F5 Inc (FFIV) 2021 Q3 法說會逐字稿

Good afternoon, and welcome to the F5 Networks Third Quarter Fiscal 2021 Financial Results Conference Call. Also, today's conference is being recorded. If anyone has any objections, please disconnect at this time. I'll now turn the call over to Ms. Suzanne DuLong. Ma'am, you may begin.

Hello, and welcome. I'm Suzanne DuLong, F5's Vice President of Investor Relations. Francois 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 session.

A copy of today's press release is available on our website at f5.com, where an archived version of today's call will be available through October 25, 2021. Today's live discussion is supported by slides, which are available on the webcast and will be posted to our IR site at the conclusion of today's discussion. To access the replay of today's call by phone, dial (800) 585-8367 or (416) 621-4642. Use MediaID 529-4198. The telephone replay will be available through midnight Pacific Time, July 27. 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 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 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 Francois.

Thank you, Suzanne, and hello, everyone. Thank you for joining us today. I am pleased to share with you our very strong Q3 results. Broad-based strength across the business drove 11% revenue growth in the quarter, marking our third sequential quarter of double-digit revenue growth. We delivered 34% software growth, 13% systems growth and 4% global services growth in Q3.

F5's business is benefiting from digital acceleration and application growth as well as heightened demand for application security. Customers' traditional apps are generating more revenue and more engagement than ever before. At the same time, customers also are accelerating adoption of modern application architectures like Kubernetes for new applications.

With our expanded application security and delivery portfolio, we are uniquely positioned to solve our customers' most significant modern and traditional application challenges on-prem, in the cloud and across multiple clouds. I will speak more about our business drivers and customer highlights from the quarter after Frank reviews our Q3 results and Q4 outlook. Frank?

Thank you, Francois, and good afternoon, everyone. As Francois just outlined, our team delivered another very strong quarter. Third quarter revenue of $652 million was up 11% year-over-year and above the top end of our guidance range. Please note, as I review our revenue mix, I will be referring to non-GAAP revenue measures for the year-ago period.

Q3 product revenue of $310 million is up 21% year-over-year, representing a significant acceleration from 3% in the same period last year. Product revenue accounted for approximately 48% of total revenue, up from 44% in the year-ago period. We continued to advance our transition to a more software-driven model. Q3 software revenue grew 34% to $129 million, representing 42% of product revenue, up from 38% in the year-ago period.

Today, we offer customers annual and multiyear subscriptions as well as a growing base of SaaS consumption models. Customers' preference for these flexible models is driving growth in the subscription-based portion of our revenue. In fact, since Q3 of 2018, we've driven subscription software revenue growth at a 3-year compounded annual growth rate of 118%. In Q3 '21, subscription-based revenue represented 78% of total software revenue, up from 73% in the year-ago period.

Customer adoption of our multiyear subscriptions continues to grow, providing much needed flexibility for our customers and future revenue visibility for us. These multiyear subscriptions are generally 3-year term subscriptions and can be for BIG-IP or NGINX or a combination of both. With customers increasingly looking to F5 to support both traditional and modern applications, our multiyear subscriptions are more frequently including both BIG-IP and NGINX. In fact, in Q3, NGINX was part of over half of our multiyear subscription deals.

We see continued strong systems demand based on broad-based increases in application usage, continued growth of system-based security use cases and 5G service provider use cases. In Q3, systems revenue of $180 million is up 13% compared to last year when systems were down 12%.

Rounding out our revenue picture, we see continued strength from our global services with revenue of $342 million, up 4% compared to last year and representing 52% of total revenue. Revenue from recurring sources, which includes term subscriptions as a service and utility-based revenue as well as the maintenance portion of our services revenue totaled 66% of revenue in the quarter.

On a regional basis in Q3, Americas delivered 10% revenue growth year-over-year, representing 57% of total revenue. EMEA delivered 19% growth, representing 26% of revenue. And APAC delivered 3% growth, accounting for 18% of revenue. The strength in Q3 span customer verticals as well. Enterprise customers represented 69% of product bookings in the quarter. Service providers represented 15%. And government customers represented 17%, including 4% from U.S. federal within the government vertical.

I will now share our Q3 operating results. GAAP gross margin in Q3 was 81.4%. Non-GAAP gross margin was 84.1%. GAAP operating expenses were $434 million. Non-GAAP operating expenses were $349 million. Our GAAP operating margin in Q3 was 14.8%. And our non-GAAP operating margin was 30.5%.

Our GAAP effective tax rate for the quarter was 4.9%. Our non-GAAP effective tax rate was 14%. Our non-GAAP tax rate is lower than anticipated as a result of an election we made with our FY '20 U.S. income tax return filed in Q3. The election related to certain research and experimentation costs for tax purposes only and have the effect of reducing our non-GAAP effective tax rate in Q3. GAAP net income for the quarter was $90 million or $1.46 per share. Non-GAAP net income was $169 million or $2.76 per share.

I will now turn to the balance sheet. We generated $182 million in cash flow from operations in Q3. Cash and investments totaled approximately $863 million at quarter end. You will recall, in Q2, we initiated a $500 million accelerated share repurchase program. During Q2, we retired approximately $400 million worth of shares. In Q3, we retired the remaining approximately $100 million worth of shares, reflecting roughly 449,000 shares purchased during the quarter.

The average price paid per share for the full $500 million program was $199.90. DSO was 53 days. And capital expenditures for the quarter were $9 million. Deferred revenue increased 13% year-over-year to $1.44 billion from $1.28 billion. Finally, we ended the quarter with approximately 6,380 employees, up approximately 20 from Q2.

Now let me share our guidance for the fiscal fourth quarter. Unless otherwise stated, please note that my guidance comments reference non-GAAP metrics. Near term, we expect customers will continue to invest to support both traditional and modern application growth and the modernization of their application infrastructures. We also anticipate continued focus on and investment in application security. Thus far, our supply chain team has navigated industry-wide supply chain challenges well. With all signs pointing to continued challenges for at least several quarters to come, we will continue to closely monitor the situation.

With that as a context, we are targeting Q4 fiscal 2021 revenue in the range of $660 million to $680 million, implying roughly 9% growth at the midpoint. We continue to expect FY '21 software revenue growth at or around 35% and feel very good about our software momentum as we close FY '21 and head into the back half of our Horizon 2 time frame.

We expect Q4 '21 gross margins of 84% to 84.5%. And we estimate operating expenses of $346 million to $358 million. We also expect to achieve our fiscal year 2021 non-GAAP operating margin target of 31% to 32%. We anticipate our effective tax rate for the year to be approximately 19%. Our Q4 earnings target is $2.68 to $2.80 per share. We expect Q4 share-based compensation expense of approximately $62 million to $64 million.

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

Thank you, Frank. Our very strong third quarter results demonstrate the powerful alignment of our expanded solution portfolio and our customers' most important application needs. Across the board, our customers are massively accelerating digital transformation to keep up with current demand and forecasted growth and to meet consumers' expectations for application performance and availability.

But it is not just keeping up with application growth that is a challenge. Customers are caught managing this robust growth across multiple infrastructures, with applications in both traditional monolithic 3-tier architectures and in modern cloud-native and container-based architectures. F5 is uniquely suited to solve customers' traditional and modern application challenges. Our flexible programmable BIG-IP portfolio secures and delivers traditional applications whether in a systems- or software-based form factor on-premises and in the cloud.

Meanwhile, our NGINX portfolio provides high-performance application security and delivery for micro services in Kubernetes and container-based environments. And with our Shape Security portfolio, we also bring industry-leading fraud and bot protection against automated attacks. So let's talk about 5 sustainable customer trends resulting from accelerating digital transformation and driving robust demand across our portfolio.

Number one, enterprise customers, developers and DevOps teams are using NGINX to insert security earlier in the application life cycle. NGINX with App Protect delivers robust application security for micro services with the flexibility and agility developers demand. In just one example, during Q3, we secured an NGINX win with an information services company that services high security customers in financial, fintech, medical, insurance and the U.S. federal government. The customer selected NGINX Plus with App Protect for its ability to deliver Layer 7 WAF protection, reverse proxy and load balancing in a single unified solution.

Trend #2, heightened security concerns and high-profile ransomware attacks are escalating demand for top-notch application security and fraud and abuse mitigation. With pronounced application growth and an ever-expanding threat landscape, including high-profile ransomware and credential stuffing attacks, we see growing demand for application security in cloud environments and rising demand for fraud and bot defense.

In an example of the strong customer interest in our Shape solution, during the quarter, a big brand athletic shoe manufacturer selected Shape to take on a sneaker bot that was relentlessly attacking its retail site attempting to siphon off shoes for resale. Through an exhaustive proof-of-concept, Shape proved far more effective than a competitor at identifying and stopping the bot attack.

Trend #3, customers are leveraging F5 for Kubernetes, containers and cloud-native architectures. Our growth in modern applications continues to accelerate, driven by NGINX, Kubernetes and cloud-native deployments. We are seeing several top use cases emerge for NGINX, including API gateway, Kubernetes ingress controller, NGINX App Protect and software-based load balancing. Customers' modernization efforts and the availability of NGINX Controller and enterprise-level app security with NGINX App Protect continued to drive larger NGINX deal sizes.

During Q3, a large health insurance provider in the United States selected NGINX to help their teams manage their modern apps. They deployed recently introduced NGINX Instance Manager to track, configure and manage their businesses NGINX open source and NGINX Plus instances. They also deployed NGINX as an ingress controller to manage secure communications between services that are both external and internal to the Kubernetes cluster. In addition, they are using NGINX to monitor PUDs running in a public cloud providers managed Kubernetes service and adjust the load balancing rules based on PUD availability.

Trend #4, customers are scaling their existing hardware-based infrastructures to handle accelerating application growth, driving continued strength from BIG-IP systems. Last quarter, I spoke about the fact that some of our BIG-IP systems demand was being driven by cloud-based and SaaS providers. These global leaders are turning to F5 to help them scale their existing application infrastructures in support of continued rapid adoption and growth of their digital products and services. In Q3, this trend continued with a global SaaS-based cloud service provider refreshing and expanding their existing BIG-IP infrastructure to efficiently and securely scale with rising demand.

And finally, trend #5, customers are leveraging BIG-IP for transformation, including cloud migration and automation initiatives. The demand we are seeing for BIG-IP systems and software is about more than just capacity additions. Customers also are choosing BIG-IP to drive transformation. When customers move traditional applications to the cloud, they are lifting and shifting with F5, choosing not to incur the time, cost and risk of refactoring their applications.

In just one example in Q3, in APAC, we won a deal with a large credit issuer with a 2-year plan to exit their own data centers and migrate all nonmission-critical applications to the cloud. They chose a combination of BIG-IP and NGINX software with a multiyear subscription consumption model to ensure flexibility throughout the process.

In another example of F5's role in app modernization, an American multinational computer technology company is embarking on a large-scale project to build their own private cloud, including repatriating cloud workloads to save costs and drive efficiency. They selected BIG-IP hardware and software as well as NGINX to execute the project.

While several of the trends I have just described also apply to our service provider customers, service providers also face unique challenges as a result of 4G to 5G migration and growing 5G traffic demands. We see Gi LAN use cases gaining momentum globally as 5G devices are enabled. We are seeing 4G to 5G momentum growing for F5 in 2 ways: first, for capacity augmentation supporting 5G rollouts; second, with virtual network function and cloud-native network function-based architectures gaining traction to replace legacy infrastructures.

In one notable service provider win from Q3, one of the largest mobile providers in India turned to F5 to scale its 4G network in preparation for its 5G deployment.

Before I wrap up our prepared remarks, I will comment briefly on our Volterra acquisition. The trends we are seeing across the business also bode well for the opportunity we see ahead with our Volterra platform. We continue to make good progress with our integration efforts and expect to have more to share about initial use cases and launch timing in the fall.

As I mentioned last quarter, we initiated a pilot program concentrating on specific use cases and focused on bringing F5 security to the edge. Our goal is to leverage Volterra's organic momentum and early customer interest. Among service providers, the excitement and early interest related to Volterra continues to open doors not previously open to F5. The combination of application growth, our expanded solutions platform and our vision for the future of adaptive apps is resonating with customers and is well aligned with industry trends.

We expect demand for application security will continue to grow as application demand grows and customers scale and modernize their applications. We believe that we are exceptionally well placed with the right perspective and tool set to solve our customers' most pressing application security challenges. Our opportunity in application security is even more exciting with the ongoing integration of F5 and Volterra, which will bring enterprise-grade F5 application security to the edge in an easily deployable SaaS model.

I will wrap up today's prepared remarks by thanking the entire F5 team as well as our customers and partners. With that, operator, we will now open the call to Q&A.

(Operator Instructions) Your first question comes from the line of Tim Long from Barclays.

Two questions, if I could, guys. First, curious if you can just update us on kind of how the cloud vertical is going for you guys, particularly on the software side, but also curious if you continue to see some good hardware traction there as well.

And then second, just wanted to follow up on the subscription software business. Can you talk a little bit about kind of what you're seeing with true-ups and consumption? Do you continue to see accelerated usage for the offerings? And if so, what does that mean economically and what does that mean as you look into newer contracts where you might be seeing higher consumption levels than you would have anticipated previously?

Thanks for the questions. I will take the first part, and then Frank will take the second part. So let's just talk about the cloud vertical. Generally, Tim, we continue to grow rapidly in public cloud, driven by increased software consumption of our BIG-IP systems and also rapidly growing consumption of NGINX in public cloud environments to scale Kubernetes specifically deployment into production. And the third factor there is the security attach rate in the public cloud continues to grow. So that's just how well we're doing in public cloud.

But if you step back, I think, behind your question, I just want to go back to -- if you look back to where we were 3 years ago or 4 years ago when I joined F5 around the perception of F5 around public cloud, I would describe the bear thesis at the time as the following. We were told that traditional applications on-premise would not grow and would only decline. We were told that the traditional applications that would survive would be -- would all move to the cloud and would be refactored, and therefore, F5 would not have a role in these applications. And finally, we were told that all new applications -- modern applications would be built as cloud-native and container-native and F5 would not have a role in these applications. And all of that led to significant skepticism about the role of F5 in applications in the future.

If you look at where we're at today, number one, traditional apps are growing. There are revenue-generating apps, and the COVID and the consumption of everything digital growing rapidly has led to traditional apps that are revenue-generating, growing rapidly. And that goes on to BIG-IP. Number two, the apps that are -- not all the apps -- the traditional apps are moving to the public cloud. A large number of them are not moving. But those that are moving, it's largely a lift-and-shift, and that benefits F5 tremendously because we are absolutely attached to these apps in the public cloud. And that's why our business in the public cloud is growing.

And number three, as it relates to modern apps, we have a significant and growing role in modern applications with NGINX, which is an enabler and becoming an enabler of scaling these modern applications, and we have a role within BIG-IP. And so you look at the picture to date, Tim, it's very different than the picture, at least that the bear thesis had 4 years ago. And if you look at where our customers are to date in, they find themselves in a situation where they have traditional apps on-premises, on private clouds that are growing. And they're building these new modern apps. And they are on a 20-year march to manage the right balance between those environments, between modernizing traditional apps, building and scaling modern applications.

And there is now a very powerful alignment between the portfolio of solutions that we have put together with BIG-IP, NGINX and our security portfolio and the challenges that our customers have to resolve to grow and modernize their applications. And that's kind of manifesting in our results, both in what we're doing in the public cloud and what we're doing on-prem. Frank, do you want to address the second part?

So Tim, in terms of the true-up, forwards and the subscriptions that we are seeing, on average, both in years 2 and years 3, we are ahead of where our internal plan was in the sort of low double digits uplift that we see in years 2 and years 3. Our utilization that we're seeing in the contracts in year 1 is actually pulled in by a month from the last quarter. And all of this gives us increased conviction in our software as we head into FY '22.

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

I had a couple. Francois, if I can start off just on the software again here. One of the questions that we get quite often from investors, and we got a lot of those this quarter, is even as you kind of saw good acceleration in software revenue sequentially in the third quarter, there's a similar acceleration that's implied into the fourth quarter and then kind of into next year. So how much of that is just the momentum of the kind of existing business relative to kind of the true-ups or true forward as well as subscription renewals that's kind of influencing that. If you can talk about kind of the confidence into delivering that sequential improvement as you go along into next year. And then I have a follow-up as well.

Thank you, Samik. So let me start. On software, yes, we are -- as Frank just said, our conviction in our growth in software continues to increase and continues to get stronger for a couple of reasons. The first is we are indeed seeing very strong utilization of our multiyear subscription agreements, getting better visibility into expansion and true forwards. And so far, what we're seeing on expansion true forwards and even our renewals, the performance of these aspects of our software business is well ahead of our own internal target. So that is an important part of our confidence.

But the second part is -- on our confidence is that we also have some catalysts in our software business that are starting to play out as we thought they would and perhaps even better. If you look at NGINX, the momentum of adoption of NGINX is accelerating, in part because we have a larger set of products and modules on NGINX from the investments we made 1.5 years ago. So the controller, App Protect, the security piece on NGINX moving into API gateway, those are growing the addressable market for NGINX. And some of these catalysts haven't even played out and will play into 2022.

We see growing demand for security, including Shape, and a lot of that is consumed in software. And BIG-IP is also growing in software, as I said, in public cloud and private cloud environments. So if you combine all these, you add to that, that we see a 5G opportunity that's in software in 2022 for the 5G cores, those are all catalysts that will continue to drive the growth that we expect to see in software.

Got it. And if I can just follow up, maybe this is more for Frank, but related to when you gave initial guidance for this year, you were expecting more of a top line growth of 7% to 8% and operating margins of 31% to 32%. Clearly, top line growth has exceeded your initial expectations. But when I look at the operating margin, you're towards the lower end of the range here. So how should I think about that? Was it like reinvesting some of the incremental growth that you got? Or was it more of the headwinds because of the supply chain constraints? Just trying to think through why not more leverage on the operating margin as revenue exceeded expectations.

Sure. So Samik, a couple of factors that I will note. One is, obviously, with the revenue outperformance, we've got natural commission expense and other things that go towards higher expenses than what we would otherwise model at the beginning of the year. We also obviously absorbed Volterra into this model where we said we are not going to change our operating plan, but we were going to absorb those expenses. And that's exactly what we did. And then just other gives and takes that put us, I think, more in the midpoint of that 31% to 32% range, not at the low end from our expectations.

Your next question comes from the line of Rod Hall of Goldman Sachs.

I wanted to just go back to the software revenue. I'm assuming that your guide is still for close to 35% growth this year. If I just simplistically put 35% in, I get a decel of growth actually in Q4, around about $145 million of revenue. And I guess quarter-on-quarter growth, seasonal growth is a little bit slower. So I'm just curious, does that make sense to you guys? Are you expecting a slowdown in growth? Or is the 35% too low? I mean can you just kind of help us square that all up? And then I have a follow-up.

Look, we're not -- as you know, we are not guiding hardware and software separately every quarter. We've said that we would drive about 35% software growth for the year. We feel confident that we're going to do that. And more importantly, I always look at this as the overall trend for our software business. For Horizon 2, we said the trend in our software growth would be 35% to 40%, and we still feel that's what the range is going to be for growth for FY '21 and FY '22.

The only thing I would add, Rod, is -- sorry.

You go ahead, Frank.

Yes, absolutely. I think the only thing I would add is we've the same methodology that we use in giving guidance for the -- since we've been talking about our software business and the back half of the year when that was looking like a pretty good uplift when we were talking last quarter. I think we bridged that quite well this quarter and leaving ourselves, obviously, plenty of room on the 35% for the full year. And so when we take a look, we take a look at the components that we know are coming in from the SaaS businesses, the true forwards and the pipeline activity of what we see.

Okay. And then, Frank, I have one for you, too, on deferred revenue. I was just looking at your long-term deferred increments versus your short-term, and I see a pretty good sized long-term deferred revenue increase in June over March. I'm just curious, can you talk to us about the duration of the deferred revenue? And what specifically is driving the big increase in the long-term part of it?

Sure. Yes, absolutely, Rob. So it seems like we keep saying this, but we had yet another record number of multiyear subscription agreements that bring in deferred revenue into that long-term bucket. Also, we had a very strong Shape quarter as well as other things that have got multiyear contracts. I believe the average duration on most of those is 2.5 to 3 years. And so that's where you're seeing the growth in the long-term deferred revenue.

Your next question comes from the line of James Fish from Piper Sandler.

Not to go back to the topic, but on the subscription side first, I guess, how should we think about kind of next year's true-up in renewal opportunity, understanding the fiscal '19 base is bigger than the fiscal '18 base. But we are having some of these true-ups come in this fiscal year. I guess can you kind of help us bridge the transitions here of how we should think about this true-up in renewal activity happening? And it sounds like we should think about it as kind of this 110 to 120 kind of net retention rate. Is that the right way to think about it?

Yes. It's the right way to think about it. And there's also an additional component with 606. So the reason why that lapping is important and what you see in '19 as opposed to the previous quarters and why I have said for the past probably 6 or 7 quarters that the back half of FY '22 is going to be interesting and when things start to look more consistent and the revenue growth is that once you actually sign those new term subscription agreements, there's a whole new revenue recognition component associated with that.

And so the true forwards are interesting, but that becomes the new baseline in which the new deal is signed. And then in those 3-year agreements, 63% of that comes to product in the quarter that it is assigned. And the balance of that is ratably deferred into the services revenue bucket over the course of that 3 years. And then the true forwards obviously have got an additive component to the product revenue in years 2 and years 3. But that lapping year is actually when you see more pickup in the product revenue on the software side.

Makes sense, Frank. And it does look like your bookings or billings were up very nicely here, 25%. Not a metric we typically talk about with you guys. But as the software piece is becoming a bigger and bigger piece, it does make some sense to talk to. First, are you guys planning on introducing any new metrics here as we think about fiscal '22, an ARR metric, or talking more to billings? And then secondly, on that billing strength this quarter, was it more on the product side? Or was it just really strong maintenance attached to these virtual BIG-IP and NGINX licenses?

Yes. I'll speak to the metrics question and then let Francois take the back half. We continue to evaluate additional disclosures of metrics. I can't make any promises of when that's going to come, but we continue to think about what's going to be the most relevant for the users of our financial statements.

And then, Jim, on the second part and where the traction is coming from, there are 2 areas that I would point to you that's driving this increase in subscription revenue. One is security. We had a very strong quarter with Shape. And in certain verticals, retail, financial services, the tech verticals, online gaming where we are -- the customers have a heightened sense of a threat environment and awareness of attack vectors. And we're able to mitigate a lot of automated attacks, but not just mitigate bot attacks, but also more increasingly profile their traffic more intelligently, leveraging Shape's AI technology. which results in improved customer experience. And so it's making us really sticky in these environments and in these verticals.

The second thing in security is we're seeing DevSecOps teams and DevOps teams increasingly wanting to deploy security earlier in the life cycle of an application. And that points to the security capabilities of F5 that we reported on NGINX. And so we're seeing NGINX security start driving growth in our security portfolio. And since both Shape and NGINX are driving subscription-based revenues, you're seeing that increase there.

Then the second area I would point to is just more general adoption of modern applications. One of the things that we are seeing over the last 6 months, and I think it's accelerated this quarter, is Kubernetes is going into production, right? A lot of customers have done development and tests with these micro services, container-based applications, and they're now looking to scale these applications. In a lot of cases, they're running into trouble. And NGINX has all the capabilities to help them scale their Kubernetes clusters, and it's driving an acceleration in NGINX adoption in addition to the fact that NGINX now has multiple products, controller, API gateway, et cetera.

So when you look at these factors, it's accelerating adoption in NGINX. One of the -- I think the most obvious manifestations of this is we have very strong momentum with NGINX. Not in just any customer, but in our top 1,000 customers, the penetration of NGINX is growing and very strong. In fact, just this quarter, if you look at -- Frank said we had a record number of multiyear subscription agreements. And NGINX was part of more than half of those multiyear subscription agreements for the first time. So it points both to the growth we're seeing with NGINX and Shape, but it also points to what I said earlier around the powerful alignment of our portfolio to the hybrid challenges that our customers face.

Your next question comes from the line of Meta Marshall of Morgan Stanley.

A couple of questions. You've mentioned a couple of times that you had a record quarter with Shape Security. Last quarter, you mentioned there had been some delays in proof of concept. So just wanted to get a sense of, is some of that strength, those proof of concepts resuming? Is it kind of the security breaches that we've seen that have driven some of that strength?

And then maybe just a second question maybe for Frank is kind of the SaaS application or cloud customer vertical something that we should consider as being more than 10% of the business at this point? Or just anything that would give us a sense of the size of that customer base at this point?

So Meta, let me start with Shape. So last quarter, we did mention we had some proof of concepts that were taking a long time. And that was exacerbated by the fact that customers are not in the office. And so pulling off this proof of concept and reducing the length of the sales cycle was difficult. We still have that issue. And I would say, for customers that are not under any kind of immediate significant pain and can take their time to make their decision, that is still a factor. And we hope that, that factor succeeds in the coming quarters, but it's still there.

On the other hand, we also have a number of customers who are either under attack and need an immediate solution. And oftentimes, the solutions they have in place are not effective enough for sophisticated attacks. Or they have a heightened sense that they are on borrowed time and need to put in place the most effective mitigation possible. And for those sets of customers, the sales cycle is pretty rapid. And this quarter, we had more of these customers come to us. I would say there's also a maturing of the go-to-market with teams being able to identify the verticals where this is mostly the case and focus their efforts. So that's why the traction on Shape is accelerating.

And then on your second part, Meta, on the cloud vertical, we don't break it down sort of on a quarterly basis in terms of quantifying exactly how much that is. But here is what I would say. When we look at where F5 is growing the fastest at the moment, if you take all companies that are either in technology or in e-commerce or whose products are digital services. So it would include all the cloud providers and the SaaS providers. If you put all of these in a bucket, this is the area of the business for F5 that is growing the fastest at the moment. And it's intuitive why because all digital services are growing rapidly and the consumption of these services are growing rapidly.

And that's driving growth for us across our entire portfolio. Shape, NGINX and BIG-IP are all benefiting from that. And I would note that it's an interesting trend because, again, if you go back 4 years ago where you would have thought that the tech companies who are perhaps the most aggressive at moving to the cloud, adopting cloud-native and container-native architectures, would not be the customers that would stay on BIG-IP appliances. And where you would have expected perhaps F5 momentum to be less in the future, it's the complete opposite now where our momentum in that set of verticals is very strong.

Your next question comes from the line of Alex Henderson from Needham.

I think you've pretty clearly proven that you guys are real play on the transition to the cloud with these quarters. I wanted to get into a couple of the items here. The first one is the conversion rate of NGINX to NGINX Plus. It seems pretty clear that since your acquisition of NGINX that the percentage of -- or the market share percent of NGINX has definitely gone up. I understand it's up in the 67% plus range now, up from like 60%. And Envoy's share has gone from over 20% to low teens, so clearly demonstrating that it's becoming the de facto standard. But can you talk about the conversion rate of NGINX to NGINX Plus and how that impacts your business?

And the second piece of that same question is if you've got a 5% increase in your subscription rate in the quarter in software, I think the standard kind of rule of thumb is around 2.2x impact on the rate of growth as you convert from perpetual to software subscriptions. So if it's up 5%, does that mean it understated your growth in -- the true underlying growth rate by roughly 10% to 12%?

I'll take the first part and Francois will take the second part. In terms of conversion of NGINX to NGINX Plus, so as you noted, Alex, NGINX is getting a lot of traction. It's now the most deployed web server in the world with north of 500 million websites using the technology. And so yes, an important motion with NGINX is the conversion to NGINX Plus. We have steadily gotten better about that in 2 ways. Number one is, because there is a broader set of products that can be offered either as part of NGINX Plus or in conjunction with NGINX Plus, the security capabilities, the API gateway and now the controllers, that makes it much easier to deploy and manage these instances. There are more reasons for customers using open source to want to have access to the commercial capability.

And then the second part is what we have found out is a number of large enterprises, customers are not aware of how many open source instances they have, how many versions they have and/or they underestimate by sometimes a factor of 10x the number of NGINX open source instances we have. And so we've been able to bring to them a new technology, we call it an NGINX Instance Manager, that allows them to discover the open source instances that they have and oftentimes prompts them to look at that portfolio and ensure that it has the right support and oftentimes move to NGINX Plus to have either access to better features and better version.

So that's kind of the -- what we're seeing in terms of better conversion rates on NGINX. But I would say, we're also getting greenfield deployments with folks who did not have NGINX open source in their portfolio because as I said before, scaling these Kubernetes clusters and scaling these container-based applications is a challenge for many customers. And what they find is NGINX is a platform that consolidates a lot of functionality into one platform. And so they don't have to deal with 5 or 7 different vendors for different capabilities. So all of that is why we're seeing that traction.

Alex. And then for the second part of your question, I would love that not to work for all of our software base. It does actually for the SaaS ratable piece of our software base. But with the adoption of 606 for our term subscription-based models, that one evens out a bit closer to the perpetual and subscription revenue recognition. And so that -- your math does work as that SaaS portion of our revenue continues to grow in the rapidly recognized portion, but it's not completely apples-to-apples for all of our revenues.

Okay. And just if I could just follow up one last quick question. So clearly as the dominant player in Kubernetes [Codis] infrastructure, can you talk a little bit about your ability to hook into HashiCorp? And to what extent your tight integration with HashiCorp is driving your adoption rates? Clearly, they're setting up to come public. And as they do, Codis infrastructure and CI/CD pipelining, and obviously, the role of Kubernetes goes to center stage, and you're obviously a critical piece of that.

Yes, Alex, it's Kara.

I knew I had you to get in there somehow.

We have hooks from a number of our products into Hashi's portfolio. And we do have a strong -- we see customers looking for our integrations that are built into their. So for example, there's a few integrations from BIG-IP into Consul that enable deployment and provisioning of BIG-IP resources through Hashi's Consul offering as well as other integrations that we have. But I would say that Hashi is one example of a broad set of automation and orchestration capabilities that we've enabled across our portfolio. So both NGINX and BIG-IP can be automated and provisioned and configured via a set of declarative APIs. And our customers use that through Hashi. They use it through things like Ansible, Terraform as well as a number of other automation technologies.

Your next question comes from the line of Fahad Najam from MKM Partners.

I guess I had a very high-level question on your subscription revenue. The disclosed number that you have 73% being subscription, can you give us a sense of how much is it from SaaS revenue versus term revenue -- term software?

It's Frank. It was 78% this quarter, 73% in the year-ago quarter. And we don't split out those components at this point, but I do appreciate the question.

Okay. If I could maybe ask kind of figuring out in terms of the opportunity heading in software growth, can you help us understand in terms of the true-ups or on land-and-expand nature of your business? Can you give us some -- or share some data points -- quantifiable data points preferably that kind of show you landing and expanding on your cell cohort customers who adopted your set of solutions, whether it's Internet (inaudible) along with F5 traditional software solutions? Just kind of understanding how much of a true-up you -- are you enjoying as you get more of Shape and Volterra solutions going forward as well?

Fahad, I don't know if I will get to what I think you want, which is an average of the true-ups or expansion that we're seeing at renewal with our customers. But let me just give you a few data points. So first of all, our subscription offers really started in earnest in 2019. And so we are in the very early stages of going through these, certainly, the renewal of the multiyear subscriptions that have expired and gone to 3 years. In terms of the ones that have gone through 1 year and so we've already had a chance to the true-up, we are generally seeing expansion in consumption that is very healthy. So we're very happy about that.

One of the things, Fahad, that we have worked on, and I think now we're getting to a very good position, is in the first year, it used to take a long time for customers to get to full 100% utilization of what they had committed to. I think the first sort of deals we did, it took north of 20 months for customers to get to that. We have steadily brought that down to now customers, in roughly 5 months or so, get to 400% utilization of their subscription. And so beyond then, they expand.

So we're gaining very healthy consumption and, as a result, very healthy true-ups. Renewals, it's early days, but I can tell you, we have had some renewals where we were close to 3x what they had committed to at the -- in the first multiyear subscription. Of course, not all of them are that way, but it's just to give you a range of what we see there. So those are some of the things that give us good -- better visibility into next year and good confidence in continued growth.

Your next question comes from the line of Amit Daryanani from Evercore.

Perfect. I guess I have 2 as well. First off, I just wondered if you could just talk through the systems growth and what you're seeing so far. It's obviously being much better than the Horizon 2 on a long-term target. So just remind us what is driving that growth. And should we rethink what this means for Horizon 2 growth for the systems business?

Yes. Amit, the -- what's driving the systems growth -- I think, look, there are a few macro factors in the sense that I think that the IT spending environment right now is fairly healthy. And there is also a lot of consumption of digital services by consumers. And that, in turn, is fueling growth in applications, so growth in demand for applications. I would say that is kind of the biggest macro factor. Because what we see is a lot of our customers when they're refreshing their appliances, they don't go just for a refresh, they go for refresh and capacity expansion.

And sometimes this capacity expansion and transformation, because we want to move in a private cloud environment, and that's driven by just more traffic and more usage of even their traditional applications. We see, as I said earlier, growth with digital and SaaS service providers. And for them, the growth comes from -- their -- sometimes their services, the demand for their services, whether it's collaboration platforms or e-commerce platforms or even SaaS providers, the demand for their services are growing rapidly. And we are built into their infrastructure. And so that drives demand for our hardware, our systems into their infrastructure.

And I would say, generally, there's also a fundamental change in stance, Amit, from -- go back to 3, 4 years ago. I would regularly hear from customers 4 years ago, look, we don't want to buy more hardware because we've got to move everything to the cloud. We're going to be out of our data centers. We've got to figure out our architecture. And at the time, we said there was a pause because people were rethinking their architecture. There is not a single CIO that has told me this in the last 12 months. Every one of them -- I think a lot of people have learned from the first implementations in public cloud, sometimes the cost and time associated with refactoring applications.

And generally, I think people are more comfortable that they're going to be in a hybrid environment for a very, very long time to come, if not forever. And so they're comfortable growing their on-prem presence with hardware where it makes sense and leveraging the public cloud for other initiatives. And I think that halo, that environment is very different than it was 4 years ago.

And then the last factor that has an impact on our systems business and it is security. I said earlier that we had very strong growth in SaaS security with Shape, subscription security with NGINX. But we also have very healthy double-digit growth in hardware security. And that's because the -- all of these apps need to be secured. And customers are aware of the risks, so they're moving forward with application security.

Got it. That is really helpful. And if I could just maybe ask you to clarify this a bit more for me. I think a lot of folks tend to think that if the software business grows 35%, systems has to decline. It's a bit of an either/or math sometimes for people. Is it fair to figure what you just outlined with hybrid being the reality that you could have systems growth and software growth be more durable over time versus that?

Yes, it's potentially a possible scenario. I would separate, though -- when you look at our software business, you've got NGINX and Shape. And I don't think there's any relationship between the growth of that part of our software portfolio and the growth in hardware. When you look at BIG-IP per se, this is where we have seen and, in fact, we continue to see some customers that we would have expected to have moved to a software form factor right now that are delaying or reconsidering in part because of COVID, in part because of the immediate demand that they see on their applications.

So that's where there is a -- I would say there is some level of give-and-get on hardware and software. But overall, the software transition for us is absolutely accretive to the business. And right now, the drivers that we are seeing in our hardware business, we feel there are a couple of one-offs that we talked about last time around our EoSD of a certain product. But I would say the majority of the drivers we're seeing right now are pretty sustainable.

Due to time constraints, we will take our last question today from Simon Leopold of Raymond James.

Great. I wanted to see if we could talk a little bit, from a market vertical perspective. In particular, federal was low for you guys this quarter at 4% of revenue. And we're coming into what's normally your strong seasonal federal quarter. So I want to understand whether there's something different in the current cycle in terms of your federal business or whether we should expect federal to be strong in your September quarter?

And then on enterprises, if there's a way you could maybe characterize where we are in terms of kind of a post-pandemic recovery, is there some aspect to the current business that we -- maybe you could characterize as catch-up spend compared to the weaker spending we saw a year ago due to the pandemic?

Simon, thank you for the questions. So the -- let me start with the third question. Simon, no, there isn't anything -- there's nothing particular for this quarter. In terms of our bookings, they were in the range of what we typically expect in a quarter like this for the fed. We do expect a strong seasonal quarter in the fed in our fourth fiscal quarter. And we continue to be well placed to win some business there. There is, as you know, a lot of additional focus on security in that vertical. And we are well placed to win and protect against some of the threats that we're seeing for our government customers. So I think that's where our focus is with the fed, and that will continue. As it relates to your question on the enterprise, Simon, remind me the question is, are we going to see the same drivers?

Well, I guess what I'm trying to get at is, is there some element of the growth you're seeing now that goes away that is more about the cycle as opposed to the longer-term secular trend. I'm trying to really discern between the 2. So you've got a relatively easy comparison with weak data center spending a year ago. And so at some point in maybe a year that peters out. So there's a cyclical aspect and a secular aspect of your business. I'm trying to discern the 2.

Okay. Well, Simon, it's a great question. And I think specifically in our hardware business, I think they have elements of both. And you're asking me which one is the 80-20. And I don't know that I have a good answer for you. I would say, yes, there is some of the aspects that are, I would say, cyclical is, a, I think the spending environment right now is helping. I think there is a little bit of a catch-up demand from, in our case, FY '19 and FY '20, where people were kind of very cautious in the early parts of the pandemic. And I think those 2 are somewhat cyclical.

I think the aspects that are more durable are things like what we're seeing in the tech sector, whether I think the demand for digital services is just going to continue to grow, and I don't see that stopping anytime soon. And I think generally, demand for traditional applications in hybrid infrastructure is also going to continue to be solid. And I think that's a durable piece.

And then the last element that's durable is security. I said we have healthy double-digit growth in hardware security. And I think demand for security is going to continue for the foreseeable future. So both elements are part of what we're seeing right now. And I think we'll -- time will tell, I think, in a couple more quarters to see how much of each is contributing.

Thank you. And this concludes today's conference call. Thank you for participating. You may now disconnect.