company.

John Marchetti - Cowen and Company

Thanks. Cowen and Company. Just a quick question for you, Andy, on the guidance, you talked obviously about a much larger range this quarter. Just curious about some of the puts and takes between sort of the 148 at the low end and kind of how you get to the different ends of that guidance between the 148 and 157? What has to go right, what has to go wrong to be on either side of that?

Andy Reinland

We talked about, when we go into establishing our guidance, spending a lot of time looking at our pipeline and our factored pipeline, which is the deals that we expect to close within the current quarter. And, we put a lot of focus on the close rates that we’ve seen in the declining trends there.

Over the last three quarters when we’ve had the misses that we’ve had, we said, we’ve applied conservatism to that, and yet again, we think we’ve done that, but we’ve also spend a lot more time going through deals with management, getting more deep with the sales management on specific deals, really, really diving down into setting the proper expectations for the quarter, and where it ended up was just with a wider range, when we have the lack of visibility that we do.

So, that put us a feeling that we needed to widen that range, took us down a little bit on the low end to the 148, but at the same time that 157 which would have some upside in it, some sequential growth. I was also looking at some deals that we see out there that could provide some good upside for us. So, that’s where we are at today, given the environment and led to that 9 million range.

John McAdam

Just to add to that. This is John. I mean, as Andy said visibility is tough, and he is talking of number of ways. I mean, if you look in the last couple of quarters, the patterns of business have been different. I mean, if you go back to the end of November, we were internally feeling very bullish. Our October and November business was extremely strong. It was up sequentially from the previous quarter, and then we saw a real slowdown at the very end of December.

The next quarter that one just finished was different, where we basically saw February has been the really improved area in terms of performance, and end marks started to take up as we have said. April is working good so far, but we’re not drawing any conclusions from that. So, the path in the business isn’t obvious either. It’s not that it’s all the back-end loaded, it’s not quite as simple as that.

John Marchetti - Cowen and Company

Just as a follow-up to that John. You know given the way the linearity did workout in the March quarter, do you get the sense of that February weakness was more from a delay of budgets getting approved by a lot of your customers or was it just everybody is being very, very careful, one eye on the economy, while the other ones on their network?

John McAdam

Well. I mean, I think they both are very similar. There’s no doubt in our mind that people were very, very wary in February. In the March it was actually pretty down as well. I think there is going to be some link there but, yeah I mean budget is just well being spent in February.

John Marchetti - Cowen and Company

Just a last follow-up on that. To get to that higher end of the guidance that you mentioned early, have you look at some of those deals out there? How many of that are sort of getting to that higher end of the range is predicated on maybe getting some early attraction with the TMOS Version 10 and the new BIG-IP?

John McAdam

I don’t think it’s as much directly related to that. It’s just some bigger deals that we have been working for a while that if everything works out right can give us some upside this quarter?

Operator

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

Mark Sue - RBC Capital Markets

Hi, it’s RBC Capital Markets. John, by all measure June is supposed to be a seasonally better quarter. And from your dialogue, there seems to be something more then just a macro. Are there structural things going on? Do you think the market is maybe saturated as applications, which can become somewhat discretionary? Any thoughts just from a high level that would be helpful, John.

John McAdam

No, I really don’t think. I think the value added we do, I could argue is increasing and that’s why we’re still doing the technology development with things like Version 10. So, we don’t feel that the market is saturating at all. What we’re seeing, what the fields are telling us. This is a perfect quarter of intense, deep-drawn what were the field and I don’t it could get anymore intense in what we’ve done over the last few weeks and with Mark Anderson and his team.

So, we’ve got pretty good view of what the fields are telling us and it’s pretty simple. Its deals being pushed or the customer actually saw he could get. Sometimes we’re talking about a fairly Senior CIOs, internally making a big argument to get spend that are just not happening, because the CFO and Procurement are delaying it. That’s been really much across the board. So, I don’t think there is anything sinister in terms of our market change right now, and I think its pure economy.

Mark Sue - RBC Capital Markets

If I just looking at the application delivery revenues mathematically John, we’re back to from a product point 2006 levels. Is there any thought kind of add to the revenue growth? How should we model ARX going forward? How should we look at the other segments going forward, any thought there, if just the ADC revenues are….?

John McAdam

Not really. Let me answer, I’m not going to give you the question tells or specifics, because we don’t give specific forecast by business. But, we’re very, very aware internally of the fact that to have another product line in a growth mode is critical to us. And ARX in particular, we believe is the one that we can and we’re doing a lot of stuff to make that happen.

Now, having said that, it’s a same old story with ARX in the short-term, which is nascent market, lot of evangelizing and the chances are that most organizations, certainly the Greenfield organization, that’s a great majority of them don’t have budgets that say to you, you’ve got this great ROI, but you need to prove it at the same time, which is a tough environment, but absolutely, we realize that ADC we still believe is absolutely a growth engine when the economy starts to pick up, but we want other one and ARX is definitely a candidate.

Mark Sue - RBC Capital Markets

And John just so, on ADC lastly, on the product base, just product, not services. What do you think that’s kind of probably at the bottom now?

John McAdam

I knew we got that question today. We are not going to call back and we are not going to call up because of visibility. I don’t want you to read anything negative into that, or positive, because visibility is a bit limited if you.

If you’d have asked me at the end of November for the December quarter and say things were, if we did update a quarter which we don’t, we’d have said things are extremely positive. March as I said was reasonable; April has started off reasonable, we’ll see.

Operator

Our next question comes from Ittai Kidron - Oppenheimer & Company.

Ittai Kidron - Oppenheimer & Company

Oppenheimer. Thanks. John, maybe first on Acopia, can you tell me how much has the work with Data Domain helped contribute to that business and how do you see that going forward?

John McAdam

We started off the partnership about four months ago, I think in reality is when it happened and we started off with a pretty good awareness. It was a bit slow last quarter, but the stuff that actually from a development perspective that we’re working on that we think will make a big difference and will pick up. So, we’ve got high hopes for it, but it was limited in terms of actual numbers last quarter.

Ittai Kidron - Oppenheimer & Company

And Andy, with regards to the service revenue, which again continues to grow very nicely, just by taking the midpoint of your guidance and your comment that you expect service revenue to grow again quarter-over-quarter, it implies that at the very least you’re expecting a decline possibly in product revenue again in the June quarter.

When is it that you think service revenues get hurt if product doesn’t reverse its course? How would you say is your level of visibility 12 months forward into that growth pattern of services right now versus what it was two quarters ago?

Andy Reinland

The visibility I would say is still similar but we just can’t ignore the reality of what we’ve seen with the product growth and obviously that’s going to affect the service growth over time. So given the assumption that product revenue doesn’t start to grow, we’ll see service revenue keep slowing. I think for the next two quarters definitely, it should still be fairly strong, not as strong as we saw last year but fairly strong.

Unidentified Company Representative

[Inaudible] the renewal business has been going very strong and we can see that continuing. The initial contract business is very much linked to the product, so we’ve obviously seen a bit of a decline on that compared to the direct correlation, but we can see going forward certainly couple of quarter, the growth is still there.

Ittai Kidron - Oppenheimer & Company

And the gross margin on it, can it hold up above the 80% which you seem to have achieved this quarter?

Andy Reinland

I think over the next couple of quarters, it’s probably going to stay in that level just giving our expense management. It’s mainly people, so yes.

Operator

Our next question comes from Ehud Gelblum – JP Morgan.

Ehud Gelblum – JP Morgan

Hi, JP Morgan. A couple of questions if I could. First of all, John because of the victory on was doing very well at telcos. It looks like tech was up relatively well. It was about 10% sequentially if I do the math right.

Can you give us a sense of roughly what percent of telco is we are putting on now? What percent of anything else is that putting on that you can maybe go to the verticals and give us a sense of to break down what percentage of each vertical possibly is the high end versus low end, the refresh versus the prior products? Just to give us a sense as to how the product portfolio cycling through these verticals?

John McAdam

Yes. I don’t have those numbers in front of me Ehud. But, certainly if you take VIPRION specifically and telcos is the best network to take about and typically the deals are pretty big. So, we are seeing more than $1 million transactions. We’ve got a pretty strong pipeline as well of fairly big opportunities, is mainly in the mobile space. Then tells us percentages, I just don’t have that with me.

Ehud Gelblum – JP Morgan

Okay. Was that a large driver of that vertical?

John McAdam

Yes.

Ehud Gelblum – JP Morgan

Without that the vertical may not have grown as much?

John McAdam

No, question. Yes. It was immaterial and telco wanted the Internet space vertical.

Ehud Gelblum – JP Morgan

On the services side, how much of the growth and services that allow two, three, four quarters, was in anticipation of version 10 coming out, because I believe if you have the right maintenance service contract version 10 is essentially free? And how much of the people actually renewed their subscription or perhaps moved to a higher level of services subscription to get wafers and 10 and then could that have an impact 1% than actually it is out in the field to the growth in that business?

John McAdam

No, it will have no impacts. Its old software upgrades, probably maintenance contract, whether you buy standard basic that was the poll or the premium, you would still get that upgrades. So there has been no change to the pattern because of the version 10.

Andy Reinland

And in fact, overall we haven’t seen a change to the pattern in terms of service renewals. As Julian said earlier, obviously the initial contracts go down, if we don’t sell the products, but in terms of renewals, we really haven’t seen a significant pattern change, so definitely no link to V10.

Ehud Gelblum – JP Morgan

Okay. And now the 8900 is out actually?

John McAdam

It is.

Ehud Gelblum – JP Morgan

Did you see any change to 8800 sales; do they fall off heavily in advance of that? Do you get the sense as to how the refresh is going from one side of products to the other?

John McAdam

The 8900 is literally just been released. So, we’re talking in the last couple of weeks. It’s interesting; we already have some opportunities in the funnel, where the 8900 is a great consolidator product. I think it’s about 40% price performance faster than 80 or 100.

Karl Triebes

This is Karl. It’s about 50% faster throughput wise and 2X faster on L7 transactions.

John McAdam

So it’s clearly going to have an effect in the 80 or 100 because the price performance is so significant, but it’s only a couple of weeks that it has been out.

Ehud Gelblum – JP Morgan

And what is the price versus the 8800?

Dan Matte

This is Dan. The price is as same as the 8800.

Ehud Gelblum – JP Morgan

So you get the higher performance. So, basically the 8800 just goes away. Was that part of the inventory right down that Andy that you were talking about?

Andy Reinland

Not that specifically. I mean, this was more for the transition across all the products, right. Since, we have done a refreshing going through the transition and in anticipation of a little bit slower transition, it’s actually gone better than we planned, and then combined with the economy just slowing down overall revenue, we ended up with component inventory that we wanted to put a bigger reserve against.

John McAdam

And remember we over the last nine months the 1600 and 3600 has similar metrics. They replaced the 15 and the 34, and they said yes. So there is no bigger change with the 8900.

Ehud Gelblum – JP Morgan

So, would you expect any further inventory write-downs of extra product or do you think you basically taken in and that’s all into account now?

Dan Matte

Well, given where I am today, all things being equal, I feel like we’ve got it covered.

Operator

Our next question comes from Brian Marshall - Broadpoint AmTech.

Brian Marshall - Broadpoint AmTech

Question with regards to the revenue levels, do you think you can support on top with your new workforce levels?

John McAdam

Well, first of all, if you look just at the very high level, we did reduction in workforce of 6%. Unfortunately, our year-over-year growth has been more than that. So I think we’re adequately covered.

Brian Marshall - Broadpoint AmTech

And so you think you can do revenues higher than 6%, obviously of a lower base?

John McAdam

Yes.

Brian Marshall - Broadpoint AmTech

And with regards to the integration of additional functionality and TMOS 10, is it safe to assume that over time FirePass and Acopia’s functionality will be merged, and so we’ll see one reported revenue line going forward?

Karl Triebes

Hi, this is Karl. The strategy always has been to take all vertical products and integrate these modules part of our TMOS suite of product base, suite of product. And I said this before in a road map session back in November that we’re trying and making FirePass or FirePass capabilities the technologies available as part of Version 10 in the future. So, you’ll be seeing that coming out.

Brian Marshall - Broadpoint AmTech

In terms of FirePass, I think it’s more and more integrated. We may take the decision to just have as part of the TMOS ADC that product suite that would make sense, and that’s consistent with what we’ve done. It’s very unlikely in the short-term you’ll see that with ARX.

Brian Marshall - Broadpoint AmTech

Okay, very good. One final question, any chance we can get any granularity on the high end mid-range and low end mix of BIG-IP or VIPRION?

Andy Reinland

I mean, from the level of VIPRION or you talking across the entire product line?

Brian Marshall - Broadpoint AmTech

Exactly.

Andy Reinland

What we have seen, and we go back a year, a year-and-half and when we brought out our new entry level products, we wanted that mixed shift to kind of go back to the entry level and provide us more opportunity that we felt we weren’t seeing there. And we do feel that’s happening, and we’re seeing that percentage go up. Beyond that we don’t break out specific percentages.

Brian Marshall - Broadpoint AmTech

And that’s a change from a couple of quarters ago, correct, when you didn’t see that penetration of that new entry level product?

Andy Reinland

Well, I think we more answered it at the time that it was still early days, so we didn’t want to put any absolutes out there, but we feel pretty confident in what we’re seeing now.

Operator

Our next question comes from Jeffrey Kvaal - Barclays Capital.

Jeffrey Kvaal - Barclays Capital

Yes, it’s Barclays Capital. Thanks very much. My question is about, obviously the past several quarters, service growth has been positive, while the product revenue has gone the other way. Could you talk about some of the drivers behind that and to what extent we would expect that to continue in the future? I worry that there will be a falloff in the service revenues commensurate to at least in the same general direction as product revenues.

John McAdam

There’s really four constituents. The first is, consulting and training, which is the smallest piece of it, but that has probably fallen off the furthest already because that’s the first discretionary spend most companies tuck. So I don’t think that’s going to fall any further than it has. An issue is a direct correlation with the product sale, so that we’ll follow along with that, and renewal has continued in a very strong way. Add to that during this year, we have stopped to support version 4 and have reduced some of those contracts, so I can see the growth of renewal continuing for some time.

Jeffrey Kvaal - Barclays Capital

Okay. So even though the product revenue was now below the run rate that it’s been for the past year or so we should still expect service revenues for several more quarters, or do you think that there is a large piece of a service opportunities fell into for the next several quarters?

John McAdam

I think definitely it’s a couple more quarters, it’s not a case of looking for a base, it’s not contracted because our attach rates are still very high and have continued to that rate, but it’s making sure we can buy every initial contract into renewals as time period goes on and we’ve been successful doing that over the last five years or so.

Operator

Our next question comes from Manjal - Jefferies.

Manjal - Jefferies

This is [Manjal] for Bill with Jefferies. Two questions, hi guys. One on the service business, are you able to increase prices on the service contract?

Andy Reinland

Are we able to increase the prices, I mean we could, but I think the prices positioned not only industry standard but with what our customer base expects for the maintenance they are getting, if I’m understanding your question correctly?

Manjal - Jefferies

Yes. I know because I was wondering in anticipation of version or is it like a fixed price of product sales?

Andy Reinland

Loosely there, it’s a rough percentage, for standard it’s roughly 15% and then premium services can add on top of that or if they go with below standard, but I think how it set up is right in line with industry standards.

Manjal - Jefferies

Does that apply to renewals too?

Andy Reinland

Yes. I mean, one of the benefits we have is that we don’t see much of a drop off in price on the renewals at all.

Manjal - Jefferies

Okay. And second question, if John is going to explain or Dan maybe your relationship with the Bytemobile. And I know you announced that in February, just if you could give us more color as to the relationship and what do you expect from it?

Dan Matte

Yes, absolutely, Bill. This is Dan. So, Bytemobile is the company that provide some mobile optimization solution that they sell to wireless carriers around the globe. They have incorporated our technology as part of their solution as a way to scale it, like better performance and high availability for us.

That’s essentially the nature of the relationships there and it’s been going quite well and the results that carriers are seeing worldwide are very, very positive and help them to squeeze a lot more capacity out of their existing networks. So it’s a win all the way around.

Manjal - Jefferies

Could you talk anything about, what kind of carrier international versus domestic and any sort of numbers or any quantitative measures?

Dan Matte

Yes, no metrics, but they are talking to and penetrating carriers around the globe.

Operator

Our next question comes from Jason Ader - William Blair.

Jason Ader - William Blair

It’s William Blair. Thank you. One question on the April booking commentary John, can you at least give us some sense of whether the bookings activity for the first three weeks of April were kind of in line with March, or I mean any kind of color on April bookings? Then you said, you were encouraged by it. Has it been momentum or is it sort of just kind of going at the same pace as March was?

John McAdam

We are in a more interest in doing comparisons as with the January month. So in other words, we have percentages for the first month and second month and then reasonably consistent even in these tough times and what we are seeing so far right. Remember, it’s three weeks, I think the three caveats already in this, I’m putting going, I don’t know other one. This is premature to make any decisions based on it, but so for example, if we are sitting here to deal with it, fairly significantly above January.

Jason Ader - William Blair

Then the second question for Andy. The discounting that you talked about on the pre-release, I actually didn’t hear you mentioned at this time, but it seems like that’s and from some of checks it does seem like discounting is picked not dramatically but definitely somewhat.

What I’m trying to figure out is how come your gross margins have held up as well as they have, I know that you have special charges this quarter, but kind of apples-to-apples it seems like gross margins have been quite strong with the last couple quarters. So, what is your like a positive force that’s outweighing the negative force of discounting?

Andy Reinland

Definitely, I mean person foremost with the product transition. The new platforms carry a better gross margin for us simply. So as we transition mark quickly, that adds to our product margin. At the same time, when we have talked about this a lot, I think both on the call and in different one-on-one meetings, we have our gross margin taskforce, a cross functional group.

We divide up those key variables that we think have the biggest impact on gross margin, whether its supply chain, design issues, discounting. All these different areas that we think can impact the margins, and this group has goals. We meet every quarter, we drive the top-line as much as we can to give us the flexibility in the business, and this product transition was a part of that. We continue to do that very actively and it’s giving us benefit.

Jason Ader - William Blair

Has there been any impact from the software modules on TMOS?

Andy Reinland

Definitely. That’s actually the software module percentage sales across the boxes as one of the key variables that we track in these meetings.

John McAdam

One of the things we’re excited about was the version 10, and I mentioned Version 10 is like with 130 features. We can not go through it in this call; it’s too complex for that. But, one of the issues is, first of all that you can run multiple modules in the product, which obviously allows just more software in the box.

We have always introduced licensing for try and buy, which frankly was pretty difficult to do previously, and we think that’s going to help. So, we think Version 10 with the features and the capability and performance should increase the number of software modules in total.

Jason Ader - William Blair

What are the most popular software modules at this point that you expect with the try and buy you’ll be able to pick more momentum?

John McAdam

Things like application security module is a really interesting one, because it doesn’t just do application security, it does lot of measurement capability. It gives you a lot of performance statistics to be able to actually try that rather than have a significant work associated with having to try is going to make big difference I think. WebAccelerator is another one with a browser based applications try it. Use WebAccelerator, and see if you get the performance, if you do buy it, that type of things.

Jason Ader - William Blair

Right, and then, last question for you and maybe Dan you can address this one. We did hear, I know you guys have talked about not being affected by competition, but we did hear from some of the work we did in March that some of the lower end load balancing solutions seem to have picked up some more interest than normal, and maybe it’s because of the economy, and people are more price sensitive, but any comment on some of the private companies or some of the smaller companies in the more generic load balancing market and the impact they might be having on your low end business?

John McAdam

The low end business has actually picked up. That’s mainly because of the competitiveness of the 16, 3600, on the positive side. Probably on the negative side, as related to the economy as well, where customers want to spend less and maybe pillion back a little bit. And we do see some competition there, but it’s not been significantly different over the last six, nine months.

Operator

Our next question comes from Richard Sherman - MKM Partners.

Richard Sherman - MKM Partners

Good afternoon it’s Richard Sherman, MKM Partners. A couple of questions here; first is, looking forward at the government opportunities that are starting to emerge, can you maybe talk about some of the work you’re doing and how you’re preparing to capitalize on some of these opportunities?

John McAdam

We’ve added some resources in that space. We had a tough quarter last quarter in Federal, just to be fairly open about it. It’s interesting, because we talked a lot about that in our reviews last week.

We have a very strong pipeline, and that pipeline is a qualified pipeline of deals we’ve effectively won. I think the word about I had internally was, we’re pregnant with opportunities that was the thing that stuck in my mind. But there has been a lot of delays in spending.

Richard Sherman - MKM Partners

Okay. So it sounds like a decent pipeline, maybe some slow uptick, but you’re also adding resources there. My other question was with the low end products out now; how long until that start to positively impact specifically your Japanese business?

John McAdam

Mark, your turn.

Mark Anderson

I’m sorry can you repeat the question.

John McAdam

So Japanese business their actual sort of numbers last quarter wasn’t that bad. They met within the guidance. Internally, the forecast for this current quarter is down from last quarter, but not appreciably which is good news, so I think we’re starting to see that already.

Richard Sherman - MKM Partners

This quarter is traditionally, seasonally a difficult quarter for us in Japan. So I think I would say that we are pleasantly surprised with the forecast for this quarter, and I think we have a really good team there. It seems like I have never done my numbers correct, but it seems like there is about 3% or 4% decline in the Japanese business.

If I remember two quarters ago or three quarter ago, I think there was some discussion about the Japanese market preferring low end products and stackable buy as you go, buy as you grow approach and then the 1600 and 3600 came out. I guess that’s what I’m trying to get is that it doesn’t seem like that’s really been a driver now for a recovery in the Japanese market whether being down again?

John McAdam

Well don’t forget the Japanese economy is a very efficient economy and it’s one that’s reacted pretty significantly to the world economy right now. So I think in general, capital spending in Japan is significantly down.

I’d be surprised if other vendors that didn’t report the same kind of thing. But, I think just in the last quarter we’ve seen a pretty good transition from older platforms to newer platforms, and I think in Japan in particular we see the certification process be a little longer than perhaps in other theaters.

So, I think we’ll continue to see adoption at the lower levels there, but at the same time we’ve morphed our go to market strategy in Japan where we are actually touching end users lot more than we were even just a year ago. So, we’ve seen some VIPRION business there. We are doing really well with banks and large telcos. So I think we’ll see a continued improvement there.

Operator

Thank you. Our next question comes from Nikos Theodosopoulos – USB.

Nikos Theodosopoulos - USB

Just a couple of quick questions. If I look at the verticals I guess with the other category that seemed to happen more significant sequential decline, is that just broad-based economic weakness, we do attribute it to some factor?

Andy Reinland

No. I think it is, you are absolutely spot on. If you look at the three verticals we have, they were pretty solid this quarter, telco, finance and technology which include the large Internet and they were pretty solid. But it’s Federal I mentioned earlier was weaker, and then I think just generally manufacturing was weaker, that type of area.

Nikos Theodosopoulos - USB

The 6% workforce reduction, was that broad-based as well, was it more specific areas in the company?

Andy Reinland

Actually, when you look at the percentage mix of employees across the company by function, we actually ended the quarter with exactly the same percentage mix that we started. So, it was very evenly distributed across the employee base.

Nikos Theodosopoulos - USB

Just two quick clarification questions; the ARX and FirePass revenue numbers you gave, are those product or combined product and service revenue number?

Andy Reinland

Combined.

Nikos Theodosopoulos - USB

Combine, okay. And I think you said there is but just the double check, the charges you talked about the pattern and inventory those are all flow through the product COGS, correct not anything on the services side?

Andy Reinland

Yes, they are product COGS. Okay, we are going to cut it off here. Thank you, Sarah. And thank you all for joining us today. Again, if you have any follow-up questions after the call, please direct them to me, and we’ll talk to you all next quarter.

Operator

Thank you. That does conclude today’s call. Thank you all for participating. You may disconnect at this time.

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Source: F5 Networks Inc. F2Q09 (Qtr End 03/31/09) Earnings Call Transcript
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