F5 Inc (FFIV) 2018 Q4 法說會逐字稿

Good afternoon, and welcome to the F5 Networks Fourth Quarter and Fiscal 2018 Financial Results Conference Call.

(Operator Instructions) Also, this conference is being recorded.

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

I would now like to turn the call over to Ms. Suzanne DuLong.

You may proceed.

Hello, and welcome.

I'm Suzanne DuLong, F5's Vice President of Investor Relations.

François Locoh-Donou, F5's President and CEO; and Frank Pelzer, F5's Executive Vice President and CFO, will be making prepared remarks on today's call.

Other members of the F5 Executive team are also on hand to answer questions during the Q&A portion of the call.

A copy of today's press release is available on our website at f5.com, where an archived version of today's call also will be available through January 23, 2019.

The telephonic replay of today's discussion will be available through midnight Pacific Time on October 25 and can be accessed by dialing (866) 397-1432 or (203) 369-0539.

For additional information or follow-up questions, please reach out to me directly at s.dulong@F5.com.

Our discussion today will contain forward-looking statements, which includes 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 the press release announcing our financial results and described in detail in our SEC filings.

Please note that F5 has no duty to update any information presented in this call.

With that, I'll turn the call over to François.

Thank you, Suzanne, and good afternoon, everyone.

Thank you for joining us today.

Overall, we executed and overachieved our 2018 plan and continue to align to our Horizon 1 and Horizon 2 goals, driving growth and strong operational results across the business during the fourth quarter.

We are seeing significant traction for the long-term vision we outlined in our March 2018 Analyst and Investor Day, and furthering momentum in software and security sales.

Customers continued to view our solutions as mission-critical in hybrid environments, as they deploy incremental workloads, dynamically both on premises and in cloud environments.

Our product revenue growth continued in Q4 with products delivering 3% growth led by software.

Public cloud continues to be our strongest software growth area with an increasing demand for security solutions.

We expect our cloud native offerings will allow us to extend our growth and expand our public cloud reach in 2019.

In addition, we continued to see strong customer response to our recently launched ELA and Virtual Edition subscription consumption models.

Good initial deal closure and strong pipeline growth indicates these new consumption models will be especially important with our new cloud offerings, including BIG-IP Cloud Edition.

Systems continued to show resilience with growth opportunities in certain geographies, including China and Latin America, and with customers that want to control and manage the end-to-end application delivery solution and certain high-performance use cases.

Rounding out the business drivers, our Services business continues to perform well, delivering 6% growth in the quarter.

We are seeing consistently strong attach rates on maintenance and driving continued year-over-year deferred revenue growth.

We're particularly proud of our continued world-class customer satisfaction scores, reflecting our relentless commitment to our customers and their increasingly complex application deployments.

I will speak more on some of the customer wins and use cases in the quarter later in our prepared remarks.

But right now, I'll hand the call to Frank to review our Q4 and fiscal year 2018 results and our outlook for the first quarter of fiscal 2019.

Frank?

Thank you, François.

As François noted, we drove strong financial and operating results in Q4 and for the year.

Fourth quarter revenue of $563 million was up approximately 5% year-over-year, above the midpoint of our guided range of $555 million to $565 million.

GAAP EPS of $2.18 per share was well above our guidance of $1.77 to $1.80 per share.

Non-GAAP EPS of $2.90 per share was also well above our guidance of $2.61 to $2.64 per share.

The beats for GAAP and non-GAAP EPS were driven largely by strength in revenue, expense discipline and lower-than-expected effective tax rates.

Q4 product revenue of $256 million, was up 3% year-over-year and accounted for approximately 46% of total revenue.

Software was approximately 17% of product revenue and grew more than 19% year-over-year.

Systems revenue made up approximately 83% of product revenue and grew 18 basis points year-over-year.

Services revenue of $306 million, grew 6% year-over-year, and represented approximately 54% of total revenue.

On a regional basis in Q4, Americas grew 1% year-over-year and represented 55% of total revenue.

EMEA revenue grew 8% year-over-year and accounted for 25% of overall revenue.

APAC revenue grew 11% year-over-year and accounted for 15% of total revenue, while Japan grew 15% year-over-year and accounted for 5% of total revenue.

Sales to enterprise customers represented 66% of total sales during the quarter.

Service providers accounted for 18% and government sales were 16%, including 7% from U.S. Federal.

In Q4, we had 4 greater than 10% distributors.

Ingram Micro, which accounted for 18% of total revenue, Tech Data, which accounted for 11% and Westcon and Arrow, each at 10%.

Let's now turn to operating results.

GAAP gross margin in Q4 was 83.4%.

Non-GAAP gross margin was 84.7%.

Both GAAP and non-GAAP gross margin were slightly better than our expectations, driven by strengths in services margin, as we continue to leverage automation to optimize our support organization.

Last quarter, we took steps to further align investment with our transformation to a leading provider of multi-cloud application services.

Specifically, we are accelerating investment in our road map and market development efforts in the fastest-growing opportunities of our business; cloud and security.

As a result, we took $20.9 million in restructuring and facility exit charges during Q4, which are reflected in our GAAP results.

GAAP operating expenses of $316 million were below our $317 million to $329 million guided range, driven largely by operating efficiency and lower-than-expected restructuring expenses.

Non-GAAP operating expenses were within our guided range at $263 million.

Our GAAP operating margin in Q4 was 27.3% and non-GAAP operating margin was 38%.

Our GAAP effective tax rate for the quarter was 16.6% lower than anticipated, due to tax benefits associated with our stock-based compensation expense in the quarter.

Our non-GAAP effective tax rate was 19.3%.

GAAP and non-GAAP effective rates also benefited from year-end adjustments related to our domestic tax filings as well as our mix of profits and lower tax rate jurisdictions.

Turning to the balance sheet.

In Q4, we generated $204 million in cash flow from operations, which contributed to cash and investments totaling $1.45 billion at year-end.

DSO at the end of the quarter was 47 days.

Capital expenditures for the quarter were $17.4 million.

Inventory at the end of the quarter was $30.6 million.

Deferred revenue increased 5.3% year-over-year to just over $1 billion.

On employees, our restructuring initiative in Q4 impacted approximately 215 employees.

Executing on our plan to invest in our strategic growth initiatives, during the quarter, we hired 150 employees and ended the quarter with approximately 4,410 employees, down approximately 65 people from Q3.

We continue to hire aggressively in our growth areas.

In Q4, we repurchased approximately 864,000 shares of our common stock at an average price of $173.69 per share for a total of $150 million.

Quickly recapping our fiscal year results.

For the full year, total revenue grew 3.4% to $2.16 billion.

Product revenue of $960 million decreased 0.5% from the prior year and accounted for 44% of total revenue.

Within product revenue, software revenue grew 23%, while systems revenue declined 4% over the same period.

Services revenue of $1.2 billion grew approximately 6.7% during the year and represented 56% of the total.

GAAP net income for FY '18 was $454 million or $7.32 per share and non-GAAP net income was $612 million or $9.87 per share.

In FY '18, cash flow from operations totaled $761 million and capital expenditures were $53 million.

Now let me share our guidance for fiscal Q1 of FY '19.

Unless otherwise stated, please note that all of my comments reference non-GAAP operating metrics.

Overall, we remain confident in our position in the market and in the growth opportunities for the business with solid software momentum.

We believe the long-term trend toward multi-cloud environment is strong and will be a fundamental growth driver for the solutions we offer today and those we will launch in 2019.

With this in mind, as well as factoring in our normal seasonality, for the first quarter of FY '19, we are targeting revenue in the range of $542 million to $552 million.

We expect gross margins at or around 85%.

We estimate operating expenses of $265 million to $277 million.

We anticipate our effective tax rate for the year will be between 21% and 22% with some fluctuation quarter-to-quarter.

Our Q1 earnings target is $2.51 to $2.54 per share.

In the quarter, we expect share-based compensation expense of approximately $39 million and $2 million in amortization of purchased intangible assets.

Finally, as has been our practice, we want to provide you with broad modeling assumptions for FY '19 fiscal year.

As we discussed in March at our investor conference, we are tracking to our Horizon 1 outlook with our FY '19 operating plan.

For FY '19, from the base of Q1, we anticipate sequential revenue growth throughout the year.

We anticipate gross margins at or around 85% for the year.

We expect operating margin in the mid-30s range, in line with recent years results, moving down slightly in Q2 and Q3 from Q1 and then in Q4 in the upper 30s.

Stock-based compensation is anticipated to be in a range of $155 million to $165 million for the year.

Capital expenditures are expected to range from $110 million to $130 million for the year.

This range includes approximately $70 million in cost related to our previously announced move of our corporate headquarters to F5 Tower in downtown Seattle, as we ready the space for occupancy this year.

With that, I will turn the call back over to François.

François?

Thank you, Frank.

As you can see, we're making good progress.

I'll spend a few minutes highlighting some customer wins and use cases from the quarter.

Then I'll conclude our prepared remarks with comments about drivers for fiscal 2019 and our evolution to a multi-cloud application services company.

The first customer win I'll talk to spotlights F5 role in network function virtualization.

During the quarter, a large Tier 1 service provider selected F5 in an initial 5G VNS deployment based on overall performance in our Virtual Edition platform's ability to consolidate various functions within the core.

Importantly, the customer expects to use this as the baseline for the future virtualized core designs.

I mentioned in my earlier remarks that we continue to see good acceptance of our new ELA and subscription consumption models, which are another element of F5's multi-cloud value proposition, offering customers insurance against the uncertainties associated with cloud deployment, including providing timeline flexibility.

As an example, we secured an ELA deal in Q4 with a North American healthcare infrastructure provider, who provides a Software-as-a-Service offering.

An existing F5 customer, this customer required the same level of F5 application services they had on-prem as they moved to the public cloud.

The ELA structure was important because it provided the agility they needed, as they scaled their offerings over time.

An added bonus, F5's ability to provide multiple services enabled the customer to consolidate several security elements on their existing infrastructure.

Turning to our security offerings.

Advanced Web Application Firewall or Advanced WAF continues on a solid growth trajectory.

F5's Advanced WAF provides a powerful set of security features that keep web applications safe from attack.

In 1 deployment during the quarter, we replaced the competitor in a Virtual Edition software environment, specifically because of our bot detection and litigation capabilities.

We were also deployed by a managed care provider who is moving to the public cloud to reduce the time to turn up new customer applications.

We worked with the customer to move critical applications from shared F5 appliances through dedicated high-performance Virtual Editions, extending the same on-prem policy to their cloud deployments and replacing the application security manager or ASM with Advanced WAF on the existing F5 appliances, while deploying Virtual Editions with Advanced WAF to support new applications in the public cloud.

This customer will also deploy our BIG-IP Cloud Edition

to support new apps going into the public cloud.

And these are just a few examples of wins the sales team is driving.

Let me close our remarks today with some thoughts about fiscal 2019.

Last quarter, we spoke to our efforts to repurpose investment to focus on growth areas and ensure our product development and sales efforts were aligned with our most significant growth opportunities.

As Frank noted, we're adding resources in priority areas and extending our software portfolio and stand-alone security products.

As a result, we've got several new drivers to move toward in fiscal 2019.

One of these drivers is our BIG-IP Cloud Edition, a bundle of our BIG-IP centralized managed solution and BIG-IP Virtual Edition sold on a per-app basis.

Cloud Edition helps us address a large subset of applications by reducing the total cost of ownership of providing application services, while providing more application's management.

We have strong conviction that Cloud Edition is addressing new use cases and will be instrumental in expanding our multi-cloud platform strategy.

While not yet a material contributor to our revenue, the platform's ability to provide a single management console for both on-prem and cloud application services is resonating strongly with customers and the regional demand we saw for the product immediately following its release in April 2018, has now turned global.

We are seeing strong interest and demand across all our territories, and we expect sales activity to increase in fiscal 2019, as we build customer references.

In our security portfolio, we've got a new stand-alone version of SSL Orchestrator scheduled for release in December.

The amount of SSL traffic is growing rapidly, requiring customers to use significant resources to greater inspect for security purposes.

F5's SSL Orchestrator has gained strong traction as a solution on a range of F5 platforms and we expect its availability as a stand-alone product to enable increased penetration with security buyers.

Designed to optimize customers' SSL infrastructure by providing security devices with highly efficient visibility of SSL-encrypted traffic, it also supports policy-based management and stealing of traffic through existing security devices through service training.

This makes it easy to integrate into existing architectures, enabling customers to easily apply corporate security controls to all their encrypted traffic.

We are already building a strong pipeline for the stand-alone SSL Orchestrator offering, particularly with enterprise and government customers, and the sales team is very excited about the opportunity to drive additional growth in new buying centers.

We are also making good progress with both our F5 as a Service and cloud native platforms.

When we spoke about F5 as a Service at our Analyst and Investor event in March of 2018, we said, we expected to launch in 2019.

At this point, I'm pleased to say we are on track for first commercial availability in the first half of calendar 2019, and are starting to build pilots for lighthouse customers.

In concert, we are working internally to build the muscle that will enable us to target the expanded customers set we expect this product would appeal to.

Our internal digital transformation efforts, include expanding our digital touch motion to ensure frictionless procurement and service renewals.

At the March Investor event, we also highlighted the investment we're making to deliver Cloud-Native Applications Services in FY '19.

This program is also on track for launch in the first half of calendar 2019.

Our innovation teams have built out functionality that enables intelligent traffic management services and an API-first interaction model across select private and public clouds.

I have seen the product demos, and I am looking forward to sharing more, as we progress with our efforts to unlock latent demand through lighter weight offerings optimized for CI/CD workflows.

In addition to pushing forward with our multi-cloud focus solution set, we're also building our public cloud expertise.

I am pleased to announce that Barry Russell has joined F5 from AWS to succeed Chad Whalen in leading our cloud sales team.

Barry is a business development, sales and operational leader, who brings us 20-plus years of experience.

Most recently, Barry was General Manager of Global Business Development and Field Operations for the AWS Marketplace and Service Catalog, where he built the AWS Marketplace ISV ecosystem, and digital software catalog.

Barry's prior leadership roles include business development and service provider sales leadership at Microsoft as well as a role at Nivio and Level 3 Communications and we're very excited to have him on board to further F5's expansion into multi-cloud opportunities globally.

Barry joins another former AWS colleague, Venu Aravamudan, who joined F5 in fiscal 2018 to lead our F5 as a Service business.

Venu is a seasoned software executive and expert in cloud computing with leadership experience spanning product development, product management, program management and product and solution marketing.

His leading-edge experience with public cloud services and infrastructure platforms, services development, deployment and operation and enterprise IT transformation to cloud made him ideal to lead our F5 as a Service program.

Prior to joining F5 in 2018, Venu was General Manager in the Amazon Relational Database Services business unit and previously held leadership roles at Limelight Networks, VMware and Microsoft.

We're excited to have both Barry and Venu's cloud expertise at F5.

In closing, I'd reiterate that we are making meaningful progress toward our long-term vision for F5 with continued momentum in software and security solutions.

My thanks to the entire F5 team and our partners for the progress we've made.

As a team, we're excited about the year ahead, and we look forward to reporting on our continued progress in fiscal 2019.

With that, we will now open the call to Q&A.

Hello, and welcome.

I'm Suzannne DuLong, F5's Vice President.

Natalie, could you open the call for Q&A, please?

(Operator Instructions) And your first question comes from the line of Rod Hall of Goldman Sachs.

I just have a couple.

I wanted to, I guess, first ask about software sales growth.

And I mean, it's a healthy sequential growth there, but it's kind of decelerating a little bit.

And not sure what we should be reading into that.

We only have a couple of quarters here, but we calculate year-on-year growth at 19%, down from 24% last quarter.

So just trying to figure out kind of what do you guys think the right growth trajectory for software is?

Is the first question.

And then the second thing that I wanted to ask about is just tariffs, and really production, where are you producing product and how much of it is in China?

And if there is any in China, what your plans may be to move out of China would be?

So if you could address that, that would be great.

Hi, Rod.

Thanks for the question.

I'll take your question on software, and Frank, will take your question on manufacturing in China.

So the first thing, Rod, on software, I'd tell you, no, you should not read anything into the 19%.

I am very excited about where we're at on software generally and where we're going into 2019.

The context for the Q4 19% is, first of all, software as a percentage of overall revenue is still relatively small.

And so as I shared in last quarter, it can be lumpy from quarter-to-quarter, but the general trends are going to be what we've said.

We -- specifically for this quarter, we had it tough compared to Q4 of 2017, which was a big software quarter.

I think that's part of what you're seeing in this growth rate that's a little less than last quarter.

But if you look overall, in Q4, 17% was -- sorry, software was 17% of product revenue, so we're up from 15% in prior quarters.

And as a percentage of the mix, we're on trajectory to achieve our Horizon 1 goals.

I said, I'm very excited for where we're at on software and that's because of what I foresee is going to be happening in 2019.

So at our analyst conference, we said, we would be, in Horizon 1, which was 2019 and 2020, we said we will see software growth that would be in the 30% to 35% range.

And I feel confident we're going to be in that range.

We've got a lot of things driving software growth in 2019.

First of all, I'll point to just 3 of them.

First of all, we're seeing really good momentum on our ELAs, these enterprise license agreements.

They're driving a larger deal size and they're also allowing us to expand our use cases and start to take footprint for either -- from either cloud native or different open source of virtual ADC competitors with these new model of consumption.

So that's going to drive growth in software.

Our Cloud Edition is ramping very well from the first 4 months we've had in the market.

So we expect a meaningful contribution of Cloud Edition in 2019.

And as you probably heard from the script, we also have new products that are coming now in the first half of 2019, both F5 as a Service and our cloud native app services platform.

So we've got very good drivers in '19, and I expect, we're going to be in the range that we've discussed for Horizon 1. Frank, on the China?

Sure.

So Rod, in relation to your question on tariffs, unrelated to the -- to any sort of trade war escalation, we actually had a plan to move our production manufacturing from China to Mexico, which we completed that transfer in FY '18.

And so we're all done and complete with that.

We've actually taken a look at where the tariffs are today and the impact that would have on our FY '19 operating plan.

It's approximately $1 million of additional cost based off the tariffs that we've already baked into our operating plan and the guidance we've given you.

Let me just follow that one up because we -- this may be instructive for other companies as well.

You guys have already made that move.

Did you find it -- I meant, we didn't really see it in the number, so it seems you have gone pretty smoothly.

Did you find it had any impact on your inventories?

Or anything else in the business?

Or was it -- did you find it pretty easy to do?

I guess, I'm just curious about that.

Look, we -- Rod, we started this move last year, in the early part of last year.

And I think the team just -- kudos to our -- both our supply chain and manufacturing team.

They executed very well on the move.

No, we did not have an impact on inventories.

Frankly, we made the move while staying with the same contract manufacturer.

And so it was the same CM that was supporting us in China, that is supporting us in Mexico, and I think that made things smoother.

And so generally, there has been no impact.

And we have -- we continue to have very high quality of the outputs that are coming, both out of the China manufacturing environment and the Mexico manufacturing environment.

Our next question comes from the line of James Fish of Piper Jaffray.

I would say -- I would like to start off on sort of the billings here and the deferred revenue.

Billings were down about 1.5% year-over-year.

It was actually down sequentially in a seasonally strong quarter.

The implication would be that it was on the maintenance side, given the upside on the product here.

I know, François, you talked about the strength of renewals and attach, but I guess, where you are having a discount more on the maintenance.

And then just along with that as we're thinking about '19, what's the impact on -- of adopting ASC 606 with guidance here?

Sure.

So Jim, it's Frank.

I'm going to take both of those.

Let me start first with the deferred question.

On the deferred revenue, we actually have -- it was a very simple explanation on that.

We saw at the end of the quarter, few customers with some larger renewals that just were trying to manage their own cash.

And so you're going to see that reverse itself in Q1.

And then on the 606, we have a very, very small de minimis impact, frankly, from the change to 605 to 606 that we've discussed in our financial statements for the past couple of years.

And so the guidance that we've given reflects the 606 impact, but it is very minimal.

And we've seen the same attach rates and do not see any unusual discount in the maintenance.

Okay, great.

And then, just one more from me.

Any sense to how pricing changes, or any more color you can give?

I know we talked about a little bit at the Analyst Day, but any color between the appliance version compared to the BIG-IP cloud version that's coming?

I get that gross margins improve as it is software, but are we talking about a 20% or 30% price reduction?

No.

So James, the -- let me we make sure we're aligned here.

On the -- so generally, you'll see that our average deal size hasn't changed.

It's still in the $120,000 range and it has been for the last several quarters.

What you're talking about is the sort of unit price of a Virtual Edition, a classic Virtual Edition of F5 versus the new Cloud Edition.

But the new Cloud Edition on a per unit basis is a fraction of the price of the Virtual Edition, but remember that a Virtual Edition typically support anywhere between 5 and 10 applications, and a Cloud Edition is bought on a per application basis.

And so what we're seeing in the initial deals that we've done on Cloud Edition is that the number of apps that are supported is significant.

And so overall, there is no impact on the deal size.

It's about the same deal size as what it's been on Virtual Editions.

It's just a different consumption model that allows more flexibility for the user to manage their infrastructure on a per-app basis.

Our next question comes from the line of Ahmed Badri of Crédit Suisse.

I wanted to get a better idea on the multi-cloud deployments.

I just wanted to get an understanding of some of your customers and their behavior.

When they decided to come back to you for more product and they decided to move into a multi-cloud architecture, on a net-net basis, are they actually buying more physical ADCs or more ADCs in general to deploy a multi-cloud architecture?

Or is it about the same number of units when they conduct that kind of deployment?

All right.

So let's just say, in general, I would say, there are a couple of scenarios in those deployments.

The -- we have a lot of customers that are buying traditional hardware motion and are adding to that Virtual Editions on -- Virtual Editions on-prem, that's kind of a classic deployment model.

What we're seeing is more and more these customers also want to deploy their infrastructure in multiple public clouds.

And their desire is to manage all these instances of ADCs as part of a single portfolio and ideally through a single pane of glass.

Our ELAs enable them to do that and give them the flexibility to consume as many licenses as they want of software, and whether they put these licenses on-prem or in the public cloud.

The initial -- I'm talking about software purely right now.

The initial view we're seeing from the consumption of these ELAs is very strong, i.e.

they signed up for a minimum amount of consumption and we're seeing in the early months of consumption that they're well on track to exceed that minimal amount of consumption, which bodes well for true-up in the future.

What we've seen as it relates to hardware is that generally customers that use us in a multi-cloud deployment scenario overall spend more with us than customers that use us just in a traditional hardware deployment models.

And so that's, I think, how I would frame it for you is the overall spend for a multi-cloud customer is larger than one that is not -- or the one that is to pure hardware.

Got it.

And then, just as a follow up to that, do you see very similar services revenue attached to those same type of deployments?

Or is it a little bit different?

No, it's very similar.

The only difference, Sami, is that when a customer signs up for an ELA or a subscription, their services is part of the subscription.

And so it will show up for us in our product revenues, whereas, in a model where they bought the hardware as the perpetual license and separately they bought maintenance, that services would show up in our services revenue.

So there is a difference in terms of where the services revenue is going to accounted for.

But in terms of the -- if your total customer spend is the same or potentially -- in terms of the amount of money they're spending on services is the same or potentially larger, if we are successful with the renewal and the expansions that we're seeing in the early days.

Our next question comes from the line of Tim Long from BMO Capital.

Can you hear me?

Yes, we can, Tim.

Back to the software line.

François, you talked about Cloud Edition and it sounds like it's off to a pretty good start.

The sequential jump in software, it's kind of the first quarter of Cloud Edition, so can you give us a sense as to how much of the contribution was from just better virtual sales and security?

And did that -- the Cloud Edition start to at least make an impact on that software line?

And then related to that, we've yet to see kind of last few quarters with software moving a little higher, particularly, this quarter, haven't seen much in the product gross margin, is that something that you would expect to start to move a little bit higher as that ramps as a percentage of sales?

Tim, the -- so on the first one, we said at the time of release of Cloud Edition that we did not expect material revenue contribution from Cloud Edition in FY '18.

And that is the case.

I would say the contribution to Q4 was very minimal, because there is -- the time it takes to get through -- go through the sales cycle, the proof-of-concepts et cetera, and then a lot of the initial views or initial sales, which will expand over time.

So minimal contribution in '18, but we do expect -- given the traction that we've seen so far, we do expect meaningful contribution in fiscal '19.

In terms of the gross margins, yes, the answer is no different than what we've sort of aimed that over time we do expect the software contribution grows to have some impact on our -- positive impact on our gross margins.

If you recall, at the end of our Horizon 2, which is 2022, we expected our software to be about 40% of total product revenues.

I think by then, we would see meaningful impact.

That being said, our margins are roughly 85% right now.

And so the room for expansion isn't significant.

What we said is that in Horizon 2, our margins would be in the 85% to 87% range, so it's incremental, but small in the big scheme of things.

We're tracking, Tim, to the Horizon 1, Horizon 2 guidance in that regard.

Okay.

And then just a quick follow up on the Cloud Edition.

Can you just talk a little bit about, are you seeing any kind of new customers added to F5 by these new offerings?

And do you expect that with the next software offerings in the first half of next year?

Then I'm done.

Yes, thank you, Tim.

So I would say, we continue -- as a company, we continue to win new logos every quarter and that's not merely driven just by Cloud Edition.

We're winning new use cases in security, in public cloud, and even I mentioned last quarter, a number of new customers coming in for hardware.

So new customer and new logo acquisitions is going to continue.

What we're seeing with Cloud Edition is, within our existing customers, we are unlocking new footprint that we didn't have before.

There are a couple of use cases that we could not address before.

One is, when customers want to really deploy on a per-app basis, we couldn't touch those types of deployments, we now can.

And two, is the ability to scale rapidly the infrastructure under an application, that sort of flexibility is a new use case for us and its expanding our footprint and touching new applications, specifically applications that are in test and development.

We didn't have the opportunity before to intercept these applications at their inception, and now we can.

And the third aspect of that is, we are also now for the first time giving application developers direct visibility into their virtual instance of F5.

And they are seeing analytics and the performance of their applications, and so we're building a relationship with that developers that we didn't have before and that's driving new deployments into new applications.

So I would characterize it right now as largely addressing the long tail of applications you heard us talk about inside of existing customers more than focusing on going and looking out for new customers.

I do think though we will address new customer segments, as we introduce in the first half of '19 F5 as a Service and our cloud native app services platform.

Our next question comes from the line of Jason Ader from William Blair.

Frank, could you talk about linearity in the quarter, and just give a sense of how that's similar or different than what you've seen in the past in Q4?

And then, François, on the systems side, it looks like that's recovered a bit, the flat year-over-year, which I think is an improvement of what you've seen over the last several quarters, can you talk about what's driving that?

Sure.

So Jason, thanks for your question.

I'll start and then turn over to François.

The linearity one is fairly straightforward.

It was almost identical to what we've seen in the past Q4s.

And so we were, if anything, saw even a little bit of better in Q -- in month 1 and month 2, but we're talking a percentage point, nothing dramatic.

And Jason, in terms of the systems, if you recall in March, we said that we expected the overall market for hardware ADCs to decline in mid-single digits going forward.

But we also expected that we would do better than that, that we expected to be in the low single-digit decline to flat going forward.

And I think what you've seen over the last 3 quarters is we've done exactly that.

In this quarter, we were flat.

And we still expect quarterly fluctuations on the hardware number, but overall, we're executing as per the plan and I think we're getting share.

And there are a couple of reasons for that.

One driver of this stability is security use cases driving spend in ADC for us, that's not all ADC vendors have access to it because they don't have the security capabilities, things like SSL Orchestration or web application firewall or Access Manager consolidated on ADC, that's driving stability for us in ADC.

There are new use cases, such as steps in the federal sector or IoT that are driving demand for our hardware products.

There are geographies where there is significant demand for new hardware, specifically in the emerging markets, places like China and Latin America.

And so all of these factors are driving stability in the hardware business along the lines of what we had said would happen at the Investor Meeting.

Our next question comes from the line of Alex Kurtz of KeyBanc Capital Markets.

Just a couple of quick questions here.

I just want to follow up on the new customer question from earlier around Cloud Editions.

I think, there was a broader view of a lot of traditional on-premise software companies that they won't be able to capture the cloud native application or the company that maybe just starts fresh in the cloud.

And I think, there's been some talk of companies, like yourself that are building software in the cloud platform, sign the customer, then maybe there is even an opportunity on-prem down the road.

So could you just double-click on that a little bit more?

I know you briefly touched on it, but I'm just wondering, have you seen cases like that?

Or is it just too soon to know?

Well, Alex, if that's what you're referring to, we have seen cases, and I wouldn't say we're seeing them by the hundreds, but we have seen cases of companies that were born in the cloud and essentially never bought or owned a piece of infrastructure.

And as they grow and start to worry a bit more about their profit, they start worrying about how they control their cost.

And we have seen some of them almost graduate from this born in the cloud environment and come back and ran colocation capabilities and actually come back to us for hardware ADCs.

So we have seen those cases.

I don't know this was a trend that's going to be much stronger in the future than it is today, but we are seeing that.

But as it relates to acquiring customers directly in the cloud for companies that were historically on-prem like us, we think it's an opportunity that largely for us is untapped because you're right, we don't play in that market today.

But that's why we are quite excited about F5 as a Service coming in the first half of '19 because that's going to allow us to really intercept these born in the cloud applications in a native cloud consumption experience for those who are building their app in the public cloud's platform environment.

And so we're pretty excited about our opportunity to play there and intercept these applications.

And then, down the road, as these applications grow, if they too have multi-cloud requirements, it will make it that much easier for us to contribute to their requirements beyond the single public cloud.

And so F5 as a Service essentially will be our leading entry into the relationship, which we will expand from.

That's very helpful.

And just back on the current environment with tariffs, higher interest rates, very strong calendar '18 for IT spend.

I think there was a lot of concern heading into '19 that things may not be sustainable.

I mean, when you talk to your larger enterprise customers, what's been sort of the initial feedback?

And how they feel about spend over say maybe in the next 6 months or so?

I would describe it, Alex, as generally the spending environment, you're right has been healthy in '18.

We continue to think overall that it's healthy, so specifically for the enterprise market.

In North America, in particular, we've seen some softness in the Tier 1 service providers in the last quarter and we're cautious about the upcoming quarters with Tier 1 service providers.

There hasn't been a sign of significant change in behavior from our enterprise customers, but like everybody else, we are a little cautious going into 2019, given what we've seen over the last 3, 4 weeks.

Our next question comes from the line of Samik Chatterjee of JPMorgan.

I just wanted to start off with the growth that you're seeing in the cloud.

You mentioned you're seeing strong growth there.

Can you remind us within -- now amongst kind of the Tier 1 and Tier 2 cloud providers, who do you have existing partnerships with?

And how should we think about kind of, have you seen any interest from additional cloud providers?

And how should we think of that as an enabler of stronger growth in software?

Yes, Samik, so we have relationship with the major public cloud providers.

So AWS, obviously, is a partner for us, Microsoft Azure is a partner.

We have integration going into Google Cloud and international cloud providers as well.

And the relationships aren't just technical integration.

Certainly, in terms of the top 2 or 3, there are significant co-marketing activity between us and them to help customers leverage their cloud and migrate applications over to the cloud.

And so in the software, we don't break out, by the way, as you know, Samik, we don't break out our public cloud revenues, but we have said before, and I can reiterate this, that within software, software in the public cloud is the faster growing part of our software business and that has been the case throughout 2018.

Got it, got it.

And then, if I can just maybe this is more for Frank, but if I kind of look at your guidance, I think, you mentioned that coming off the 1Q base, you expect sequential improvement in the revenues through 2019.

That seems like the more visibility than you've had typically, and correct me if I'm wrong on that and it seems like more confidence about base of improvement there.

Is that something more specific that's contributing to that?

Is it more about kind of sequential acceleration in those software revenues?

Or anything else that's contributing to that higher visibility even on the quarterly cadence of revenues?

Samik, honestly, I think it's fairly consistent with what we've said in the past in terms of our sequential improvement.

It's the cadence in which our quarters generally fall.

I think, we're obviously happy about the traction that we've seen in software and continue to see in the software visibility that we've got, that actually -- that's got nice predictability for us.

And so that gives a base in and of itself, but in terms of the specific, a qualitative guidance for the broader FY '19, that's fairly consistent to where we've been in the past.

Our next question comes from the line of Tal Liani of Bank of America.

I'd like to ask a question on security.

First, what's the level of security revenues right now?

I know you didn't disclose security as a percentage of sales revenues in the past.

Do you have any kind of disclosure?

And if not, when -- what needs to happen for you, or what level of revenues needs to happen or need to materialize for you to disclose security?

Second is, when you look at 2019, what's the road map for addressable markets for security?

Meaning, what are you going after?

And if you can give us also a snapshot of the current offerings of security, where do you see success and where do you still need to work on?

What do you still need to work on within the security portfolio?

And then, I have a follow-up question.

Tal, that's 3 questions in 1. We'll address them in that order, Tal.

So in terms of disclosure of security revenues, we -- as you know, we don't break that out.

I would say that the percentage of our ADC sales that are driven by security use cases or that include a component of security in the overall bundle has steadily increased.

And today, it's a meaningful percentage of our ADC sales.

We don't break it out.

It's not just a question of on the size of the revenue, but it has to do with -- in a number of cases, it's very subjective to determine whether a sale was driven by security or ADC or both.

And so that's the reason that we don't break it out today and there is not a clear trigger for when we will.

In terms of your -- and I'll take the third part of your question then the second one.

Where we have been seeing very strong success to date, historically, and Tal, I would say that would be up until kind of the middle of 2018 was really in these consolidated use case, where we -- it's very convenient for a lot of our enterprise customers to consolidate onto an ADC application firewall, identity and access capability, some encryption, decryption capabilities.

And so this use case of consolidation in the ADC and the enterprise has been extremely successful and will continued to be.

That is also true in the service provider world where our capabilities around CGNAT, CCP optimization, carrier-grade firewalls, consolidated into an ADC capability is very appealing to service providers.

So I would say, if you look historically, the consolidation of multiple security modules and functions that allows 1 to reduce CapEx and reduce complexity has played out in the enterprise and service providers.

Going forward in 2019, we're very excited about 2 stand-alone security use cases.

The first one is our advanced web application firewall, where we've already released that product and we're seeing great initial traction.

We're really differentiated relative to other players because of our Layer 7 capabilities, but also bot litigation capabilities, and that differentiation today is on-prem, but we're going to bring our WAF capabilities into F5 as a Service and we think that's going to be a big differentiator for us.

And then the second one we're very excited about is our SSL Orchestration capability.

So mid mass use this case because all enterprise customers are dealing with -- the vast majority of their traffic is encrypted and we provide a very efficient solution to encrypt and decrypt the traffic through what we call break and inspect and then chain multiple security services together, which saves very significant dollars to an enterprise customers.

So these 2 areas, Tal, we expect them to be 2 meaningful growth drivers for us in stand-alone security next year.

And if you recall, that was one of our growth pillars from the conversation at [AIM] in March.

So what are the other things you need to do with your business in order to address the opportunities?

Meaning, product -- launching product is great, it's one aspect.

How about dedicated sales team need, or you don't need dedicated sales engineers, marketing around security branding -- different branding?

Or is it part of the ADC branding?

So can you discuss the outer activities outside of product innovation?

Yes, Tal, it's a great question.

And the -- so there are other activities, but we have been doing them already for several years.

So if you look at our sales organization, in a lot of cases, a lot of our accounting specifically major accounts are already facing the CISO community and the SecOps buyer.

So there isn't -- it's not like our sales team isn't capable today of selling security solutions because they've been selling them in a consolidated bid ADC fashion, and so they're very conversant in the solutions.

But they're addressing new use cases with the SecOps buyer.

In terms of marketing and top leadership, most of our customers see today as a security company.

We have a significant muscle in security, in threat research of an organization called F5 Labs that publishes research on security issues on a regular basis and that is very well read within our customer and partner community.

So there are tons of things that we don't necessarily talk about, because they've been in the go-to-market motion of F5 now for already several years.

Our next question comes from Simon Leopold of Raymond James.

Natalie, why don't we move on to next one and maybe go back to Simon?

Our next question comes from the line of Paul Silverstein of Cowen & Company.

And I'll ask you the questions that Simon probably should have asked.

So François, first a clarification, I heard your response to the end demand question, with respect to, I think, I heard you say that U.S. service provider weakened in the last 3 to 4 weeks.

My question on that is within enterprise, what are you seeing from an end demand perspective?

And if you look regionally, I think, you've now posted high single-digit growth in the EMEA region for the fifth straight quarter.

The Americas were flat and they've been flat-to-low-single-digit in the region for the last several quarters.

Asia-Pac was 11%, following 8% growth in the preceding quarter and Japan was 11% following 4% in Q3.

Some of that may be easy comps in the latter 2. But my question to you is, if you look at the regions, what accounts for the differences?

You would think from an economic perspective, with U.S. having perked up, and in EMEA much less so, it's sort of counterintuitive.

But is this a reflection of ongoing service provider weakness?

What's going -- what is that regional information?

What should it be telling us in terms of the strengths and weaknesses of your business?

And then I have a follow-up question.

Paul, I'll clarify first, I didn't say service provider had weakened in the last 3 to 4 weeks.

I said, we were seeing in the last quarter or so softness in Tier 1s in North America.

And as you know, service provider business can be lumpy.

But if you look at -- that also is the, I think, the majority of the explanation on why North America has in relative terms -- is more flattish than other regions.

A, it's largely driven by the softness we've seen in the Tier 1 service providers in North America.

So I just wanted to be clear, if we looked at your -- if we saw the numbers for your North America enterprise business, we would be something mid-to-high-single-digit growth consistent with EMEA, any other regions, is that the case?

We don't break that out, Paul.

But we will see the number that would be higher than the aggregate number that you're seeing here.

All right.

Let me ask one other question, if I may.

François, to what extent, historically, if we go back to the dawn of what was in-load balancing back in the late 90s, which you guys pioneered along with a couple of others, and we fast-forward to today, historically, you also sold to the networking side of the IT organization with enterprise.

And over time, and it's still ongoing, but the locus of purchasing power seems to be shifting, seems to be in progress.

To what extent do you all have an issue?

And if you do, to what extent you're addressing it?

And separate from Tal's security question, in terms of addressing the application developers who have increasing power in that equation in terms of making the purchasing decisions.

Do you already have the mindshare?

Or do you need to do meaningful work in terms of gaining the mindshare among that community?

Yes.

Paul, that's a great question.

So the -- there are 2 -- you are correct that both application developers and their close cousin, DevOps people are gaining mindshare and influence in large enterprise organizations.

That's resulting into 2 things.

First, for our traditional buyers, Network Infrastructure, that is typically in central IT, they want to offer a better SLA to app developers and DevOps people.

And so part of our portfolio strategy, our multi-cloud strategy is to enable our current buyers to offer that better SLAs.

Cloud Edition, just -- I just discussed earlier, does exactly that.

It offers this per-app capability, which means an app developer doesn't have to wait for a maintenance window for 5 weeks so that all applications can align to an upgrade.

They can do their thing on their part, on their infrastructure.

We also get more analytics and got more visibility in their application.

But that Cloud Edition is typically purchased by a network operation's person and they use that new technology to offer a different SLA to app developers.

So that's kind of motion 1. The solutions we're releasing in 2019, both F5 as a Service and our cloud native application platform, those will appeal directly to the DevOps buyer.

And they will allow them to essentially procure their own technology on their terms.

And so associated with that, we have a significant efforts around digital marketing, digital sales, and a tech touch for these buyers that essentially allow them to procure the -- to trial and explore trial and procure the technology in the way they want to do it, which is very different than our traditional buyers currently.

So that's how we will address that community as well, but that journey starts in 2019.

Our last question comes from the line of Simon Leopold of Raymond James.

Can you guys hear me okay this time?

Yes, Simon.

Paul did ask great questions, but unfortunately not the ones, I was going to ask.

So I wanted to go back to the cloud guys.

Given that AWS and Azure offer load balancing, yet, you talk about them as partners.

could you maybe compare and contrast how you might be competing with them at times and using them as a way to go-to-market?

Where does it make sense for an enterprise to engage the solution offered by an AWS or an Azure versus engaging F5 for the functionality?

All right.

Great, Simon.

So let's start.

So today, there are applications we don't support, that are typically applications that are born in the cloud either in test or development or even in production and that, I would say, have relatively simple load balancing requirements.

Those applications are largely addressed by the native load balancers offered by the large public cloud providers.

And now in -- so that's where they play.

And today, we largely play in enterprises that have either on-prem requirements or multi-cloud deployment requirements.

So if somebody wants to deploy an application or a portfolio of applications in multiple public clouds, typically, we're going to have a play there because we are cloud agnostic.

And we will in that scenario partner with the public cloud providers to help the customers migrate their application to these environments.

And when F5 is supporting an application on-prem and it migrates, in the vast, vast, vast majority of the cases, we will stay with that application and they will stay with us.

Now in -- so that's kind of the lay of the land today.

In 2019, as we introduce our new platforms in F5 as a Service, we will also play in born in the cloud applications.

But the value add that we bring beyond the cloud native load balances is the future depth and breadth that a lot of these applications want, when they want global server load balancing, some security capability.

And our partners in this case, the cloud providers are actually interested in partnering with us to enable these capabilities in their environment in a seamless way for these applications.

And that's actually one of the reasons that I mentioned in the script earlier, that Barry and Venu have joined us from AWS.

One of the reasons for that is they have deep insights, both into the economics of application, public to public cloud and the technology associated with the deployment and they're very interested in this multi-cloud strategy and how we're going to deploy our business in these environments.

And maybe just a quick follow up to that.

It seems as if Google Cloud has really been trying to catalyze multi-cloud, given that they're the third player.

They've got the most to gain, I believe.

Where are you in terms of relationship with Google?

We have a relationship with them as well.

I would say, just for clarity though, Simon, when we talk about multi-cloud, we mean by that multiple, multiple public clouds, colocation, on-premise, private data centers and on-premise private clouds and we are seeing all of these deployment models happen within our customer base.

Thank you.

And that concludes today's conference.

Thank you for participating.

You may now disconnect.