F5 Inc (FFIV) 2014 Q3 法說會逐字稿

Good afternoon, and welcome to the F5 Networks third-quarter 2014 financial results conference call.

(Operator Instructions).

Also, today's conference is being recorded.

If anyone has any objections, please disconnect at this time.

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

Sir, you may begin.

Thank you, Nancy, and thank all of you for joining our call.

Welcome.

On today's call, John McAdam, President and CEO; Andy Reinland, Chief Financial Officer, will be the principal speakers.

And the other members of our executive team are here to answer any of your questions following the prepared comments.

If you have follow-up questions after the call, please direct them to me at 206-272-6571.

If you haven't seen a copy of today's press release, you can pull one down from our website at F5.com.

In addition, you can access an archived version of today's live webcast from the Events Calendar page of our website through October 29.

From 4:30 PM today until 5 o'clock PM Pacific Time, July 24, you can also listen to a telephone replay at 800-391-9853, or 203-369-3269.

During today's call, the discussion will contain forward-looking statements which include words such as believe, anticipate, expect, and target.

These forward-looking statements involve uncertainties and risks 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 would like to turn the call over to Andy Reinland.

Thank you, John.

The third quarter of fiscal 2014 was a quarter of solid revenue growth and profitability, driven by strong uptake of our expanding array of systems and application services.

In particular, demand for our security solutions was a key driver of product revenue growth.

And sales of our Good, Better, Best bundled solutions, weighted heavily toward Best, continue to grow ahead of our expectations.

Revenue in Q3 increased 5% from the prior quarter and 19% year-over-year to $440.3 million, above our guided range of $428 million to $438 million.

GAAP EPS of $1.05 per share was above our guided range of $0.99 to $1.02 per share.

Non-GAAP EPS of $1.39 per share also exceeded our guided range of $1.33 to $1.36 per share.

Product revenue of $236.9 million grew 5% sequentially and 20% year-over-year, and accounted for 54% of total revenue.

Service revenue of $203.4 million increased 4% sequentially, 17% year-over-year, and represented 46% of total revenue.

The Americas region accounted for 57% of total revenue during the quarter.

EMEA contributed 23%; APAC, 15%; and Japan, 5%.

On a year-over-year basis, Americas revenue grew 17%; EMEA revenue, 33%; and APAC revenue, 17%.

Japan revenue was down 3% year-over-year.

Enterprise customers represented 68% of total sales during the quarter.

Service providers accounted for 20%, and government sales were 12%, including 3% from US federal.

In Q3, we had three greater-than-10% distributors: Ingram Micro, which represented 18.3% of total revenue; Westcon, which accounted for 14.8%; and Avnet, which accounted for 13.2%.

Our GAAP gross margin in Q3 was 82%.

Our non-GAAP gross margin was 83.2%.

GAAP operating expenses were $234.7 million, within our guided range of $228 million to $236 million.

Non-GAAP operating expenses were $206 million.

GAAP operating margin was 28.6%.

Our non-GAAP operating margin was 36.4%.

Our GAAP effective tax rate for Q3 was 37.6%.

Our non-GAAP effective tax rate was 35.2%.

Turning to the balance sheet, cash flow from operations was $138 million.

After repurchasing approximately 1.45 million shares of our common stock for a total of $150.5 million, we ended the quarter with $1.12 billion in cash and investments.

$481 million remains authorized under the share repurchase program.

DSO at the end of Q3 was 50 days.

Inventories were $23.1 million.

Capital expenditures for the quarter were $5.5 million.

Deferred revenue increased 19% year-over-year to $617.4 million.

We ended the quarter with 3,745 employees, an increase of 110 from the prior quarter.

With continuing strength in sales of our security solutions and Good, Better, Best bundling options; momentum with Cisco ACE replacement opportunities; and a general trend toward broader adoption of our full solution portfolio by large enterprises, service providers, and government customers, we anticipate a strong close to our fiscal year.

With that in mind, our revenue target for the fourth quarter of fiscal 2014 is $453 million to $463 million.

GAAP gross margin is anticipated to remain in the 82% range, including approximately $3.5 million of stock-based compensation expense and $2.7 million in amortization of purchased intangible assets.

Non-GAAP gross margin is expected to be at or around 83.5%.

We anticipate GAAP operating expenses in the range of $232 million to $240 million.

This includes approximately $23.5 million of stock-based compensation expense, and $0.5 million in amortization of purchased intangible assets.

For Q4, we are forecasting a GAAP effective tax rate of 38%, and a non-GAAP effective tax rate of 35.5%.

Our GAAP EPS target is $1.15 to $1.18 per share.

Our non-GAAP EPS target is $1.46 to $1.49 per share.

We plan to increase our headcount by 125 to 150 employees in the current quarter.

We estimate DSO will be in the 50-day range.

We expect inventory levels within a range of $23 million to $26 million.

And we believe our cash flow from operations will be at or around $150 million.

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

Thanks, Andy, and good afternoon, everyone.

I was very pleased with our performance in Q3.

Revenue growth from both services and product was very solid, with strong sequential and year-over-year growth in both cases.

I was particularly pleased with our year-over-year product revenue growth of 20%.

From a sales perspective, the Americas, EMEA, and APAC all recorded double-digit year-over-year sales bookings growth.

However, sales in our Japan region were down versus last year due to a number of significant orders slipping into Q4.

Our services business delivered another solid quarter, with 17% year-over-year revenue growth and once again added a healthy 19% increase to our deferred revenue balance, which now stands at $617 million.

We continue to experience strong momentum with our Good, Better, Best sales motion in Q3, with customer adoption continuing to be very strong in the Best category, highlighting the successes we are seeing with our security solutions.

Q3 was our first full quarter-over-quarter comparison of sales of GBB bundles, and I was really pleased to see sales of GBB bundles up 49% sequentially, with 73% buying Best.

Sales of GBB bundles now account for a very material percentage of our overall quarterly sales.

Our security business continues to be our largest growth driver, with strong sales across the security solutions portfolio, including ASM, APM, and AFM.

We also started to win sales of our new Secure Web Gateway solution last quarter.

Cisco ACE replacement opportunities were another strong business driver last quarter.

As we have seen in previous quarters, customers continue to take the opportunity to add functionality -- for example, our ASM and/or our AFM security modules -- when they implement the new F5 solutions.

Also, our competitive win rate on these engagements is extremely high, with win rates above 90%.

In fact, we saw a rise in competitive win rates across the board last quarter as our salesforce and partners leveraged our product technology leadership, our GBB pricing, and our Synthesis architecture, with the unmatched depth of our security and application optimization services functionality.

We closed the acquisition of Defense.

Net last quarter.

This acquisition increases our growing security solutions portfolio with cloud-based security services for protecting data centers and Internet applications from distributed denial-of-service, DDoS, attacks.

Defense.

Net's high-capacity cloud service is complementary to F5's existing on-premise DDoS protection capabilities.

The combination provides customers with the most comprehensive hybrid DDoS solution, engineered to absorb the full threat spectrum of DDoS attacks.

In the service provider market, we are seeing good traction with our integrated service provider solutions.

For example, we are seeing project wins of our new Policy Enforcement Module, PEM, to provide traffic steering and policy-based enforcement.

Also we are making good progress with our Gi firewall consolidation strategy, and we believe this to be a very large opportunity in the service provider customer base.

We continue to see new project wins for our Traffix diameter solution, including a new Tier 1 service provider in Europe, which involved a new use case for Wi-Fi offload.

In Q3, we introduced early utility licenses on Amazon Web Services, AWS.

We now have two offerings inside of AWS.

Customers can now deploy the F5 BIG-IP platform in the AWS cloud, utilizing either their own license, via bring-your-own-license, or they can purchase early licenses on AWS Marketplace.

Both models cover a wide spectrum of customer needs, allowing us to serve our current enterprise customer requests as well as the needs of new, smaller customers.

Both offerings have adopted our Good, Better, Best pricing models.

I'm very excited about our technology direction and proposed deliverables on our product roadmap in the short-, medium-, and longer-term.

Our product roadmap priorities align well with the trends in the many areas of our business focus.

You will see F5 continue to introduce significant enhancements and world-leading technology in our key areas of focus: security, service providers and mobility, the cloud and software-defined data center architectures, F5's solutions-as-a-service, and management and orchestration.

We will be delivering another major revision of TMOS in the near future, known internally as our Alpine release.

The TMOS Alpine release includes approximately 124 new features, with over 50 new features for security.

Examples of new security functionality include full integration of our Versafe module on BIG-IP for native deployment of Web safe antifraud and detection services; centralized management support for ASM and BIG-IQ; more Gi firewall support for AFM, including significant new centralized management capabilities in BIG-IQ; security to support extremely large customer deployments with large rule sets; and significant new DDoS capabilities, including over 100 vectors and hardware with new capabilities such as behavioral analysis.

Alpine will also include a new REST API for our ASM Web application firewall.

The REST API support for ASM allows operators such as enterprises and service providers to provision and scale large services from the cloud.

Alpine will also include significant features focused on our service provider market, including new message-based traffic steering capabilities, allowing BIG-IP to natively steer and process SIP and diameter traffic; additional enhancements to our new Policy Enforcement Module for fixed line use cases, as well as PEM and traffic SDC integration; new carrier-grade NAT features, including new iRules-based capabilities for additional programmability and flexibility; and powerful enhancements to our TCP optimization functionality, giving service providers significant increases in functionality for optimizing their ever-growing traffic workloads.

The Alpine release will also include powerful features for SDDC and cloud architectures, including integrated support for Cisco ACI, VMware NSX SDN, Microsoft System Central Virtual Machine Manager, and an OpenStack plug-in for the Neutron load-balancing-as-a-service module.

We are making great progress with our SDN partnerships, and I believe that these partnerships will prove to be significant business drivers for us in 2015.

As far as the outlook is concerned, Andy indicated that we expect to deliver both sequential and year-over-year growth this quarter.

The drivers of our business remain robust as we enter the final quarter of fiscal 2014.

We experienced a very strong increase in our new business pipeline in Q3, up significantly from last year, which should bode well for Q4 and fiscal 2015.

Our Synthesis architecture for software-defined application services provides F5 with the opportunity to play a very strategic role, as customers continue to strive for competitive advantage and maximum agility by moving to new technology architecture.

Also, our portfolio of application products and cloud services continues to expand aggressively, which in turn expands our addressable market and increases the types of revenue streams available to our salesforce and partner channel.

As Andy mentioned earlier, we are planning to invest for growth in the business moving forward.

Our intentions are to continue hiring in Q4, with a target of greater than 125 net adds to the F5 team.

We will also be making infrastructure investments in additional data centers and security operation centers, to ensure growth in our cloud-based opportunities, including Defense.

Net, Versafe, and general F5-as-a-service solutions.

As I stated earlier, I believe F5 is in a really good position to take advantage of industry trends and customer requirements.

In conclusion, I'd like to thank the entire F5 team, our partners, and customers for their support last quarter.

And with that, we'll now hand the call over for Q&A.

(Operator Instructions).

Ben Reitzes, Barclays.

Could you talk a little bit about -- as Cisco is rolling out ACI, what your go-to-market situation is like, and if you are seeing a pickup there?

And the pipeline of those related sales around ACE, and whatnot.

And then also, if you could just comment on federal and carrier verticals.

What are the trends there?

We've noticed federal picking up with some folks.

Thanks a lot.

Okay.

Regarding Cisco and ACI -- and, in fact, the comments I'm going to make actually apply to VMware with NSX as well -- in that with the both those organizations, we're deeply involved in integration at the product development level right now.

And we feel good about the progress in that.

And we are actually starting to train our salesforce in both solutions.

We're also, on a sales-by-sales territory scenario, meeting up with our counterparts and making sure that our go-to-market is absolutely optimized.

And maybe Dave Feringa will want to comment more on that.

Yes, I would say across all three theaters worldwide, we are seeing great engagement with both Cisco and with VMware and a number of large opportunities.

The one thing I think is really encouraging is it's happening organically.

There's not a lot of push from the executive management for it to happen.

The salespeople themselves are seeing the opportunity to work together.

And we're seeing a lot of great momentum in that business, and we think it's going to be great for us over the next year or so.

Yes, and on the verticals -- first of all, federal -- it was typically a little bit lower, from a revenue percentage, this quarter.

However, actually, sales bookings were higher than that.

So we feel reasonably good about federal moving into the final quarter.

We expect it to be pretty solid, actually.

We love the team there, and it's actually [money movement] through the pipeline and the forecast, and that feels quite strong.

So we'll see what happens there.

On telco, it's pretty similar.

You are going to see that lumpiness.

It was at 20% this quarter; it's been as high as 27%.

We tend to look at it in the 20% to 25% view.

Still very project-oriented.

And the thing I did say on my prepared remarks were, we're starting to see some nice progress with new solutions like our Policy Enforcement Module, linking it in with the SDC traffic solution there as well.

And so, both that and finance are really our strongest verticals moving forward.

That's great.

Thanks for the color.

Brian Modoff, Deutsche Bank.

In terms of the new product release, can you talk about what features you think are going to be the key to customers, in terms of what their demands are?

And how do you expect that to affect hardware loading in demand, on terms of people needing to upgrade their boxes to accommodate some of these new features, particularly around the telcos?

Thanks.

Sure.

Hi, Brian, this is Karl.

It's a big release, and it's pretty broad.

And basically we're adding significant enhancements across the board for security, service provider, our cloud products, our core market products.

And so in terms of loading and the impact it might have on -- in terms of customers and CPU, I think you're referring to that -- as you turn on more functions, you can use more system resources.

And so I don't know that the features would have that big an impact.

I think the packaging; and with Good, Better, Best; and how this is being taken to market probably has more of an impact, because the customers now are consuming a much greater number of our services across the board.

So, especially a search provider, for example: we introduced a lot of capabilities around Gi Firewall to make that work better for them (technical difficulty) features there.

So, we would expect that to uptake, but the performance that we have in that product is still quite a bit off the charts.

Now, PEM uses quite a bit of functionality in the platform.

It does things like classification.

It's enforcing policies.

It's doing balance limiting, and doing a lot of traffic steering capabilities.

So, depending how that's leveraged, that could be -- that can use a number of resources as well, and encourage people that use it to go for our bigger platforms, like the 8-slot VIPRIONs or the 4-slot larger ones.

So I think there's just a lot of opportunity there.

We've introduced a lot of new enhancements to the PEM.

We're classifying over 750 protocols in applications, both Web-based and non-Web-based.

So it's quite a large set of capabilities and differentiated capabilities there.

I don't know if there's anything else (multiple speakers).

Yes, no, and I'd just add, from my perspective, Brian -- it's not quite answering the question -- but the thing that excites me about the Alpine release, if you listen to some of the story that I did in the prepared remarks, is that we've really focused a lot of the functionality on the real growth drivers that we're seeing right now, like security, like solutions-as-a-service, taking the Versafe acquisition and putting it into TMOS as a module there.

We have a long history of that; been a very successful technique for us.

So I think we're doing it well there.

I think Manny (multiple speakers).

Yes, the only thing I would add, Brian, to that -- because you asked specifically about service providers.

And we're seeing it, and this is predominantly -- we're seeing it across the globe.

But the use case I'll talk about is predominantly right now in Asia, where as we've enhanced the feature functionality for those service providers, they are actually telling us that based on the Internet traffic growth -- because now we have strategic point of control in those service providers' network -- that they're wanting to see not only faster interfaces, but actually faster even boxes, whether we cluster those boxes, or we actually build faster boxes.

So you're absolutely right: as we consume more services, the need is there for higher performance, both on the throughput level as well as the connection levels.

And really it's the growth that's happening with mobile that's driving that innovation, if you will, in the service provider arena.

So, we're well positioned there.

Okay.

Thanks, guys.

Mark Kelleher, D.A. Davidson.

I was wondering if you could give some more detail on the geographic breakout.

Japan is down 3%.

You said orders were slipping.

Is that a competitive situation?

I know one of your competitors is strong there.

Or is it a macro?

And then to flip that, EMEA very strong, up 33%.

What's driving that?

Is that macro, is that specific deals?

Thanks.

Yes, I think -- that's a fair question regarding the competitive scenario.

We don't have enough details on the actual -- what really happened in Japan, apart from the fact we know that a few fairly large deals -- and when I say large, I mean multimillion dollar type opportunities -- did slip.

So that was the biggest reason.

Having said that, A10 have done well competitively in Japan, and we'll see what our win rate is there as we look in more detail.

But the main message is, elsewhere our competitive win rate has gone up pretty significantly this quarter against everybody.

In the Americas, we looked at that on Monday, and we saw a fairly material rise in percentage wins.

So, Japan, I don't know what -- it may be the one outlier there.

They do tend to focus, by the way, in Japan on lower-end products, so we'll see.

But, overall, we feel really good about our competitive position.

And EMEA, was that --?

Yes, EMEA has been solid for us for a while now.

And we're making a lot of progress there.

David, do you want to comment specifically on the --?

Well, I'd say one thing the EMEA team has done a really good job of, they've been leaders with our security solutions for quite a while, and they've really been driving it to our customers.

And I think that's been one of the reasons we've driven up growth in EMEA at a really nice clip.

Okay.

That's all I got.

Thanks.

Troy Jensen, Piper.

Congrats on the nice quarter, gentlemen.

Yes, quick one here for John.

John, I know over the past year you've talked about the number-one company objective was accelerating product growth.

You've clearly achieved this, but the comps start to get harder from here.

So just curious to know if there's any type of a product growth rate that you are targeting going forward, or something we can benchmark you to.

And then I have a follow-up for Andy.

This is another one where I'm smiling here, Troy.

We knew we'd be asked this question.

We are very, very focused on product growth.

Product growth is what makes the world go 'round in companies like ourselves, and we're very focused in doing that.

We're not going to give any forward statements.

We've given you -- you've got the guidance we've given for Q4, and you can make up your mind on that.

We've said the pipeline -- I did say the pipeline, that we did have new business pipeline, was very significant -- the create rate last quarter, so that makes us feel good.

But we're not going to give any actual numbers.

Another indication, typically, of our confidence is our hiring.

And you can see that we want to go on a fairly aggressive hiring focus, next quarter as well.

All right, perfect.

And that goes into my follow-up here, maybe for Andy.

Both of you guys talked about investing for growth.

So can you just talk about implications on operating margins?

Do you expect to see much deterioration, or just kind of modest with the spending here?

Yes, well if you line up the guidance that we have, I think you'll see that for Q4 we'll see a little more strengthening in the op margin for the quarter.

And next quarter we'll talk on the October call, where we give guidance for the year.

But what I would expect is for us to pretty much outline an operating margin in the year like we saw this year.

But, again, that's if we're seeing the revenue growth, we're going to keep investing to drive the top line, and that's going to be the focus.

All right, understood.

Good luck going forward, guys.

Thank you.

Matt Robison, Wunderlich Securities.

Yes, I was wondering if you could help us understand -- you characterized the installed -- the age of the installed base you are replacing these days.

And maybe talk a little bit about the security market adjacencies that we can expect with Alpine or any other near-term product releases.

Right.

And, Matt, that's interesting.

I don't know if it was in previous calls or in webcasts, I've given out information at a certain point where we were in the installed base with installations greater than two years, three years, and five years and above.

And these are significant numbers.

I don't have them to hand right now.

But what we will make a point of doing is the next public event that we get the chance to do that, we will give out that information.

And the reason that I'm saying that is there is still a long way to go on the product refresh.

I know that; I just can't give you the exact numbers, in terms of the greater-than-three-year installed base.

Because with us, it tends to be pretty significant.

Sometimes because there is some deeper deployment goes on as they do refresh -- but in terms of, do I feel that the product refresh capability has still got a year or two years more, two years plus in it?

I think it really has.

What's going to drive that is extra functionality as well, but we'll try and get that data out at the next public event.

Nice to hear you've got such visibility in what's left to do.

What about the adjacencies?

Yes, I mentioned it's our biggest driver.

We continue to add the functionality to it, in terms of the solution portfolio.

DDoS I think is going to be very big for us, with our differentiated hybrid solution of on-premise.

And now with Defense.

Net, we think we've got a great decision there.

By the way, within just over a week of the DDoS acquisition, we started to see orders coming in where we were actually approached.

I don't want to get too carried away on this one.

But we did see that at the beginning of the -- we're actually balancing, in fact, how aggressively we bring that to market with the resources that Julian and his service team that are going to drive this are putting in place.

But I think that's going to be good for next year.

And then you have things like what we're doing to Gi firewall.

There's a whole lot of work going on in security, specifically.

This is Karl.

I would just add a couple things.

With integration of WebSafe from Versafe into BIG-IP, that that simplifies our anti-fraud deployments.

And we actually have a mobile application, as well, that we're in the process of integrating as part of that.

So we'll be able to address both traditional PC-based access as well as mobile, as we go forward.

So that simplifies that.

Gi firewall, as John said, is big because we have massive scalability.

But we're also shortly releasing extensive new capabilities on our management platform that gives us -- to centralize management for both firewall, as well as for our web application firewall.

And so now it makes it much easier for large service providers to go off and deploy these services, and there's native capabilities there.

So, those are just a few examples, as John said.

The other -- I'm not sure I would call this an adjacent market -- to some degree, it's an adjacent scenario.

But we really believe, with the progress we're making with our SDN partnerships that that could be very very, profound, is a word I've used quite often about this, in terms of being a growth driver going into next year, as well.

Is the outbound and application firewalls fitting in to any of this stuff?

Well, for outbound, we have our Access Policy Manager, with our Secure Web Gateway integration as part of that.

And so that's a portion of that outbound use case, if you look at that.

We're actually integrating identity as part of our firewall solution.

So we're actually using the identity components that we have in our Access Policy Manager to allow security policies, not just based on application, but user and endpoint, as part of that; and, actually, endpoint application as well.

So that opens up additional use cases.

We're not trying to go head-to-head, say, like with the traditional next-generation firewall from, say, like Palo Alto or somebody like that.

This is more inbound, user and application focused.

Thanks a lot.

Ehud Gelblum, Citigroup.

A couple questions.

First of all, I know you don't give the technology vertical anymore.

You stopped doing that a few quarters ago.

But if you were to isolate the Web 2.0 type players out there, from the other service providers and the other types of customers, is there anything you can give us a sense as to what their activity level is doing?

Are they accelerating in line with what we're seeing out of your top line, or stronger?

And then on Versafe, now that you've got a couple of NOCs up and running, it actually has real OpEx associated with it, as opposed to some of your other products, where they basically have COGS but not -- sales, et cetera, or OpEx -- but there's actual, real OpEx in operating the Versafe operation.

I was wondering, is it breaking even yet?

And where do you expect it to -- obviously, integrating it into Alpine should provide a huge boost for it.

Where do you expect it to go?

So I'm trying to get a sense as to where it is now.

Where do you expect it to go?

And if we can look at it from a profitability perspective, with respect to its ongoing costs, and the return on that, that would be helpful.

Yes.

This is John, Ehud.

Let me answer the Versafe, and I'll pass the vertical to Andy, although I'll help him on that before I do.

(laughter)

On Versafe -- no, absolutely; we are investing in this right now.

It's absolutely not at breakeven, because we haven't unleashed Versafe yet to the salesforce.

And, frankly, we'll probably do that as we start the fiscal year at the sales conference.

It will be a lot easier for us to do it when we have it integrated as a module in TMOS.

Having said that, we've taken orders over the last couple of quarters, so we are building the customer base.

But we're really at early stages of increasing the investment in the SOCs; and, therefore, obviously that's some OpEx.

But I think it's something I think we're digesting and balancing well.

And I think it's going to be a nice growth driver for us.

Regarding the verticals, and I'll pass to Andy if he wants to add more to it.

But we're not breaking out the technology; that means we don't want to talk about it.

But we're not talking -- we believe it is very similar to enterprise, and that's why we put it in there.

Because we're talking about companies like the large server companies as well as some of the dot-com companies; we include that in the vertical.

But what I will say is, that is still a strong part of our business, and I don't see that changing.

And that's exactly what I was going to say, is it continues to be a strong vertical for us.

We just have chosen the tact of not getting into detail, especially because it's a smaller number of large companies is the implication to that discussion.

And that really isn't the makeup of that vertical; it's much more broad than that.

So we'll stick to the enterprise level.

This is Karl again.

I was going to say one other thing about Versafe.

It's not only interesting at its core business, but the technologies involved in that -- we're able to leverage these in other areas.

And so we're working on some new products for the future that will allow us to have much more advanced capabilities around things like, say, botnet detection, or being able to detect -- so for our DDoS capabilities -- being able to do things like that; being able to detect things like malware.

There's a lot of areas that this technology can take us.

And we're looking at these, and how we might productize some of this as we go forward.

We'll talk more about this at our November conference, but --.

Right.

You'll talk about it at our conference in September, too.

But just to clarify, John, what you said -- so it's not breaking even, or it is breaking even?

Oh no, it's not breaking even yet.

Okay, that's what I thought where you were going with that, okay.

Thank you.

So that's the reason, one of the reasons that it's weighing on operating margin right now, why operating margin is in the 36%s.

Presumably without this, it could have been 1 point or so higher.

Well, we're not going to say that.

But the key thing we look at, Ehud, for the operating margins, is the hiring we're doing.

That's got the biggest effect.

Right.

Okay, I appreciate it.

Thank you.

Jeff Kvaal, Northland.

I was wondering if you could help us a little bit, talk about how far through the transition the Good, Better, Best pricing structure that you are.

Obviously, it's been very successful in your first two-plus quarters out of the gate.

It sounds like it's a material percentage of sales.

Is this something that's going to be a tailwind for another two quarters, another two years?

How should we think about that?

Yes, we'll see.

As you pointed it out, it's 2.5 quarters -- it's not even 2.5 quarters.

It's just over two quarters.

And we're feeling really, really happy about the sequential increase this quarter.

More importantly, we feel very, very happy about this sway towards the Best choice, which is way above what we modeled.

But when we look at it by geography -- and I guess this is no surprise -- but the Americas is way in front, in terms of the percentage that they do.

So we would expect EMEA probably to catch up fairly quickly, and then APAC and Japan to catch up as well.

So that gives -- definitely, I think, gives us a headwind there.

But the enthusiasm in the salesforce is very good in this, and the customer reaction is very good.

So, I think it's going to be a pretty good momentum, but we don't want to say for how many quarters.

The other thing that I'd add is that we saw our average order size increase again this quarter, from $110,000 to $115,000.

Still too early to pin that directly on Good, Better, Best, alone.

I think there's broader momentum in the business that is also adding to that, but that still is an element to it.

Yes, and the other thing I would add, Jeff -- this is Manny -- is although we're in this transition, and it's becoming one of our primary selling motions from a licensing perspective, and I think that will increase.

To John and Andy's point, there's an aftereffect that we believe will also happen, and that is as customers try the new modules, because we're bundling those modules, they are beginning to deploy those modules, we should see additional footprint.

So there's the other effect of more presence in these accounts in new places in the network that we classically have not been in.

And that's the result of having that functionality, and extending that functionality using the software-defined application services architecture.

So, hopefully they will be in the future for a long time.

I get it.

So the idea, then, is they'll be using more modules; and, therefore, it will require more capacity; and, therefore, the incremental sale will come (multiple speakers).

Well, also, as they test out modules, they'll buy more of them.

Okay.

All right.

Thank you, gentlemen, very much.

James Faucette, Morgan Stanley.

I just had a couple of quick questions related to your business with service providers.

We've heard from a few other vendors that service provider has been weak, and just wondering if you've detected anything in that area.

Or if your -- particularly your new products are doing so much to mask that, that that's hard to detect for you at all.

And then secondly, on the service provider opportunity, I think you've said in the past that Traffix alone might be worth as much as $100 million to $200 million.

Just wondering if you still feel like that may be the case, and how you were thinking about the size of the service provider market overall.

Yes.

Well, first of all -- and we get asked this question a lot when you hear about capital spend and service providers.

I just don't think it has a significant, material effect.

We're still very project-driven; we're very driven by traffic being managed on the network and going into the data center.

We gain from introducing new technology, like a Gi firewall and like the PEM area.

So, that does mitigate that type of spending constraints, but I don't think that's a big issue for us.

I think it's more project-oriented.

Regarding Traffix, no, we've not given out any -- very, very specifically, we've not given out any guidance in terms of what we think the size of that can be.

In fact, we've even been asked about the size of the market; and you can look at various analysts' reports, and we don't even comment on that.

We're more focused on finding project wins, finding use cases, and just growing the business that way.

And the other thing about Traffix, just to remind you, is this is -- it's a much more complex sale for us, and that includes revenue recognition.

It's not just a matter of shipping the product, and invoicing the customer, and getting the money.

It's all about milestones and consultants.

So it's a longer sales campaign and a longer implementation campaign.

But we're not giving out any numbers in terms of guidance.

Thank you very much.

Okay, Angie, this is John Eldridge.

We're going to take two more questions, and then end the conference.

Rohit Chopra, Buckingham.

I just wanted to ask you a question on security, if you don't mind.

Just want to come back to Secure Web Gateway and DDoS.

John, these are highly competitive markets; they have embedded players; people have been there for years.

How do you get material traction there without having an impact -- for example, a negative impact on operating margin?

If you could just maybe talk about the go-to-market there, and how do you make a bigger splash in that market?

Yes, let me start with DDoS.

First of all, we've been very, very successful with DDoS ever since we introduced our AFM module, our general firewall module.

In fact, our drive into security -- apart from the WAF, that we've had for years -- our drive into the firewall space actually started with DDoS attacks, with the -- there was a whole WikiLeaks business that went on, where a bunch of our customers were attacked regarding the WikiLeaks fiasco.

And we actually put our iRules on to our ADC platform to protect them because the firewalls couldn't cope with the volume.

So, long story short, an ADC architecture is ideal for protecting against DDoS attacks.

And as I say, our on-premise capability along with our roadmap, where we've been putting DDoS protection vectors within FPGAs in the hardware because of the volume -- very differentiated.

So for us now to have an off-premise solution is very synergistic.

We've already got a great reputation there.

And to be able to offer the hybrid capability is, frankly, an easy sale, and was well accepted by the salesforce.

Although remember my remarks earlier, is that we're making sure we invest appropriately before we unleash the off-premise version on the salesforce, but we've already seen orders for it.

This is Manny.

I'll just add maybe a little bit more context around each of them, first starting with DDoS.

There's no question that DDoS, as John said, it's something we've been doing for a long, long time.

And our on-prem footprint is what has led customers to ask us to be out in the cloud.

So, the cloud has really been customer-driven, because they want a hybrid solution of being able to do that.

And what drives that is our success on-prem, what's driving that is our performance capability on-prem, the fact that we continue to do things at wire rate on-prem.

Karl, in the Alpine release, will have over 100 DDoS vectors, all done in hardware.

And then having a hybrid solution is a differentiated solution in the market.

Nobody really provides a hybrid solution today.

They either have a service on the cloud or a service on-prem, not truly a hybrid one.

And on Secure Web Gateway, it's a similar set of technologies.

Performance is one leadership position we have.

We feel very comfortable with the performance we have there, relative to anything that's in the market.

Obviously, we're starting out with an on-prem solution; that makes logical sense.

By bundling it as part of GBB, that gives us an advantage.

Customers can now test that module and reduce their total cost of ownership, while getting the performance benefits that they have out there.

And the other piece is more and more of the traffic that's leaving the enterprise is encrypted.

It's leaving out as https transactions encrypted, and customers need high performance decryption capabilities to be able to inspect that traffic for data loss prevention and things of that nature.

So, those are some of the value statements, if you will, from just a raw technology point of view that we bring to the table, that lead to very promising conversations.

Thanks, John.

Thanks, Manny.

Mark Sue, RBC Capital Markets.

Gentlemen, as we conclude, I just have a question on just the pricing dynamics that we've changed.

Intuitively, when we have a la carte pricing that benefits the buyer, and when we bundle, and the deals gives you the advantage to the seller, now there's a bit of more for your money here with GBB.

So the question is, what happens when customers have fully adopted the pricing change?

What happens over the longer term?

Are we actually front-loading some consumption?

Yes, no, I don't -- first of all, I'm not convinced on the statement you made, Mark, that us bundling GBB -- I think that actually benefits the buyer in a big way.

And the actual incentives we've given to make that happen are quite significant, which I think is why it has been so successful.

No, I think the real thing, the real issue is -- and we have to make sure we do this -- the real issue is to make sure that the customers -- and the account managers make sure the customers realize the depth of functionality they have; use as much as possible.

And then that will increase that usage of the functionality.

I think that's the real opportunity for us.

John, should we think of it as super-sizing, and adding the fries and the Coke, and the customers actually wait a little longer to come back?

Or do they actually consume more?

Oh, they tend to consume more.

The best example of this -- and it's not really GBB -- is the Cisco ACE opportunity where it's been fascinating for us to watch.

The initial conversation is, can you replace our load balancer?

That quickly moves to knowing we have much more than that.

And then that quickly moves to, oh, we're going to install your WAF -- I'm giving examples here -- WAF as a firewall throughout the organization, as they look at the whole portfolio.

Mark, it's Manny.

Just a quick comment.

This is not a -- and obviously Dave Feringa could talk about this in great detail; we can when we get together in November.

But a typical selling motion that can occur is a customer who comes in on -- I'll talk about an ACE replacement -- who may come in and want to do like-for-like transaction; replace an ACE load balancer with an F5 load balancer, because of the market leadership position we have.

And once we explain to them the platform and the delta in value that resides in that platform as it pertains to the additional services, it is not uncommon for me to hear the words: I'm not sure where to start.

And what that means is, how many issues or problems we can help alleviate for them.

Obviously the place to start is just a replacement, and to grow from that replacement as we move forward.

But that is highly -- a very typical situation that we see out there.

And we're exposing with GBB is that additional value, making it easy, taking the friction out of that.

And as a result of that, hopefully customers can realize that value going forward.

And the value includes not just extra functionality that we're talking about, but typically saves them money on their existing deployments in a big way.

In other words, taking 100 firewalls and replacing it by five of ours.

That type of thing.

That's all helpful.

Okay, thank you, gentlemen.

Good luck.

Thank you.

Okay.

Well, thank you all for joining us today.

And we look forward to another good quarter, and we look forward to talking with you all again in a couple of months.

Thank you.

That does conclude today's conference.

Thank you for your participation.

You may now disconnect from the audio portion.