F5 Networks, Inc. F3Q08 (Qtr End 06/30/08) Earnings Call Transcript

 |  About: F5 Networks, Inc. (FFIV)
by: SA Transcripts


Welcome to the F5 third quarter financial results conference call. (Operator Instructions) I would now like to turn the call over to John Eldridge, Director of Investor Relations.

John Eldridge

Welcome to F5s conference call for the third quarter of fiscal 2008. Speakers on today’s call are John McAdam, President and CEO and Andy Reinland, Senior VP and Chief Financial Officer. John Rodriguez, Senior VP and Chief Accounting Officer, Mark Anderson, Senior VP of Worldwide Sales, Julian Eames, Senior VP of Business Operations in Global Services, Chris Lynch, Senior VP of Data Solutions, Dan Matte, Senior VP of Marketing and Karl Triebes, Senior VP of Product Development and CTO are also with us to answer questions following our prepared comments.

During Q&A today we’d ask that you limit yourself to two questions. That will ensure that everyone who’d like to ask a question has an opportunity to do so. If you have follow up questions that are not addressed on the call, please direct them to me afterwards at 206-272-6571.

If you don’t have a copy of today’s press release, it is available on our website, www.f5.com. In addition, you can access an archive version of today’s live webcast from the events calendar page of our website through October 22, from 4:30 pm today until 5:00pm Pacific Time, July 24 you can also listen to a telephone replay at 800-216-2086 or 402-220-3765.      .

During today’s call, our discussion will contain forward-looking statements which 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 and described in detail in our SEC filings. Please note that F5 has no duty to update any information presented in this call.

Now I will turn the call over to Andy Reinland.

Andrew Reinland

During Q3, solid top line results marked our 22nd consecutive quarter of sequential growth, driven by strong execution in our core business.

Revenue for the third quarter of fiscal 2008 was $165.6 million, above our guided range of $160 million to $162 million. GAAP EPS of $0.23 per diluted share was also above our guided range of $0.21 to $0.22. Excluding stock-based compensation expense, non-GAAP EPS of $0.37 per diluted share was also above guidance.

Product revenue of $114.8 million represented 69% of total revenue. Service revenue of $50.8 million accounted for 31%. Book to bill for the quarter was greater than one.

On a geographic basis, the Americas represented 58% of revenue, EMEA accounted for 21% and APAC was 13%. Japan contributed 7% of total revenue reflecting continued weakness, which was compounded by expected seasonal softness.

Revenue from our core application delivery networking business was $153 million and accounted for 92% of total revenue. Revenue from our ARX storage virtualization products was $5.1 million, down from $8.1 million in Q2, and accounted for 3% of total revenue. At $7.5 million, revenue from FirePass was flat with Q2 and represented just under 5% of total. During Q3, technology was our strongest vertical at 22% of total revenue. Telco and service providers represented 21%, and the finance sector was 20%. US federal was 4% and total government accounted for 9%.

During Q3 we had two greater than 10% distributors, AB-NET technologies at 14.2% and Ingram Micro at 10.8%.

Moving down the income statement, GAAP gross margin in Q3 was 76.9%. Excluding approximately $1.1 million of stock based compensation expense non-GAAP gross margin was 77.6%. GAAP operating expenses of $100.2 million were within our target range of $98 million to $101 million. This includes $13.8 million of stock comp expense.

GAAP operating margin was 16.4%. Non-GAAP operating margin, which excludes stock based compensation expense, was 25.4%. Our GAAP effective tax rate was 38.1%. Excluding stock based compensation expense, our non-GAAP effective tax rate was 34%.

On the balance sheet we ended the quarter with $447 million in cash and investments. Cash flow from operations was $55.8 million. Also during the quarter we repurchased $50 million of our common stock, representing approximately 1.8 million shares. Accounts receivable DSO ended the period at 53 days. Inventories at quarter end were $9.7 million. Deferred revenue increased 13% from the prior quarter to $139 million.

Capital expenditures for the quarter were $11.3 million and depreciation and amortization expense was $6 million. We ended the quarter with approximately 1,665 employees, essentially flat with Q2 as guided on the last call.

Moving on to the fourth quarter outlook, we are targeting Q4 revenue in the range of $172 million to $174 million. We expect GAAP gross margin in the 76% to 77% range, including approximately $1 million of stock based compensation expense. We anticipate operating expenses in the range of $108.3 million to $111.3 million. This includes approximately $15 million of stock based compensation expense and a one time $5.3 million charge related to office consolidation at our corporate headquarters.

We have entered into subleases ranging from three to five years for excess office space. We believe we have sufficient space to accommodate our growth at headquarters during this time frame. When we report our non-GAAP results for Q4 of 2008, we will exclude this charge due to the non-recurring nature of the expense.

Our GAAP EPS target is $0.19 to $0.20 per diluted share. Excluding both stock compensation and the non-recurring facility charge, our non-GAAP EPS target is $0.38 to $0.39 per diluted share. We are forecasting an effective tax rate of 38%. Excluding stock based compensation and the non-recurring facility charge, we expect a non-GAAP effective tax rate of 34%.

On the strength of the quarter just ended and our outlook on the business, we plan to increase our headcount by 40 to 60 employees in the current quarter.

We estimate DSOs will be in the mid 50 day range. We expect inventory levels within a range of $10 million to $12 million and we believe our cash flow from operations will be in excess of $50 million.

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

John McAdam

I was delighted with the F5 team’s performance in Q3. From a geographic perspective, we saw strong results in Americas, Asia Pacific and EMEA, where we continue to win million dollar plus wins on a global basis. As expected, business in Japan was down sequentially during the first quarter of Japan’s new financial year, and our US Federal business was up sequentially in Q3 but still remains below our internal targets.

Once again, our professional services business was very solid. We achieved our largest ever increase in our deferred revenue balance, which now sits at $139 million. Our core application delivery controller business was also very strong, driven by significant sales of our new chassis based product, VIPRION. As I mentioned in last quarter’s call, we believe there is no competitive alternative to VIPRION in the market today, and we expect VIPRION to be a key driver of our business in Q4 and throughout fiscal 2009.

Business from our ARX range of storage specialization products was down sequentially from last quarter, and below our internal target. The main reason for this was a precipitous drop in business on the financial vertical, where budgets for new projects are extremely tight. Regardless of the ROI benefits that would be obtained, the ARX business from the financial vertical was under $500,000 in Q3, down from over $5 million in Q1. This contrasts with business from our core application delivery controller products, which continues to be very strong in the financial vertical, and we expect strong demand to continue in Q4 and into 2009. On the positive side, sales of ARX outside the financial vertical continued to be strong in Q3 and we are very focused on continuing expansion of our ARX business by penetrating other verticals in Q4 and in fiscal 2009.

From a product and technology perspective, I feel very good about our competitive position in the marketplace. As I mentioned earlier, VIPRION has no real competition. The pipeline of VIPRION’s deals has grown steadily during last quarter, and interest level for its high performance capabilities and unique feature set continues to grow. We also have a comprehensive product line refresh on our road map, which we believe will maintain our technology leadership throughout next year and be a significant driver for continued growth in our business.

Today we issues a press release announcing a new entry level product – the BIG-IP 1600 and the BIG-IP 3600. These two products will replace our existing BIG-IP 1500 and 3400 products, and significantly increase our competitiveness at the low end of our product line. The new 1600 and 3600 products offer twice the performance of the existing products for approximately the same price. More importantly, we increased the functionality of these products significantly by adding new features including application firewall and web acceleration capabilities.

We believe we have created a significant buyer to entry with our TMOS architecture and the clustered multi processing application which we developed for VIPRION. This new architecture has been deployed in these new entry level products, which allows us to deliver the increased performance and additional functionality. We have already taken orders and shipped these new products on a limited availability basis, and we expect to see strong interest in the new products in this coming quarter and into fiscal 2009.

As I stated earlier, we have a comprehensive plan to refresh our entire BIG-IP product portfolio. The entry level products mark the first phase, and we expect to be introducing more products in the first half of fiscal 2009.

As far as future guidance is concerned Andy indicated that we see Q4 revenue guidance in the range of $172 million to $174 million. As we commented on last quarter, the key business drivers for our products remain in place. Internet traffic and unstructured stories continue to grow significantly and F5’s products provide our customers a very compelling and substantial return on the investment.

However, the economic situation makes for a conservative spending environment and we believe we are taking a suitably cautious but realistic view of our opportunity. Q4 is usually a very strong quarter for the company, and our pipeline moving into Q4 is very solid. We also enjoy a competitive leadership position with ARX, BIG-IP and VIPRION and we expect to increase this competitive leadership with new products like the new BIG-IP 1600 and 3600. I continue to remain very optimistic about the opportunities for F5 and I would like to close by once again thanking the F5 team and the partners for their efforts in Q3. And with that we will turn the call over for Q&A.

Question-and-Answer Session


(Operator Instructions) Your first question comes from Erik Suppiger - Signal Hill.

Erik Suppiger - Signal Hill

The ARX was weak in the financial sector, but it sounds like your BIG-IP did very well in the financial sector. Why the difference between those two?

John McAdam

Yes, we’re pretty sure we understand the difference. In fact, if you look at a number of the surveys that have been done on the financial sector in general spending with CIO, they come back loud and clear, but the financial sector is still spending what is absolutely key to their business and the internet, the projects that have already started, it’s growing because the internet traffic is growing, etc. etc.. Where it’s a new project of any kind, whether it’s technology or otherwise, they’re being very, very cautious in their spending. So our pipeline in ARX still remains quite good, but we definitely are seeing significant caution when it comes to a new project and, of course, ARX is a very niche market.


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

Mark Sue - RBC Capital Markets

Maybe just deal sizes, and also, John, if you could comment on sales cycles if that’s changing. And within deal sizes if you could normalize it, understanding VIPRION is a big part of that, and just your thoughts if the environment is improving, deteriorating or if it’s still status quo on the macro.

Andrew Reinland

In terms of deal sizes, we saw them right around $200,000 for the quarter, which is not up much from last quarter. Overall, we’re seeing a lot more million dollar deal sizes broadly in our business. We’ve seen that grow over the year, and compared to a year ago it’s increased significantly. So, that, combined with VIPRION. VIPRION didn’t really pull it up dramatically, so - $200,000.

John McAdam

And then in terms of the macro environment it’s pretty interesting, especially in our core ABC business, we had a solid quarter, rate run quarter. It really was pretty linear in nature and quite encouraging. The other thing is, we’ve mentioned in the past couple of quarters about the pipeline and how it had reduced. It actually went back to normal levels last quarter, which is interesting. I’m not going to make any call on that, in terms of what that really means. It could mean a number of things, obviously. We’re probably being more conservative in the way we factor the pipeline, just by definition. I think we’re also gaining now from the sales productivity, where we see the aging of our sales force improve. So, overall, we’re pretty happy with the way things went.


Your next question comes from Kim Watkins - JP Morgan.

Kimberly Watkins - JP Morgan

Just a quick follow up on a Acopia first, ARX. I know previously adjusted guidance of $25 million to $30 million for the fiscal year. I realize that Q3 was a little bit soft, so I wanted to hear if there’s any update on that. And then secondly, you called this out, but the service business continues to be really strong and you specifically mentioned professional services. I just wanted to dig into that a little bit more and wanted to see if you could talk about how large professional services is now and what’s really been driving the growth. Is it still renewals on maintenance, or primarily professional services at this point? Thank you.

John McAdam

As we look at the ARX business for the moment, we now believe it’s going to be on the original forecast that we gave after the acquisition, in between $25 million and $30 million. We had been saying previously, in the last couple quarters, we thought it was going to go above $30 million, but given last quarter’s slowdown in financial, between $25 million and $30 million. In terms of our service business, we are talking about our pure vanilla services business, maintenance contracts, general support, and the issue there is that we’re in a mission critical environment, we’re seeing great renewal rates, we’re seeing great attach rates, our deferred revenue is at the highest level it’s been, and we get pretty good visibility in that. So you should expect that to be remaining that strong for now as we move into 2009.


Your next question comes from Troy Jensen - Piper Jaffray.

Troy Jensen - Piper Jaffray

John, could you give us any framework around what BIG-IP revenues would be, low, single digit millions, high single digits, any insight would be helpful.

John McAdam

No, we don’t give out by individual product the numbers, but it was significant. It did definitely have a significant effect on the quarter. The actual order sizes, the general size of the overall deal, is clearly much bigger than the previous products. But we’re not giving out specific numbers.


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

Matt Robison – Pacific Growth Equity

First off, my usual DevCentral user question, and I know you had real tough comparison with the big jump in the March quarter, what was that? And then, curious, you went out with more of a campaign in the application ready network solutions and I’m curious if you’ve seen any incremental system integration partners, or any applications that really drove the numbers incrementally there.

Dan Matte

On the DevCentral side, we’re just over 29,000. We ended the quarter in terms of user count. And then looking on the ARN side, and what’s going on, I don’t think we picked up any new partners, specifically, but we did extend the programs we had. Some people, like with HP, definitely extended what we’re doing with them. We had issued a couple of press releases, actually, implementing things like SAP and Sharepoint in conjunction with web accelerator based on the strength of our application ready networking story and coming through partners as well. So, I think we continue to see improved traction on that front.


Your next question comes from Paul Mansky – Citigroup.

Paul Mansky - Citigroup

Couple questions on the 1600 and 3600. First and foremost, can you talk a little bit about the margin profile on those products relative to the Legacy solutions. Then I was hoping you could wrap a little bit more color around when in the quarter you anticipated volume ramp, and then possibly quantify, to the degree that you can, how much, if any, business you think slipped out of June into September in anticipation of the release.

Andrew Reinland

So, on the gross margin front, actually, these products are going to be right in line with the Legacy products and, as we’ve talked about a lot, when we enter design and pricing for our product line, we price to margin and were able to do that again with these two products, so really no change.

John McAdam

And in terms of business slipping, we really didn’t see any significant amount of that. The issue with that question is it’s pretty subjective because you don’t always know the answer, but our instincts are that we didn’t see any customers waiting any significant amount of time.


Your next question comes from Ken Muth - Robert Baird.

Ken Muth – Robert Baird

The EMEA region slowed down a little bit here sequentially. Are you seeing any slowdown and, if so, what countries would you highlight that you’re seeing a little bit of softness in?

John McAdam

EMEA we were very happy with. Their year over year growth has been fantastic, and the comparison was pretty tough. But they had a pretty solid quarter. Clearly, as we go into this Q4, EMEA tends to be somewhat flat to maybe slightly up given the seasonality, but that’s very normal so we’re very, very happy with that geography. We don’t see any issues – I think it’s going to keep growing aggressively year on year.


Your next question comes from Manny Recarey - Kaufman Brothers.

Manny Recarey – Kaufman Brothers

Could you just tell me where the employees are looking at hiring. Are those more in the sales and marketing or in any other areas? And then, with the product refresh that you’re looking at later in this year or calendar 2009, how do you feel about customers pulling back considering the economic environment, and waiting for the new products?

Andrew Reinland

Yes, so in terms of the hiring, Manny, I think it’s going to be a little bit weighted – maybe 40%ish to sales and sales support and then the rest of it you’ll see split between product development and service.

John McAdam

In terms of product refresh, this is something we’ve been doing very successfully for over six years, you could argue eight years, but certainly over six. And we’ve had massive product refreshes like Buffalo Jump, VIPRION, now the 1600 and 3600, and with those being complacent, we’re very confident that we will manage future products as well. So I think we’ve got that very much in control. I don’t think we’re going to see any significant slowdown. And that’s been the nature of the type of business we’re in.


Your next question comes from Rohit Chopra - Wedbush Morgan.

Rohit Chopra – Wedbush Morgan

Can you talk about the competitive environment, maybe some pricing, anything going on over there? And then also, if you can give some more color on VIPRION – maybe the make up of the customers, how many boxes they’re buying or something like that just to get a sense of what’s happening.

Dan Matte

As far as the competitive environment goes, relatively unchanged in terms of what’s going on with the players. The one thing I’d draw your attention to is just looking at market share statistics, we continue to pick up share against folks like Cisco and Citrix out there over the past couple quarters. So that’s good news. And, of course, the last information that was published by Gartner, for example, was for calendar Q1. So it’s a little bit dated and we’ll see the refresh of that. But in terms of pricing environment and other types of behaviors pretty consistent with what we’ve seen over the past couple of quarters?

John McAdam

And then with VIPRIO, we’ve mentioned this, large internet based companies, big dot com type of environment, there’s been a really good take up there in doing some really cool applications in that type of environment. Telco and especially in the mobile space as well, and also some enterprise, which I mentioned in the last call. But definitely, as we look over the next six months, we think Telco and big internet will continue to be the big market movers.


Your next question comes from Doug Ireland - JMP Securities.

Doug Ireland - JMP Securities

I was wondering, on the 1600 and 3600, if you’ve seen any change in tone at the low end and if you expect to gain market share down at that end.

John McAdam

We said this a couple time over the last nine months – if you split a product line between the entry level, which is effectively the 1500 and the 3400 now to be replaced with the 1600 and 3600, and then the 6400 and above, then we’re seeing growth in the order of high 30% year over year, sometimes in the 40% range, and we’ve been seeing a slowdown in the 1500/3400 range. We’re pretty convinced that one of the big issues there was that a lot of the feature sets and modules, etc. didn’t run in those products, and that’s why we changed it.

If we could see our entry level get into a scenario where the growth was flat, we’d be in a very, very good position. So, that’s the issue we’re trying to address with these new products, and we think we have a very good chance of doing that because not only now have we added the features that we’re missing, but as I said in my introduction, we’ve introduced a product that’s incredibly more reliable from an architectural point of view and is approximately double the performance for the same price.


Your next question comes from Ryan Hutchinson - Lazard.

Ryan Hutchinson - Lazard

It looks like with the Acopia disappointing, core revenue grew around 14% year over year, versus around 11% last quarter. What I’m trying to get at is, is it fair to assume that the March quarter was at the trough and we should expect an acceleration here moving forward with that core business?

John McAdam

We’re not going to describe it that way, but we’re very happy with the core growth. Internally we’ve been expecting our product in the core ADC gaining momentum. I think we’ve actually said that. I think it’s very linked to the fact that we introduced VIPRION in this fiscal quarter. I think the 1600 and the 3600 are going to help it even more. And I think the product refresh will do the same during the year.


Your next question comes from Brent Bracelin- Pacific Crest Securities.

Brent Bracelin – Pacific Crest Securities

First, on deferred revenue, obviously $23 million sequential spike here, highest in 5 years by a wide degree. What’s driving that? Is there some acceleration attached to maintenance contracts ahead of some of these new products? Any color on why you’re seeing an acceleration there?

Julian Eames

On the maintenance contracts, the standard contracts are growing at the rates we’ve seen in the last 2 or 3 years, and we’ve added additional services, particularly around RMA, over the course of the last 18 months and we’re seeing a great pick up on that as well. So we see that growth deferred over those two added together.

Brent Bracelin – Pacific Crest Securities

Looking at your service provider business, obviously it looks like that had a healthy rebound. Was that solely tied to VIPRION, or were there any other factors that drove the strong sequential rebound there in service provider?

John McAdam

VIPRION helped it. It wasn’t alone, because we did see some fairly big projects in the 8800 front as well, but we also did see some VIPRION deals.


Your next question comes from Saud Masud - UBS.

Saud Masud - UBS

I just wanted to get some color on where you’re investing, in terms of your headcount, where you’re compelled to put more feet on the street. Is there any particular vertical, geography? If you can provide some color on that. And then I just have a follow up on any opportunity you can share with us that could be created from this Brocade Foundry transaction. Is there anything that we should look forward to from that?

Mark Anderson

Sure, on the sales side – this is Mark, Saud, we talked about 40% of the hires we’re looking at this quarter coming from sales. We’re just going to invest where the growth is the greatest, and right now we see that in EMEA, North America and APAC. We still have account managers out there that call on a couple of countries, so there’s lots of opportunity to split territories and drive up sales productivity, and addressing a demand that we’re not getting to right now.

And regarding Brocade Foundry, we don’t see any short term effect on that acquisition. And by short term, I’d be surprised if it had any effect on our business during fiscal 2009. We really don’t compete much against either company. We do have some competition with ARX and Brocade’s product, but it’s pretty small. And we have pretty small competition with Foundry but again, they’re very, very small


Your last question comes from Scott Thompson - Banc of America Securities.

Scott Thompson – Banc of America Securities

We hit on VIPRION versus 880, is there any cannibalization there? If there is, anything you are doing to try to limit it.

John McAdam

Again, this is one of these things where there may be some, but it’s very, very natural. It’s the same when we introduced the 8800 with the 8400, which was introduced after the 6800. If you’re asking is there anything that we see that is different from what we expect, absolutely not. It’s been very natural. So, yes I think there’s probably some customers that ordered the VIPRION that may have, if we hadn’t produced VIPRION, would have ordered some 8800 possibly, but it’s not something that’s an issue in our business.


That was the last question.

John Eldridge

Thank you for joining us. Please give us a call if you have any follow up questions.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.


If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!