F5 Inc (FFIV) 2005 Q3 法說會逐字稿

Welcome to F5's third quarter financial results.

All parties will be on listen-only mode until the question and answer session.

Today's call is being recorded.

If you have any objections please disconnect.

I would now like to turn the call over to Mr. John Eldridge, Director of Investor Relations.

Sir, you may begin.

Thank you, [Sarah].

Thank you and welcome to our third quarter 2005 conference call.

The speakers on today's call are John McAdam, President and CEO; and Steve Coburn, Senior Vice President of Finance and Chief Financial Officer;

Julian Eames, Senior VP of Business Operations and Global Services;

Tom Hull, Senior VP of Worldwide Sales;

Dan Matte, Senior VP of Marketing;

Jeff Pancottine, Senior VP and General Manager of our security business unit; and Karl Triebes, Senior VP of Product Development and Chief Technology Officer, are also present and will be available to answer questions following our prepared comments.

Steve Coburn will begin today's call with a review of the financial results for the third quarter and our current outlook for the fourth quarter of fiscal 2005.

John McAdam will review the Company's operations during Q3 and add his perspective on the Company's goals and outlook for the current quarter.

We will then open the call up for questions.

If you don't have a copy of today's release, it's available on our website, www.F5.com.

In addition, an archived version of today’s live webcast will be accessible from the Events Calendar page of our website through October 25th.

From 4:30 p.m. today until 5:00 p.m.

Pacific time July 22nd, you can also listen to a telephone replay at 800-217-1707 or 402-220-3902.

The pass code for the replay is F5 Earnings.

Except for the historical information presented, our discussion today contains forward-looking statements which include words such as "believe," "anticipate," "expect," and "target."

These forward-looking statements involve risks and uncertainties that may cause the Company's actual results to differ materially from those expressed or implied by these statements.

Factors that may affect F5's 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.

If you have follow-up questions after today's call please direct them to me at 206-272-6571.

Now I would like to turn the call over to Steve Coburn.

Thank you, John.

In my comments today I will cover the results for the quarter just ended, our decision to begin expensing stock-based compensation effective July 1, and guidance for fiscal Q4.

For the third quarter of fiscal 2005 revenue of 73.1 million was above the 70 to 72 million target we set on our April 20 conference call.

EPS of $0.35 per diluted share was also above our guidance of $0.33 to $0.34.

Sequentially, revenue grew 5.3 million, or 8%, over the prior quarter.

Year over year revenue was up 28.8 million, or 65%.

North American revenue, which increased 25% over the prior quarter, represented 64% of total revenue with international accounting for 36%.

As expected, Japan was down sequentially, representing 8% of total revenue.

EMEA and APAC accounted for 18 and 10%, respectively.

Product revenue represented 78% of total mix and service revenue was 22%.

Security revenue, including approximately $600,000 of TrafficShield sales, was $7.6 million, or 10% of total revenue.

Sales of BIG-IP version 9, our Buffalo Jump product line, represented approximately 70% of both Traffic Management revenue and bookings.

During the quarter we had one greater than 10% distributor, Ingram Micro which accounted for 22.6% of total revenue.

The book-to-bill ratio for the quarter was greater than one.

Moving down the income statement.

Gross margin came in at 76.7%, comparable to prior periods and within our expected range.

Total operating expenses of 36.6 million were slightly above our targeted range of 35 to 36.5 million.

Our Q3 operating margin was 27%, up from 26% in the prior quarter and 16% in the third quarter a year ago.

Our tax rate for the quarter was approximately 35%.

On the balance sheet, accounts receivable DSO ended the period at 46 days.

Inventories came in at 2.3 million and represented approximately 30 turns on an annualized basis.

Cash flow from operations was 21.2 million, and we ended the quarter with 329 million in cash and investments.

Capital expenditures for the quarter were 3.3 million, and depreciation and amortization expense was 1.6 million.

We ended the quarter with approximately 730 full-time employees.

Next I would like to address the issue of expensing stock-based compensation, which will be included in our operating expenses going forward.

Effective July 1, the Company began issuing restricted stock units to employees instead of stock options.

In our proxy statement issued last February, we made a commitment to our shareholders that equity shares granted would not exceed 4% of the total number of shares we believe to be outstanding at fiscal year-end.

As many of you know, restricted stock grants must be expensed under both old and new rules regarding stock compensation.

Accordingly, we decided to begin expensing all stock-based compensation, including unvested stock option grants, effective July 1st, one quarter ahead of the October 1st date mandated by SFAS123-R.

For the fourth quarter, we anticipate recording a pre-tax charge for stock-based compensation of approximately 5.2 million, or $0.08 per share after tax.

For fiscal year 2006 we expect the pre-tax charge to be approximately 6 million per quarter, or 24 million for the full year.

This number includes current follow-on grants and a provision for grants to new employees but does not include any additional follow-on awards which may be granted in the fourth quarter of 2006.

Next year's stock award program will be reviewed in the context of future industry and marketplace practices which are currently in a state of flux.

We will update information on the 2006 program as appropriate.

Going forward we intend to report earnings on both a GAAP and pro forma basis to allow for comparison to prior quarters.

With that in mind here's our fourth quarter outlook.

We have set a revenue target of 76 to 78 million, which contemplates sequential growth in all geographic regions.

We expect gross margins will remain in a range of 76 to 77%.

Operating expenses are currently targeted at 42.2 to 43.7 million, including the stock-based compensation charges of 5.2 million discussed earlier.

Excluding these charges, we anticipate operating expenses in a range of 37 to 38.5 million.

We expect an effective tax rate of approximately 36% for the quarter, which should result in a annualized tax rate of 36% as well.

Our after tax EPS target, including the charge for stock-based compensation is $0.29 to $0.30 per diluted share.

Without the impact of the stock-based compensation charges, we believe EPS would be in a range of $0.37 to $0.38 per diluted share.

We estimate DSO's in the mid to upper 40-day range, and inventory levels are targeted within a range of 2.5 to 3.5 million.

We are currently forecasting cash flow from operations in excess of 25 million.

With that, I will turn the call over to John McAdam, who will discuss factors that contributed to our Q3 results and provide further details about our outlook for Q4.

Thanks, Steve, and good afternoon everyone.

Once again, I'm very happy with the overall performance in the quarter. 65% year over year revenue growth, 8% sequential growth, combined with further improvement in our operating margin to 27% demonstrates continued momentum in our business.

From a geographic perspective, we saw very solid revenue performance in EMEA led by strong sales in most of the key European geographies.

Asia Pacific revenue was approximately flat over Q2, but sales bookings showed good growth which bodes well for next quarter.

As expected, Japan was down sequentially and, in fact, was below our internal expectations.

We do, however, believe that the Japan revenue will increase sequentially as we move into Q4, and I will refer to that in my discussion on Q4 outlook toward the end of my talk.

U.S. federal business was also weak in the quarter as we continued to see budget constraints for federal projects.

Our services business showed continued strength, and I was particularly pleased with the relatively large increase in deferred revenue, which is a key driver for our service business in future quarters.

The star of the quarter was North America led by enterprise and service provider sales where we saw very strong revenue growth in all regions resulting in over 25% sequential growth and over 69% growth year over year.

When you consider the Q3 North American sequential growth followed a very solid Q2 performance, then it makes this result all the more impressive.

From a product sales perspective, as Steve mentioned, version 9 of our BIG-IP products, also known as "Buffalo Jump," showed continued momentum accounting for approximately 70% of Traffic Management revenue.

Overall, our security business also demonstrated healthy growth with revenue up approximately 16% and accounting for 10% of total revenue.

We started to see solid momentum with our TrafficShield application firewall product in the quarter.

Interest in the product continues to grow as does the prospect pipeline, and I believe the potential for TrafficShield will accelerate when the product is integrated with BIG-IP on our TM/OS operating system.

And more about that later.

As expected, the bulk of our security revenue came from the FirePass business, where we again closed several new enterprise wins.

As I said on the previous call, we see deal sizes increasing for FirePass and we see the prospect pipeline increasing at a healthy rate.

We also believe that we are in a very strong competitive position with the FirePass product; however, I still believe we can make more progress on our closure rate and length of sales cycles, particularly in North America where we continue to see customers looking for evaluations before purchasing.

Last I'll talk about our product road map and our competitive positioning.

Obviously, we will see market share numbers soon after last quarter's results are announced.

The most recent market share numbers published by Dell'Oro showed F5 getting almost 12% in the total Layer 4 to Layer 7 market, giving us 28% market share in that market.

We believe that the introduction of version 9 under TM/OS operating system was a significant contributor to these market share gains.

We believe TM/OS is a generation ahead of the competition in terms of performance, functionality, and its ability to consolidate and integrate application layer solutions on a single platform.

We delivered our first WAN optimization product in Q3 with the Application Accelerator 3400.

We also announced a unique WAN optimization feature set called TCP Express, which is an integral component of TM/OS.

TPC Express -- TCP Express, I should say, delivers up to 80% performance improvement to users and up to four times improvement in bandwidth efficiency.

I'm also happy to inform you that we recently entered into Beta phase with TrafficShield running as a software module on BIG-IP with TM/OS.

In addition, we have entered Beta phase with the GTM and Link Controller software modules running on TM/OS.

GTM is our global traffic management product previously known as 3DNS.

These are strong proof points on the power of the TM/OS architecture that we have been talking about in previous calls.

From a system architectural perspective, we continue to invest not only in the software road map but also in the platform technology to significantly increase performance and throughput.

We intend to hold an analyst's day in early November, which will be publicly webcast to go through our overall strategy and product road map in detail.

I also wanted to take a few minutes to talk about our approach to application optimization, application delivery, and application security.

It's now over four years since we introduced the concept of iControl with our ability to allow application developers access to the BIG-IP products through an open API, giving them the ability to exercise control over the network.

This continues to be very successful and has resulted in key partnerships with the large application players like Microsoft and Oracle.

We have extended this open API concept to our security products FirePass and TrafficShield.

The combination of iControl, our application solution center, the unique iRule capability we have in version 9 combined with our application development community website called "DevCentral" gives our customers and partners a world-class capability to develop, deploy, and secure business applications on their networks.

The number of users utilizing the DevCentral website has increased rapidly since we introduced version 9 with TM/OS and the new iRules functionality.

We now have approximately 4,500 registered members with a good global presence, and we have seen new members join at the rate of 20 to 30 a day.

We recently announced a DevCentral iRules contest for version 9.

We have already seen some amazing solutions come from the DevCentral community with some potential killer apps for optimizing and securing data center applications across the network.

We believe the depth of application fluency of our products is second to none and is a major barrier to entry for our competition.

Regarding Q4 outlook, Steve has talked about the sequential growth of our business continuing with an overall revenue target in the range of 76 to 78 million with a further increase in profitability.

We expect to see continued growth in the North America enterprise business as well as sequential growth in U.S. federal as budget is allocated before the fiscal year end.

We expect to see sequential growth in Japan, where we have the midpoint of Japan's financial year as well as some overall growth in the rest of Asia Pacific.

We are taking a relatively cautious outlook in EMEA given the potential seasonality effect of the summer months.

And we also expect to see continued growth in our services business given the increase in the Q3 deferred revenue backlog.

In summary, I believe that F5 continues to be well-positioned from a competitive viewpoint.

Clearly, the competitive of landscape is changing very quickly in the Layer 4 to Layer 7 marketplace, and we are not by any means complacent.

But I believe we have a sustainable position from a product viewpoint and a technology road map that can maintain our technology leadership position as we move into fiscal '06.

Once again, I would like to thank the entire F5 team and their partners for their efforts last quarter, and with that, we will hand the call over for Q&A.

[OPERATOR INSTRUCTIONS].

Your first question comes from Troy Jensen.

Your line is open and please state your company name.

Piper Jaffray.

Congrats on a nice quarter, guys.

Thank you.

Hey, a quick question.

I know you have been asked about competition all quarter, but could you maybe quantify, give us like a percentage of deals where you had competition against NetScaler, RedLine or FineGround ?

Wow.

I don't think we have those numbers available yet, Troy.

Yes, we didn't see any significant difference in the competitive landscape last quarter that's frankly worth noting.

Our win rate remains incredibly high, I think it was about 45% of our business was new business.

Some of that was against NetScale and RedLine, but we just don't have that data.

Okay.

You said previously though that you didn't bump into those three too frequently, correct?

And that's correct.

And that was a very similar scenario, the quarter just ending.

Citrix overlap, I don't know if you guys have stated publicly what percent of your channel overlaps, but I think they've stated something along the lines of 30%.

I'm just kind of curious to know what you guys think overlap is with Citrix.

We certainly don't have a number, but frankly, I'm looking around the room here and there's a lot of surprised looks on the faces, 30% seems pretty high to me.

And how about just -- last question.

Can you talk about the marketing?

It looks like it was up on a sequential and absolute basis, just as kind of -- get the word out with all the competition out there or any color on jump in sales in marketing would be helpful.

Sure, Troy, this is Dan Matte speaking.

Last quarter -- we have a couple of things that occur on a regular basis, and primarily N+I, Network plus Interop, two major shows going on for us, one in Las Vegas, and one in Japan.

So those two combine to drive things up in that quarter.

Perfect.

Good luck guys.

Thank you.

Your next question comes from William Becklean.

Please state your company name.

Yes, Oppenheimer and Company.

Can you hear me okay?

Yes.

I mean, everyone is well aware of the acquisitions that were made by Juniper, Cisco, and Citrix, of companies potentially in your market.

What's your assessment of those acquisitions?

How soon do you think those become more significant competitive threats to your business?

And did you see any delays in closing business as a result of that activity during the course of the quarter?

Okay.

Let me do the final one, because that's pretty easy and it's similar to Troy's question.

No, we didn't see any delays in activity based on that, and last quarter we didn't really see any change in the competitive landscape.

So I think these acquisitions, if they are going to have an effect, it is going to be from probably this coming quarter onwards that we'd see that.

You know, we feel really good about our product technology map and the product platform competitiveness at the moment.

Frankly, if this would have happened two years ago before we took two and a half years to build TM/OS, which we think is incredibly unique along with the iRule stuff, that's why I took some time to talk about it, I think it would be a different market.

But we really believe from a functionality point of view and a performance point of view we're in absolutely the best shape we have ever been in.

Obviously, competition, nobody ever wants competition, so you want to avoid that whenever possible and we would like to do that, but that's not happening.

But the other side of that coin is that it’s underwriting the market potential that we've got, and I can see a positive side to it where we actually get involved in more prospect situations.

Because I think the more we get involved in, the better chance we have got.

So yes, I mean, in a sense we welcome it, but we think we're in great shape.

Okay, thank you.

Your next question comes from Ehud Gelblum.

Your line is open and please state your company name.

Hi, thank you very much.

It's JP Morgan.

Couple questions if I could.

First of all, the end of last quarter, John, you were talking about seeing a little slippage in March that you said spilled into April and that April started off very strong.

On that note, can you just comment a little bit whether all that was received in April, and then how that flowed into the linearity that you saw throughout the quarter?

Yes, it was pretty amazing.

I haven't seen a similar effect, and I've frankly only seen that effect once before, which was last quarter, which was -- and I'm talking about Q2 now of course -- we had some big deals that got delayed that closed very quickly in the first few days of that quarter 3, so that happened.

But that had already happened in the call, which is why I drew attention to it.

And the reason I drew attention to it was it was so [inaudible] unique.

But we have been back to business as normal now.

So if you were to describe the linearity throughout the quarter, was it stronger in April because of that and then kind of tailed off, or was it pretty much kind of linear throughout the quarter or was it accelerating?

This is Steve Coburn.

With regard to linearity, really, the metric that we have been discussing in the past is really what percentage of our bookings is booked in the last month of the quarter.

And looking out over the last 18 to 24 months, we have been in the range of 40 to 50% of our business being booked in that last month of the quarter.

For the current quarter we are about in the midpoint of that range.

Okay.

And that was pretty much the same as last quarter, the quarter before that?

Last quarter we were at the lower end of this range; we're at the midpoint this quarter.

Thank you.

If I could ask just one or two more quick questions.

On margins, clearly gross margin was essentially flat with last quarter and you started leveraging the OpEx a little bit more.

As you -- how should we be looking at the operating margins going forward now?

Should we be modeling OpEx, trailing a little bit behind revenue growth so that there's a little bit more operating margin expansion to come?

And I guess that dovetails with other things like the software modules that I was going to ask next, in terms of are we on-track for that on gross margins.

So I guess the two questions are how are you -- what's your perspective today, in terms of where operating margins can get to over the next 3, 6, 9, 12 months, I guess, as you lever your OpEx?

And also, how does gross margin fit into that with the software module introductions later on this year?

Yes.

Again, Steve Coburn.

Quick one -- let's start with gross margins -- with regard to gross margins, our position is very similar to -- very consistent with previous quarters where we had said should we see the attach rates on the software modules increase or come strong, I think we would view that as an opportunity to have a lot of flexibility as a business; for example, lowering prices, increasing channel incentives, or letting product margins go up.

So I think at this point we wouldn't necessarily guide to gross margins going up under that scenario, but I think it would give us some flexibility to do some things as a business; that remains our position.

With regard to operating margin, we're not going to update our target longstanding target margin.

Just to remind people, it's been 20 to 30%.

We did say as we start reaching the upper limits of that guidance we will consider recalibrating that.

It's probably more appropriate for us to address that at the end of our fiscal year going into the next year, where we give some broad guidance to the upcoming year.

So it's likely we will probably address that issue on the next call.

But directionally, our belief is that the business model will continue to show improving operating margin and operating leverage from the places that we have seen it in the past will be the places we see it going forward, going up.

So we think that improvement will continue.

Okay.

And then finally, you admitted -- or said with Japan that Japan was below your internal estimates.

So I take it from that you have internal estimates for a lot of things.

You don't guide specifically to security revenues, but how did the 7.6 million compare to your internal estimate?

It was pretty close to the overall internal estimate.

It was below the goals that we give out at the sales level, but that's not an abnormal situation, so it was pretty close.

The one thing I did see and I was getting some hint was that I think with FirePass in particular, the execution over time will improve as we get better at not having to do as many evaluations.

But we're pretty pleased with the result.

Okay.

Thank you very much.

Thanks.

Your next question comes from Erik Suppiger.

Your line is open and please state your company name.

Erik Suppiger, Pacific Growth.

First off just with the restricted stock, John, can you comment how we -- or Steve maybe you could comment -- how should we think about that from a dilution perspective?

Okay.

I mean, I'll give you a quick answer and if you need more detail I'm sure Steve can do that.

The way we have looked at it, first of all just to put the thing in perspective again -- I know Steve talked about it -- but if you go back approximately two years, the shareholders didn't vote the proposal put forward by the board of directors on our stock option scheme.

Having said that, thankfully, this year the shareholders did approve our proposal.

That did leave us somewhat limited in terms of the pool that we had.

And we do believe that stock grants and stock options is really critical in our business for recruitment and retention, I guess that goes without saying.

What we did do initially then at the beginning of this year was we decided to wait until July because that's when we were expecting all companies to be making this announcement.

Now of course that date changed.

But what we decided to do was because we had actually not given an annual grant, if you like, for actually 15 months, we decided not to slip (ph) that date, and that's why we have done it.

And frankly, we'd be doing it next quarter anyway.

Now, to give you a direct answer to the dilution, we view -- what we have been doing in terms of our allocations of restricted stock, we have assumed a ratio of four to one in terms of restricted stock to options, which obviously has a better effect and a more favorable effect in dilution versus options.

Okay.

Then you are going to be granting some restricted stock you say, shortly, I guess, to employees; is that correct?

Yes, in the current quarter, Erik, we are granting restricted stock units.

Okay.

And in terms of expenses, so should we just assume the restricted stock really is just a replacement for the options that you used to grant and, therefore, we wouldn't assume there's a necessary element that you need to use more salary or dollar compensation in lieu of the options that you're not granting?

Yes, the restricted stock units are intended to replace the stock option grant programs that we previously had.

Okay.

On the SSL/VPN, a while ago you had announced a deal with NTT.

Any updates in terms of how that's progressing in Japan?

Yes, I mean it is progressing.

This is Tom Hull.

In Japan I'd say it's on track and moving as things typically do in Japan in a very conservative manner, but we're still -- the deal is still moving forward.

In addition, we are working on a several other opportunities.

So things are progressing very, very well.

Is it at a point where it's starting to ramp?

It is ramping, but slowly.

Okay.

Then last question, John, you mentioned you have been comfortable with the sales force transition.

Do you think that the sales force is at a point where you've made a lot of the changes in it and at this point it's going to be relatively stable in terms of the personnel and whatnot going forward?

I hope so is always the answer to that.

You want as little transition as possible.

I think I said this actually when we talked about Steve's announcement.

We have a new guy in North America, Mark Anderson, who is doing an absolutely sterling job and you can see that by the numbers.

And Mark has made some changes over the last nine months in fact; it fundamentally started in the East coast and we made some changes in the West coast.

And some of that has been voluntary and some has been involuntary, but we have really moved really quickly and built a very strong team now.

We always, every quarter, look at the sales force, look at effectiveness, and make personnel decisions.

We try to be as minimal as possible in that for productivity reasons and all sorts of other reasons.

But I think we're probably at a pretty stable point now, actually.

Very good.

Thank you.

Your next question comes from Samuel Wilson.

Your line is open and please state your company name.

JMP Securities.

Just a couple small questions.

I guess, first -- and I hate to do this with Steve in the room -- but do you have any update on the CFO search?

Yes, I knew the question was going to be asked so don't worry about it.

No, I don't have any specific update.

I think I said in the call when we talked about Steve's decision, I said that we would be doing -- we would have an external head hunter and they would be acting on that and looking externally.

We actually have some internal candidates as well.

We're right in the process of that, of staffing interviews and that.

I've actually done a couple of external interviews in the last 48 hours.

We're seeing a very good response to the opportunity.

So my target is to get this done and introduce whoever that person is at the next call.

I'm not going to compromise and we want to make the right decision.

Got it.

And then could you give us an update on the wireless portion, the cellar wireless, roughly what percentage of business that is and what the trend has been there recently?

Sure, Sam.

This is Dan Matte.

We report on the telco portion which is running about 18%.

We don't break the wireless out specifically as a portion of that, but it's a healthy bunch.

In terms of what's going on there, I think the biggest changes that we're seeing not only the SMS and MMS stuff that's been very solid over time, but also we're seeing more things that apply to a SIP, more voice-over-IP being deployed in the wireless area, and then also people thinking more about security as it applies to wireless, especially in the SSL space.

So what we do, obviously, is highly applicable to that, so I think those are some of the underlying factors that we're seeing that continue to influence business there.

And then one last question -- and this is kind of for anyone, but probably for Dan -- in general in iControl over the last few years you have seen a number of your iControl partners like Oracle, like BEA, etc., roll out applications that took advantage of iControl.

Is that kind of wave done now where all the partners in some form or fashion have iControl-enabled versions of their core software or are there still partners out there who are still catching up?

Oh, God, that is ongoing and probably will never end as people continue to roll out new iterations of their applications or even new versions of their software.

So we continue to see just tons of amazing things going on.

Microsoft is an example; their launch of the live communications server just recently, and that features deploying BIG-IP because of what we do with SIP and because of iControl, it's part of the best practices of rolling that application out.

So I would -- we're nowhere near done in terms of what's going on with those application vendors.

Got it, thanks a lot, gentlemen.

Thank you.

Your next question comes from Alex Henderson.

Your line is open and please state your company name.

Thanks.

Citigroup.

I've got a couple questions for you.

I just wanted to hit some of the rumors that have been running around.

You kind of touched on it already, but I just want to put them out there really crisp and clear.

Rumor one was lots of sales people leaving the firm unhappy about compensation structure.

Can you address what the [expletive] that rumor is about?

If you have had any sales people leaving, under what circumstances, what magnitude, so that we can clear up the air around it?

Yes, I don't have magnitudes for you, Alex, but basically -- we did have a reasonable amount of attrition in the West Coast where we had -- there's been a change of management and quite often that can happen when you have a change of management.

I'm not attributing it to that, but that can happen.

In terms of when anybody leaves the Company, a human resources group tend to do talks with them to find out the reasons for leaving, etc.

Compensation wasn't high up there on the list so I don't know where that rumor came from.

Part two of that was that management changed the compensation system during the most recent couple of periods, and because the Company has been doing so well they raised the bar on comp.

Can you talk about when you changed compensation?

We do it once a year and we didn't do it two quarters ago.

So that rumor is false.

So just to put that one to bed, do you change the compensation -- or you set the compensation at the beginning of each new year and it hasn't been changed in between?

That's right.

I mean, there may have been subtle changes I'm not even aware of -- and I'm looking at Tom Hull to see if there was anything -- but nothing of any significance.

Sometimes what we'll do is we will maybe say okay, we want to do an incentive, which is -- let's say software modules or something like that.

I think we did an incentive for partners with FirePass about two quarters ago, but there was absolutely nothing significant happened in the comp plans.

I don't know where that rumor has come from.

Great.

Well, put those to bed easily then.

Okay.

The second topic, AON, Cisco has announced its application-oriented networking, which obviously plays beautifully to your basic thesis but represents a change in their positioning in a way that could alter the equation with a lot of your partners, particularly your iControl partners.

Can you give us your assessment of a) what do you think of what they said; b) how does it impact you; and c) how does it impact the competitor or your partners?

Yes.

I'll pass this over to Dan to just give a very quick comment.

I actually mentioned the word fluency, application fluency in my presentation, and it wasn't by any accident.

We believe you need to be really fluent at the application level with your product, not just oriented.

And to understand that you need to look at the detail; you need to look at the detail of iControl, you need to look at the detail of the sophisticated iRules capability we've got, the work we've done with all the partners.

But I really believe that's our barrier to entry.

In a way it's good that they have done this, because I think it absolutely underlines that we have got the right strategy, but I think we have got a big leadership position in it.

Yes, absolutely, Alex.

This is Dan.

Totally, totally singing the same tune that we have been singing for quite some time, that injecting intelligence into the network is absolutely the right thing to do and really is the only logical way to better secure, optimize, and deliver the applications that are critical to business.

So when we look at AON, specifically, and some of the key differences in terms of how it's being approached by Cisco compared to what we're doing, that's really where our paths differ.

So with our approach, with iControl, we think being open is very important. iControl and having SOAP/XML and letting people, giving them free access to the system to be able to program things, integrate their applications with the network, we view as being critical as opposed to having to ask the vendor to go and add specific programming to support specific types of applications.

We also view the whole system as being more that just XML; web services certainly are very important going forward, but it's not the only protocol that lives out there.

We also don't believe that asking people to perform a multifaceted upgrade is really -- ultimately a viable thing to get people to do.

Anyway, we believe that there will be some hesitancy and resistance from the marketplace from that standpoint.

So when I look at all the things that make up AON, totally agree with the concept, totally agree with the direction and the stated goal of adding intelligence to the network in order to help the delivery of applications.

But I don't believe that Cisco really has changed their approach much from the islands of dysfunctionality that we've described over time in terms of the different approaches from the different groups and different product sets.

So the final question on the AON is to the extent that Cisco has announced an initiative that is -- almost lays on top of what you've been doing, in clarity saying that you have got the right approach, but actually doesn't have a product since it’s only a concept at this point.

Does that cause hesitation or does it cause acceleration in your business as customers say, "Ah, I can buy this today and I can buy it from these guys, and theirs works and it has better functionality than what Cisco is promising to have down the line."

We hope that a lot, obviously.

You guys can pay me five bucks for that question afterwards.

So can you address that?

It's probably the latter.

We have had minimal (ph) experience since the announcement and we certainly see no indication of partners or customers saying no, we want to wait until the end of this calendar year or 2006 to look at products that we have already got.

So I do believe it gives us a lot.

We don't have much --

Has it shifted the world from a missionary sell to a mainstream sell?

Oh, absolutely.

And I actually -- I believe application traffic management optimization, delivery, and security -- well, maybe not quite security -- is there as we move to that position, and I think that's why we've been seeing the strong growth.

Where we need to see that happening is on the securities side and that will come, but it will take a little bit longer.

Thank you.

Thanks.

Your next question comes from Ryan Hutchinson.

Your line is open and please state your company name.

WR Hambrecht.

Good afternoon, guys.

A couple questions here on the -- starting with the product road map.

I think, Dan, you indicated a couple quarters ago that you would be introducing a fairly big product announcement before Montreal.

Any update there and any update on Montreal as well, and then just a quick follow-up.

Hi.

This is Karl, I'll answer that question.

We do anticipate a new platform with some new, significantly enhanced ASIC technology showing up prior to Montreal.

Montreal itself we had targeted for I think Beta, as we stated out in early calendar year '06, but it looks like it will be some time later in the year; it won't be right at the beginning.

Does that mean back half of the year?

We expect it to be fiscal year '06, but it will be out closer towards the end than the beginning of the fiscal year.

Okay.

And as -- related to that in terms of the software modules here, any sense that you can guys can provide in terms of an uptake, any metrics that you guys are tracking of the BIG-IP add-on modules and then any expectations for additional add-on module announcements here in the next quarter or so?

Yes.

We've taken a decision not to give the detail on that yet.

I know it must be frustrating, but we still think it's quite early.

What we're -- we will make another decision come the end of this quarter as we move into fiscal '06, is that we start actually talking about it, especially when products like TrafficShield are available.

I think that's the gating (ph) item we're looking at.

So it has been increasing in volume and it has been increasing across the module set.

So that has been happening.

And it's a non-trivial amount as well; so it's not like it's a few hundred thousand dollars or anything like that.

But we've just decided not to give the specific numbers out yet until it's more -- it reaches some sort of maturity stage.

What about any color there in terms of which modules?

SSL, compression, and -- that's probably the two ones, yes?

The two biggest ones.

Is caching out there yet?

It's out there, but it's recent, it's more recent than the other modules so it's a smaller percentage.

Okay.

And then the government business, in the past you have given that as a percentage of total revenue, both government overall and then U.S. government.

Can you provide that, please?

Sure, absolutely, Ryan.

It’s Dan.

Overall it was 7% and for federal it was 4%.

4%.

Okay.

And of the ASGs -- my final one and I'll let it be here -- the TrafficShield revenues, the $600K, any part of that coming from the Sanctum acquisition?

This is Jeff.

We just started that -- the whole strategy of working with WatchFire and approaching the customers and we are right now in that process.

So not really?

No.

That happened during the quarter, not at the beginning of the quarter.

So minimal revenues from then?

From that relationship, yes.

From that portion, yes.

Okay, great.

Thank you.

Your next question comes from [Jung Chao].

Your line is open and please state your company name.

Lehman Brothers.

Thank you very much.

A couple questions.

In the past couple quarters you talked about some supply chain issues and shipping delays.

I was wondering could you give us an update whether or not the problem or the issues have been resolved in this past quarter?

Jung, this is Steve Coburn.

Yes, we made a lot of progress on our supply chain issues this quarter.

We didn't -- we saw some improvement that we were hoping to see, so we didn't see significant delays resulting from supply chain issues and it really returned to more normalized levels in terms of lead times.

Okay.

As a reminder, I think the issue back then was some shortage in components, right?

Yes, that's correct.

And we have done exhaustive work through all of the supply chain both here and overseas, and we've seen no delays at all in that area.

Okay, great.

My second question is on the deferred revenue, just was wondering, I saw your deferred revenue was up like $4.5 million.

Was that all to services or there was some product in it?

It was --the vast majority of it was services, virtually all of it.

Okay.

My last question is on the TCP Express and application accelerator.

I was wondering could you talk about the revenue contribution from these two products for the quarter you just finished and any expectation for the current quarter?

First of all TCP Express is actually included in TM/OS, so that's part of the BIG-IP revenue.

In terms of the application accelerators, it's too early.

We just announced the product and started training the sales force, so it's pretty small.

But we did take initial revenue.

We did take initial revenue, yes.

Okay.

Great, thanks guys.

Thanks.

Your next question comes from Brent Bracelin.

Your line is open and please state your company name.

Pacific Crest Securities.

Thank you.

John, I just want to dig into the demand drivers, specifically in North America, where you saw the unusual strength this quarter.

I think you certainly were expecting strength there, but was there a higher contribution security business that you saw in North America that helped?

Was there some new vertical that you guys were seeing, demand trend pop up, or are there some new applications that seem to be driving the growth there, specifically in North America?

Yes, because you're right, it was a very solid quarter and it followed a solid quarter before that as well and it was across the board.

So we saw Buffalo Jump in particular -- I mean if you were going to point to one thing, version 9 TM/OS, the core Traffic Management was the big driver, and it was the big driver into enterprise accounts and into service providers.

So core business stuff, but where we're getting more and more penetration -- where those projects are getting more and more sophisticated therefore require bigger solutions.

I mean, that was really it; pretty active.

And it was across the regions as well [inaudible].

Was there change in deal size at all, noticeably at all, in the quarter?

Generally there has been a change in deal sizes -- I'm giving you a global answer now, not just North America -- I think to the tune of about 10% in ASP, up.

Okay.

And then I should look at -- given the strength of North America, even with some of the concerns on some of the transition issues in the sales force, are you seeing more of a pull through the reseller channel or I know you were starting to broaden your reach with some security VARs.

Was that partially attributed to some of the strength in North America as well?

I think it's something to do with it.

I mean we've really -- Mark Anderson has installed a really strong management and sales team in North America, and I think we have been benefiting directly from that.

But we've also seen when we look at the partner statistics in terms of the number of deals that the partners give us, that continues to tick up, which is clearly a good metric for us.

But there's no one thing, Brent, that I can think of that we see specifically.

It's not like we had one big sales win or anything like that; it was very much across the board.

Is it too early to say there is somewhat of a broadening interest with all the M&A activity in the space in the specific product lines or are we too early?

I think it's too early.

I would love to see it, but I just think it's too early to see that.

Okay.

Great.

Then my last question really is more futures oriented on acquisitions -- you guys clearly don't certainly need some new technology to -- given you guys are driving 60%-plus growth here, but what is on the back burner on the acquisition front and are there any kind of interesting technologies a) that you can potentially talk about today or we will talk about at the analyst day in November?

Yes, we will talk more about this in the analyst day in November.

By the way, we'll be much more detailed on the product road map as well because we've made, we believe, some pretty good decisions.

Some of those decisions resulted in -- as Karl was saying -- Montreal moving out a little bit, but things have moved in because of that and we will talk about that in detail.

Now is not the time to do it.

In terms of acquisitions, our strategy hasn't changed, which is the acquisitions we tend to be interested in would be technology; typically would be small; it would fit into our core competence, in other words, either the application layer either optimization or security, and over time, and hopefully time wouldn't be long, it would integrate with TM/OS.

So it is, where that's the case, we are pretty interested in if we can accelerate our road map.

And some of these haven't changed.

We're always looking at the whole XML space as an example, and there's more we can do in one optimization, areas like that.

Okay, great, thank you.

Thanks.

[OPERATOR INSTRUCTIONS].

Your next question comes from --

Okay.

Oh --

I'm sorry, your next question comes from Tal Leani.

Your line is open.

Tal Leani, your line is open.

Hi, this is actually [Stan Koebler] for Tal Leani.

How are you guys doing?

Good, thanks.

I just have a question as far as the TrafficShield product, I remember last quarter you were talking about how it could be on-track to somewhere around 1.5 million to 2.5 million.

You had pretty good direction this quarter and it seems like you're reaching to the higher end of that range.

I'm wondering if you can give us an update if it can go somewhere beyond that?

No, we're going to stay there.

I mean, a) I didn't like having to change the range anyway so we're not going to make any changes to that but we did see some good traction.

And as I said in my script, that the prospect pipeline is building.

Now having said that, we're going to go through a transition period now where we're starting -- we've started Beta phase with TrafficShield customers, and that actually may -- I don't know -- but it may lead to some transition issues with it.

But the numbers, I think, that we have talked about are pretty conservative, but we're not going to change the guidance on that.

Just one more quick question on the gross margin side.

The pricing pressure is not really evident; you said your ASPs went up 10% and good deal sizes.

Maybe you can give us a deal size number.

But the services gross margin is going up, your deferred revenue is going up and it seems like you're probably having some good attach rates with the modules.

So I'm just wondering why the conservative guidance on gross margin?

If you're not seeing pricing pressure on the product side, why couldn't we go beyond the 77, 78% product gross margin?

It's been there for a while, but what's the contra argument against that?

Yes, this is Steve Coburn, Stan.

I think what we are saying, one of the things that you saw with our ASP going up this quarter, part of that is attributable to our transition to Buffalo Jump, which we previously said was priced about 10% higher than the product it replaced.

Buffalo Jump also has higher cogs (ph) associated with it, with that pricing increase and the increased cogs associated with it and some modest assumption for software attach rates.

That's why we had some confidence that we would be able to maintain our product margins as we transitioned from the old product to the new product.

And, in fact, that is the case; you've seen remarkable stability with the product profitability through that.

I think that's a win for us.

That's the way we expected it to play out and, in fact, it has played out that way.

I think we are going to reserve judgment, as we continue to say; if the software tax rates go up and we have the opportunity to have higher product margins we may do some other things there that may or may not include (technical difficulty) letting (ph) the product margins go up.

We might do something with product pricing or channel incentives; that's why I think we're in the enviable position, should we enjoy that, to make some decisions of which product margin going up could be one.

But we're -- I've got to say at the end of the day we're satisfied and happy with our product margins.

They're close to the highest in the industry, and I think our plan and goal would be being able to maintain those going forward.

Okay.

And if I could throw in a quick one, just at the start of the quarter some of your competitors have reported saying that the third calendar quarter is off to a better start and just wondering if you're seeing similar positive trends early on, if you can talk about how the quarter is [inaudible] --

Well, we're really only two weeks into it, this is the third week.

So I think it's a bit soon to talk about that.

We've given guidance and we think the start of the quarter is marked on (ph) that guidance, so we will see where it ends up at the end of the quarter.

Sounds good.

I'm not going to comment in two weeks.

Okay.

Thanks, guys.

Thanks.

Your next question comes from [Doug Ruddish].

Your line is open.

Hey guys, great job.

A couple of questions, one, maybe isn't too germane to your business, but I'm just curious and I'll take a shot, which is -- I guess congratulations for your stance with respect to running through the options expense and doing it proactively and early.

Philosophically, you had the choice not to talk about it yet and wait, so I guess first of all congratulations.

Second of all, why did you decide to start expensing it now rather than waiting like most people are doing?

Well, as I said in an earlier answer, actually we normally do that annually every 12 months, and we had waited 15 months and we thought that was enough of a time, that was long enough, and we didn't want to wait any longer.

But that's the grant; it's not necessarily from a FAS 123 perspective.

You still don't need to run the expense through the P&L, so that's what I'm sort of congratulating you guys on.

You're being pretty proactive about doing it, so why?

Doug, this is Steve Coburn.

The fact of the matter is going forward we felt the instrument that would best serve F5 in terms of retaining and attracting employees, as well as minimizing dilution going forward, was going to be the restricted stock units.

The restricted stock units require expensing under both the old and the new rules.

Then given -- taking a longer-term perspective and saying that these restrictive stock units really are in the long-term best interest, we believe, of both the Company and the shareholders.

And we didn't want to wait -- should we have to wait another quarter, you're looking then at 18 months between follow-on stock grants.

We didn't think that was appropriate.

So accordingly, we just went ahead and said we're going to do the whole thing right now.

I understand.

We would have to expense the restricted stock units regardless.

And the choice of using restricted stock now versus options, did you just think it's a better method for your employees over the long term?

You know, we really do.

And the fact that the restricted stock really wasn't considered in the past or really even a practical given the fact it always required expensing.

Given now that everyone has to go to expensing, restricted stock units really came on the radar screen as being a viable alternative for us.

And do you like it because there is permanent value to the restricted stock, and that way you don't have to worry about fluctuations in your stock and employee morale?

Is that the benefit of restricted stock that you guys saw (ph)?

I think in the eyes of the employees there is some benefit in that the fact that they would not be under water.

I think from a shareholder perspective, given the four to one ratio in terms of the grant, that they're much more efficient in terms of dilution.

Got it.

Great.

The second question is [inaudible] (technical difficulty) the competitive acquisitions people asked you about, even though -- who knows what the effect is externally from a customer perspective, but internally does it cause you guys to do anything different in terms of either how you invest in R&D or how you go after customers from a sales and distribution perspective?

Oh, yes.

I mean, first of all I think you ignore competition at your peril so by definition we're always looking at what the competition are doing, if they've got ideas we haven't thought of, probably we would copy them.

So from that perspective the answer is yes; it's always yes in that scenario.

I don't think -- in terms of has it made us do anything different, if you ask that direct question, probably not, certainly nothing significant, but over time it may though (ph).

Got it.

And the last question is just with respect to your continued exceptional growth rates, my sense was -- and I'll throw out the hypothesis and correct me if I'm wrong -- if you look back a year ago, the narrowly defined Layer 4 to 7 market which a year ago might have been primarily more low balanced than anything else, wasn't growing that quickly but you were taking a lot of market share from other guys that didn't have products as good as you or weren't executing as well.

Do you think that's still the case or do you think now your growth is more a function of the overall market growing and less as a function of share?

How do you think about it?

It's pretty subjective, this one.

But first of all, fiscal '04 we grew at 48%, which is a pretty healthy growth.

So the three quarters we've been in the 60's year on year, have been on a 48% year, so it's not just a one year track with us; it's now been going more than two years.

I think we have gotten more competitive, I think Buffalo Jump has been very significant for us from a competitive point of view.

But the big deal is I think when we go into prospects and large enterprises and large service providers, the knowledge level of what they can do with application, traffic management, and application security has increased.

And that tends to, by definition then, give you more of an opportunity from a market perspective.

Got it, thanks.

Thank you.

Your final question comes from Alex Henderson.

Your line is open and please state your company name.

Well, I haven't changed since the last question, I'm still with Citigroup.

Hey, I wanted to talk a little bit about the Asian business, a little bit more detail.

As kind of back of the envelope crank on the numbers, it looks likes that's down almost 50%.

Am I cranking the numbers right to start with, and b) what the [expletive] is all that about?

I mean, 50% is a little bit more than seasonal norms.

Right.

No, when we talk about Asia -- you're talking about Japan as well aren't you?

Yes, just Japan there.

Yes.

Yes.

So Japan tends to be down quite a bit between one quarter and the next from the half year to the full year.

But what I did say, Alex, was it was below our internal expectations as well.

So it was down more than we expected it to be.

Is the number I cranked out in the ballpark?

Sorry?

Is the number I just indicated in the ballpark for the decline?

I think it is actually, yes.

So 50% sequentially is more than normal, yes?

Well that's what I said, it was below our internal expectations.

But we expect it to be up this quarter.

What -- is it just the environment in Japan, is it something in your sales organization?

We had a pretty full quarter last quarter and we expect it to pick up as it gets to the half year.

Okay.

So you just think this is the seasonal pattern, there's nothing wrong with your operations?

I think it's the seasonal pattern plus we did see a tough quarter in Japan last quarter.

So Japan may be a persistently underperforming geography is what you're saying because of conditions there?

That's correct.

Okay so the issue there then is not one of anything internal or operational with your products or your management or your operational structure?

I don't think so, no.

All right.

Thank you.

If we'd have thought that we wouldn't have given an expectation of it increasing this quarter.

You might have changed somebody and not told us.

No.

No.

No changes.

Okay, well, I just wanted to explore that, thanks.

Okay.

And we didn't change the comp line either.

Okay.

Well, just keeping you honest.

Okay.

Thanks guys.

Okay.

Thanks a lot.

I think that was the final question?

Yes it was, sir.

Okay.

So thanks a lot for dialing in and we will talk to you again next quarter.

Thank you.

That does conclude today's conference.

You can disconnect at this time.