Good afternoon and welcome to the F5, Inc. Third Quarter Fiscal 2022 Financial Results Conference Call. At this time, all participants' lines have been placed on mute to prevent any background noise. Following the presentation, we will conduct a question-and-answer session and instructions on how to queue up will be provided at that time. As a note, today's conference call 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. Ma'am, you may begin.

Hello and welcome. I am 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 A copy of today's press release is available on our website at f5.com, where an archived version of today's audio will be available through October 24, 2022. Visuals accompanying this call will be posted to our IR site at the conclusion of the call. To access the replay of today's call by phone, dial (888) 674-7070 or (416) 764-8692 and use meeting ID 468081. The telephonic replay will be available through midnight Pacific Time, July 26, 2022. For additional information or follow-up questions, please reach out to me directly at [email protected]. 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 will turn the call over to Francois.

Thank you, Suzanne, and hello, everyone. Thank you for joining us today. In Q3, we delivered above the midpoint of our revenue guidance and well above the top end of our non-GAAP EPS guidance. Software growth of 38% drove 4% revenue growth year-over-year, partially offsetting continued supply chain constraints for systems. Overall, we delivered 5% product revenue growth. While supply chain challenges continue to limit our ability to ship systems, our demand signals remain strong, and we remain ahead of our initial FY '22 demand plan. While we have not seen meaningful improvement in supply volumes in the last three months, we also have not seen further deterioration. In general, our suppliers' commitment held up better in Q3 than in the previous two quarters. Based on what we see today, we continue to expect our ability to ship systems will improve during our second quarter of fiscal 2023 as a result of our efforts to design out the most constrained component and the additional capacity our key suppliers expect to begin in the last calendar quarter of 2022. We likewise continue to expect that fiscal Q1 2023 will be the low point in systems revenue. We continue to see our growth opportunity fundamentally tied to applications, the growing number of apps, as well as increased usage and heightened business value. In Q3, we saw strong demand as customers added, scaled, and secured their applications, with demand for security and from our service provider vertical fueling sales in the quarter. In fact, security concerns continue to drive the majority of our customer engagement with demand showing up in both software and hardware form factors and across multiple consumption models. In one example from Q3, an existing BIG-IP hardware customer and one of the world's largest banking and financial services organizations turned to F5 when a large 4G incident revealed other vendor solutions were insufficiently protecting against zero-day threats. As a strategic partner, F5 demonstrated that our advanced web application firewall provided immediate protection against current and future vulnerabilities. Also during Q3, a large global retailer turned to F5 after experiencing challenges with their existing bot defense provider over a head-to-head three-month proof of concept against their current solution. Our distributed cloud bot and risk solution demonstrated significantly higher efficacy, and the customer is now deploying F5 to protect their apps and their customers. We have said previously that our customers are increasingly operating both traditional and modern architectures and looking to F5 to unite their strategies and simplify their operations. In the latest example of this trend, during Q3, an American multinational financial services corporation selected a combination of BIG-IP and NGINX to secure and process their high volume of critical encrypted transactions globally. Last quarter, I also spotlighted our new SaaS offering, F5 distributed cloud services, which we launched in February. With this platform, we are delivering security, multi-cloud networking, and edge-based computing solutions on a unified Software-as-a-Service platform. While it is still very early, we're seeing good traction and customer interest. During Q3, a global company specializing in clinical services and customizable medical devices selected our web application firewall and API protection solution to ensure rapid deployment of their security policy at scale and to provide global delivery of services in a hybrid multi-region support model or via SaaS. Finally, service providers drove demand in the quarter as customers scaled and secured 4G cores and began to move 5G cores into production. In one win in the quarter, we expanded our carrier-grade firewall business with a North American service provider as they continue to grow both their 4G and 5G traffic. In another service provider win, we expanded our offerings with an APAC-based customer to include BIG-IP cloud-native network functions for its 5G mobile core. These recently introduced cloud-native functions are perfect for moving workloads from legacy NFV to a modern cloud-native architecture. Cloud-native functions enable service providers and large enterprises to realize the full benefits of the cloud, automating and simplifying their operations with a more secure and scalable network. Before I turn the call to Frank to review our Q3 results and our Q4 outlook, I will comment on the macro environment. As I said previously, we saw strong demand in Q3, and we've got a strong Q4 pipeline. At the same time, we also observed more backend linearity in Q3, and our sales teams noted instances where more approvals were required to close deals. While we are not seeing that today, we believe the combination of macro uncertainty and inflation will put pressure on customer budgets and eventually force customers to reprioritize investments. We will continue to closely monitor signals from our customers, and like others, we are assessing adjustments we would make in the event that the environment or our customers turn more cautious. We have built a stronger and more resilient business by expanding our solutions portfolio and our consumption models. As a result of our business transformation, F5 is positioned to benefit both from software growth drivers, including BIG-IP, NGINX, and our F5 distributed cloud services SaaS offerings, and what we expect will be persistent demand for systems. As a result of our successful transformation efforts to date, we have a stronger business model that increases our confidence in sustained revenue and earnings growth. Now I will turn the call to Frank.

Thank you, Francois, and good afternoon, everyone. I will review our Q3 results before discussing our Q4 outlook. We delivered third quarter revenue of $674 million, reflecting a 4% growth year-over-year, with 5% product growth. Product revenue represented 48% of total revenue in the quarter, and software represented 55% of product revenue. This is the second quarter in a row where the majority of our product revenue has come from software. Q3 software revenue grew 38% to $179 million. Systems revenue of $148 million declined 18% year-over-year due to ongoing supply chain challenges and resulting shipment delays. Similar to Q2, we added systems backlog of tens of millions of dollars in Q3. Rounding out our revenue picture, global services delivered $348 million in Q3 revenue, up 2% from the prior year. Taking a closer look at our software revenue, subscription-based revenue contributed 82% of total software revenue in the quarter, a new high. Term-based subscriptions continue to represent over half of our subscription revenue, with smaller but growing contributions from Software-as-a-Service and utility consumption models. Revenue from recurring sources, which includes term subscriptions, Software-as-a-Service and utility-based revenue, as well as the maintenance portion of our services revenue, totaled 72% of revenue in the quarter. This is another milestone for us and is up from 66% in the year-ago period. On a regional basis, the Americas delivered 5% revenue growth year-over-year, representing 57% of total revenue. EMEA declined 7%, representing 23% of revenue, and APAC grew 15%, representing 19% of revenue. I'll remind you that given current supply chain constraints, our geographic revenue distribution in a quarter is not fully indicative of demand for each given region. Enterprise customers represented 70% of product bookings in the quarter. Service providers represented 18%, and government customers represented 12%, including 3% from U.S. Federal. I will now share our Q3 operating results. GAAP gross margin was 80.6%. Non-GAAP gross margin was above our guide at 83.2%. While we continue to experience increased component prices, expedite fees, and other sourcing-related costs, our Q3 gross margin reflects some improvement in average selling price on systems in the quarter. We are not ready to say it's a trend, but we are encouraged about the overall direction. GAAP operating expenses were $436 million. Non-GAAP operating expenses were $367 million. This is lower than our guided range as a result of some investments we delayed in anticipation of potential macro headwinds that did not materialize in the quarter, and lower international expenses related to the strengthening dollar. Our GAAP operating margin was 15.9%. Our non-GAAP operating margin was 28.8%. Our GAAP effective tax rate for the quarter was 18%. Our non-GAAP effective tax rate was 17.4%, largely driven by a nonrecurring benefit associated with the filing of our federal income tax return during the quarter. GAAP net income for the quarter was $83 million, or $1.37 per share. Our better-than-guided gross and operating margin performance and lower tax rate contributed to non-GAAP net income of $155 million, or $2.57 per share. I will now turn to cash flow and the balance sheet. We generated $71 million in cash flow from operations in Q3. This is net of more than $30 million of payments to partners related to securing component inventory to support future hardware builds and component expedite fees. Capital expenditures for the quarter were $9 million. DSO for the quarter was 61 days. Similar to last quarter, this is up from historical levels due to back-ended shipping linearity in the quarter resulting from ongoing supply chain challenges. Cash and investments totaled approximately $757 million at quarter end. During the quarter, we repurchased approximately $250 million worth of F5 shares, or approximately 1.5 million shares at an average price of $171 per share. Deferred revenue increased 14% year-over-year to $1.64 billion, up from $1.60 billion in Q2, largely driven by subscriptions and SaaS bookings growth and, to a lesser extent, deferred service maintenance. Finally, we ended the quarter with approximately 6,900 employees. I will now share our outlook for the fourth quarter. Unless otherwise stated, please note that my guidance comments reference non-GAAP metrics. We expect Q4 revenue in the range of $680 million to $700 million. Our pipeline indicates Q4 demand that would put our software revenue growth towards the high end of our 35% to 40% target for the year. As Francois discussed, however, we are very cognizant of the broader, more cautious environment. And as a result, we see more risk at the top end of our software growth range than there was a quarter ago. Given the Q3 strength in global services, we now expect global services revenue to grow approximately 1.5% to 2% for the year. We expect Q4 gross margins in a range of 82% to 83%. We are seeing component costs continue to rise and expect that they will be higher still next year. As a result, we implemented an approximately 15% price increase in systems effective July 1. Given our backlog, we expect it will take some quarters for the price increase to manifest into sustainable gross margin improvements. We estimate Q4 operating expenses of $374 million to $386 million, which would put our FY '22 operating margin at approximately 29%, an improvement of 100 to 200 basis points from our prior outlook. Factoring in the tax rate benefit from Q3, we now expect FY '22 effective tax rate will be approximately 19%. Our Q4 earnings target is $2.45 to $2.57 per share. We expect Q4 share-based compensation of $61 million to $63 million. Finally, as we announced in the earnings press release, our Board authorized an additional $1 billion for our share repurchase program. This new authorization is incremental to the $272 million remaining in the existing program. As we have over the last two years, we expect to continue to balance share repurchases with other strategic uses of cash. This concludes our prepared remarks today. Operator, would you please open the call to Q&A?

Thank you, everyone. We will now start the question-and-answer session. Your first question comes from Sami Badri of Credit Suisse. Please go ahead.

First thing, I wanted to just clarify was, I think there was a reference to the backlog increasing or at least adding more revenues to the backlog. Could you clarify if the backlog exiting fiscal 3Q is actually higher than where it was exiting fiscal 2Q '22? So that's my first question. The second question is there's a lot of interest in the investor base around the software growth trajectory of the business. And I know you guys discussed coming in at the higher end of the range at fiscal year '22, but could you characterize or give us an indication on what fiscal year '23 is going to look like, just because the growth rates are rather significant?

Sami, I'll take the first question, and then I'll let Francois speak to the second question. So yes, the backlog was higher and significantly higher in Q3 than it was exiting Q2. We did not quantify that. We talked about that we would do that at the end of the fiscal year. So, we'll actually release the number as part of the October call, and you'll see it in the K.

And Sami, I'll take the second part of your question. So, obviously, this is not a time where we are guiding for fiscal 2023. Overall, if you look at our performance of the business in software, we guided 35% to 40% of our investor meeting about almost two years ago now in November of 2020. And we have delivered that in the first year in 2021, and this year we are delivering closer to the top end of the range of that guidance. So we feel very, very good about the drivers of software growth in the business that we talked about, including modern applications, the strength we are seeing in security, and the adoption of multi-year agreements with F5 driven by digital transformations and automation. And so we will talk more about software growth for 2023 in October. But when you look at 2023, frankly, the factors, I think some of the factors that will affect that, one, of course, like every other company is the macro environment and will that have an effect on our growth rate. Today, frankly, it's too early to say, because we haven't seen a fundamental change in the buying behaviors of our customers across the globe based on the macro at this point. And I think the other factors will be, we, through the pandemic, and this is specific I would say to the BIG-IP part of our business. We have seen continued demand for hardware, and we have seen a number of customers that had declared that they would move to software pretty quickly that have actually recommitted to hardware and stayed with hardware longer. So, we are seeing very, very strong resilience and strong demand in hardware, sometimes at the expense of customers that would've moved to software. So if that, kind of mix shift, if you will, continues in 2023 that may affect our software growth rate some, but it wouldn't affect the top-line because it would be more of a mix shift factor if we continue to see that shift in customer behavior.

Thank you for that information. I wanted to follow up specifically regarding service providers, as they were mentioned several times during this call. Could you provide more details about the current shift and why service provider customers are increasingly relying on the F5 portfolio? What specific aspects are they finding most beneficial or suitable? Additionally, could you elaborate on the current situation and perhaps specify a type of service provider?

I think our service provider business is performing strongly due to two main investment areas that are aligning well with the market. On the software front, we've made significant investments in cloud-native functions that enable service providers to develop 5G cores and transition to these cloud-based environments alongside us. We now have several design wins in this domain that are beginning to enter production, contributing to our revenue this quarter, and we anticipate this trend will continue. We believe we are well positioned for the upcoming cycle of next-generation software deployments with service providers, both in core infrastructure and at the edge. The other factor at play is that service providers are expanding their 4G capacity to accommodate rising traffic, particularly 5G traffic. As we mentioned previously, we have made ongoing investments in our hardware platforms to meet this growing demand. Consequently, we have achieved pricing and performance levels that satisfy the requirements for high-scale, high-capacity service provider deployments, especially in the GI land segment of the network for applications like carrier-grade firewalls. This is driving strong demand and positive execution in the service provider sector.

Your next question comes from James Fish of Piper Sandler. Please go ahead.

Wanted to go off the software question from before. Is there a way to think about how much the unattached software deal flow is either independent or dependent on some of the systems deal flow given you're already selling into some of the largest organizations out there? And also, you mentioned there, Francois, multiyear agreements just now. Is duration actually extending for software?

I'll start with the second part of your question, Jim. The trends regarding multiyear agreements are quite stable. Typically, these agreements are for three years, and we haven't observed any significant changes in their duration. Addressing the first part of your inquiry, our software business, particularly the segment driven by net new modern applications associated with NGINX, operates independently of hardware dynamics. Similarly, our managed services and SaaS business offering distributed cloud services also isn't influenced by hardware trends. For BIG-IP, most of the software business isn't linked to hardware dynamics. However, we still have several customers transitioning from a hardware-first to a software-first environment. Over the past 18 months, we have seen some customers accelerate their shift to a software-first model, while others have delayed that transition and remained in a hardware-first environment. This has impacted the BIG-IP business, where we observe strong resilience in hardware, but it has slightly affected our software growth rates.

All right. And then maybe for Frank. I do want to unpack your guide a bit here, essentially the back of The Street for Q4. Is there a way to understand for how much during the year will be a net issue from the supply chain constraints versus that prior, I believe, $60 million to $90 million headwind versus the macro impact you're now including in guidance?

Jim, you'll likely get a clearer picture in Q4 when we discuss the backlog number. Our policy is to release the actual backlog number if it exceeds 10% of product revenue, which we expect it will. This will allow you to discern the differences and make assumptions about their impact on software revenue or total revenue. If you can wait three months, you'll have your answer.

Your next question comes from Meta Marshall of Morgan Stanley. Please go ahead.

This is Meta. A couple of questions. Just on the supply chain piece, when you're expecting improvement by kind of the second quarter of next year, does that mean that the redesign process is kind of complete at that point or that there is component availability you expect to take place at that point? And then maybe as a second follow-on question, just how is the rSeries transition from iSeries for production versus expectations?

When discussing the improvements in our shipments for the second fiscal quarter of 2023, there are two main factors at play. First, we anticipate better availability of components from our suppliers based on their commitments to us. From our observations, they are making good progress in fulfilling these commitments, particularly regarding the most limited components. Second, we have been working on redesigning certain elements to work around these constrained components, and we expect this design work to be completed by the end of the calendar year. This will enable us to use the new components in the second fiscal quarter of '23. So, these are the two factors driving our optimism. Currently, both aspects are progressing well, and we are looking at developments that will unfold over the next six to nine months, focusing on the second half of 2023. However, it's important to note that there is still significant execution ahead and commitments from our suppliers that need to be fulfilled. Overall, we feel more positive about the situation compared to three months ago based on our suppliers' commitments and our projections. Regarding the rSeries, we are very pleased with its progress. It is currently ramping up faster than any new platform we've launched before, at a rate that is twice as fast as previous introductions. This acceleration is largely attributed to the advantages of the rSeries platform. We began investing in this platform a few years ago to integrate several features of the cloud into our customers' on-premises environments. Our customers are experiencing substantial automation benefits, including the ability to run multiple software tenants on the same platform. For those looking to automate their systems—a key aspect of digital transformation—rSeries offers not only price-performance benefits but also cloud-like advantages. We are excited about rSeries and what it means for our business, both this year and in the years to come.

Your next question comes from Tim Long of Barclays. Please go ahead.

I'd like to ask about the software business. First, could you provide an update on achieving more consistent metrics such as RPO, ARR, and dollar retention? I’m curious about when we might see those numbers in more detail. Also, Frank, can you share your insights on the positive growth in software, particularly regarding new deals and first true-forwards? How should we interpret this aspect of software growth for the quarter? Lastly, Francois, as we approach the three-year anniversary of significant first-term deals, could you discuss your thoughts on how the renegotiations or renewals might unfold and how they could fit into the model? It seems like a crucial time to renew those deals. Are those renewals expected to be higher than the original contracts like some of the other business that has been performing above run rates? Thank you.

Sure, Tim. Thanks so much for the question. I'll start and then I'll turn it over to Francois. So in terms of the split out on the software metrics, as we talked about ongoing, we're just starting to hit the second term of where a lot of this business started to take off. And so we are still tracking those metrics internally. We're not ready to release them externally. Again, as I've said in the past, we want to make sure that they are used in the right way and they can be predictive for the future outlook of the business. And as we get more and more of these data points over the next coming quarters, we do expect it's going to be more of a when, not if, we do release these metrics, and so more to come on that in FY '23. I know you had another question for Francois, specifically on some of the renewals.

Yes. Generally, Tim, on the renewals, the early indicators on the revenue expansion opportunity are really good on these large multiyear agreements. What we're seeing is continued growth in application usage, and that's a part of what's driving the expansion in some of these opportunities. So, it's early days, as you said, but it's going very well. I would say the other driver, both of renewals and new multiyear agreements, is security. We had a very strong quarter, again, in security. And what we're seeing is that the portfolio that we've put together that allows our customers to put security capabilities across their environment is really making a difference. So this quarter, we had a very strong quarter on security with BIG-IP and WAF. And in fact, WAF across all of our form factors and BIG-IP, and we had a very strong quarter with NGINX security. This was the second quarter in a row where we had over 100 wins of NGINX with security. We have a very strong debut, if you will, for our distributed cloud services WAF offering, which is our SaaS offering on security. And we're bringing all of these security offerings over time under a single SaaS console that will allow our customers to push the same policy to all of their environments for protecting their applications. So that, if you will, competitive differentiation, we're seeing the benefit of that both in terms of expansion of existing agreements as well as new agreements that are driven by our security software.

Okay. And Frank, if I could, just to follow up on the metrics. In the past, you've talked a little bit about the software growth in the subscription business being driven by true-forwards and/or new deals in the pipeline. So could you just give us a little color on the kind of mix of growth between true-forward contribution and kind of new deal contribution?

Yes. So we're not going to split that out in the quarter. I think both of them were quite healthy. When I take a look at where we have been in the past, the true-forward contribution was along our expectations for the growth in new business. That was also in line with our expectations, and it resulted in the 38% software growth, but I'm not going to give a specific split between the two for the call.

Your next question comes from Alex Henderson of Needham. Please go ahead.

So across the presentation, you've made a number of references to buying behavior, specifically said at one point that buying behavior patterns haven't changed. Another point, you said that there are some increases in the number of signatures required. And you've weighed into your guide the expectation of continued softness in the broader economy. But can you talk a little bit about where you are in terms of the pipeline of activity that you're chasing, whether the activity is more robust or less robust than you would expect for this time of year? And particularly whether the deal sizes are bigger, smaller, how the price increase might impact that longevity; and within the backlog, whether there's any concern around cancellations of orders?

Alex, let me start with the last part of your question. So no, with the backlog, we have absolutely no concerns about cancellations of orders. And that's because we haven't seen any. There hasn't been any trend into cancellation. And also, our lead times, whilst elongated, are still at about four months. And relative to some of the other hardware networking players, our lead times are still less than a number of others. In fact, we have seen some of our orders delayed because customers were willing to get their networking gear that had 12 months of lead time before ordering from F5 that only has two to six months of lead times, depending on which platform you pick. So we're not worried about cancellations at all. Let me talk to the other dynamics. You mentioned customer buying behavior, the implications of price increases. So if I take a picture right now, Alex, of where we're at, no, we haven't seen on a global level, I would say, with the exception of Europe specifically, I'll come back to that in a moment, we have not seen a fundamental change in buying behavior. We have seen a little back-ended linearity this quarter, and yes, some deals that had a little more quickly in terms of the number of approvals. But when we looked at the overall demand signals in the quarter, they were very strong. And we didn't see a fundamental change in close rates, if you will, from our pipeline. That is, I would say, across the globe is true. In Europe specifically, we did see some continued softness and very back-ended linearity. And we think the macro is definitely affecting buying behavior in Europe already today. Now when you look forward around what we think we will see in coming months, let's start with our pipeline is strong for Q4, and it is about what we would expect to have as of today for our Q4 pipeline. We have a number of large deals, specifically in software. Q4 is always a quarter with some of the largest deals, and we have that pipeline of large deals to deliver against our guidance. That being said, what we are cautious about is, of course, we see the dynamics in the macro environment. And I think the combination of inflation in the U.S. and elsewhere and also outside the U.S., foreign exchange, which ends up making our deal more expensive to customers in Europe, Latin America, and Asia, those increases in cost to customers will force them to make prioritization calls on their investment. And we think that that may result in some deals being pushed out or a different prioritization of projects than what we are currently expecting. We haven't seen any sign of that to-date, but our view is that given that every other networking vendor out there has made increases in prices, including us, customers at some point, their budgets are not going up exponentially, and they'll have to make these prioritization calls. I think that's the macro effect that we think we are likely to see in the next few months.

Your next question comes from Samik Chatterjee of JPMorgan. Please go ahead.

Francois, I wanted to start by discussing the privatization of spending from your customers or the cautious environment you're operating in. It seems like you're beginning to make internal preparations for this situation. I'm interested in how you're considering adjusting levels, making changes, or reprioritizing within F5. Will you be increasing sales incentives for the software business or placing greater emphasis on security? What levels are you contemplating aiming for in response to any changes in customer behavior due to the macro environment? Additionally, since the 15% price increase on systems, what order trends have you observed?

Samik, just the last part of your question about the 15% price increase, what was your question about that?

Can you provide insights on the order trends since implementing the price increase?

Let me begin by addressing that part of the question. Yes, we implemented a price increase on July 1, which led to many customers placing orders early in the third quarter to avoid the increase. When we analyze demand for Q3, excluding these early orders, we still see a strong demand quarter. Regarding order trends since the price increase, we’re only at the beginning of the quarter, and the trends we observe so far are consistent with what we typically see in the first month of a new quarter. In response to your question about our preparations for potential macroeconomic changes, we are exercising caution. Currently, we have not observed any shifts in demand signals; however, due to the broader macro conditions, we have significantly reduced hiring across functions over the past month. Additionally, we have postponed certain investment initiatives to better assess the macro environment before deciding whether to move forward with those investments. Our focus is currently on managing our operating expenses and maintaining a steady operating expense run rate. The incentives for our software teams remain robust, and we expect that to positively impact our software growth rates.

Your next question comes from Rod Hall of Goldman Sachs. Please go ahead.

I wanted to come back to the comment, I think, Francois, you made about the back-end loaded nature of the quarter and kind of the DSOs. I guess I was curious about the drivers of the back-end loading. I mean you guys are saying you're not seeing demand impacts, but I wonder how you would characterize the drivers for the back-end-loaded nature of the quarter? Was there a particular type of product you were selling more in the back end of the quarter? Was there a promotion, something like that? And I'm curious also on the DSOs whether you think next quarter those might come back down again.

So yes, Rod, let me start with the DSO side of the question and then let Francois talk about some of the back-end linearity of it. So the DSO, a lot of that, but I think it's going to be a little more linked to not bookings but just frankly when things can be shipped and is the components that came in, in the back half but then had the shipments go out. The bills can go out associated with that, and that drove the increase in the AR balance, which is the calculation for your DSO. So, it's likely going to see a return to normalcy when we get into the back half of FY '23 and that AR balance coming down. I will note that the quality of those receivables that you haven't seen any aging increase; it just happens to come after the end of the quarter. So, I will expect that DSOs, as Francois mentioned, in the shipping side in the back half of FY '23 to see when that's going to start coming down and that AR balance coming down.

Yes. And Rod, on the back-end-loaded quarter, first of all, yes, it was more back-ended but on a very, very strong demand quarter. And so I think I mentioned earlier that we saw at the very end of the quarter some orders that we felt should have come in Q4 that came in Q3. We attributed some of that to customers doing so ahead of a price increase. I think if you normalize that out, that would normalize a little more the linearity of the quarter. The other factor is Europe, which was, in fact, back-end loaded in linearity. We think that has to do with the macro and the scrutiny there. And if you normalize out these two factors, there was probably also an element that we started to see around more customers, I want to say outside of Europe that had more approval cycles in their orders. And so, it may have pushed some orders that we may have expected in the second month but happened in the third month of the quarter.

Your next question comes from Amit Daryanani of Evercore. Please go ahead.

I have two as well. I guess maybe to start with, on the software side, even see at the higher end of the 35% to 40% growth rate this year. Is there anything you would call out that's more onetime in nature that you think helped you on software growth in fiscal '22, ELAs or big deals or something? And if you do end up in a slower macro environment in '23, does that help or hinder your software business over time?

Amit, I'll begin with that and then let Francois address the latter part of your question. There is nothing unusual compared to what we anticipated. I want to highlight that we had significant deal activities occurring three years ago that have recurred this year. This will contribute to the normal process and the reasons behind potential quarter-to-quarter fluctuations, even with larger figures. As these numbers grow in the denominator, that variability will lessen and become less pronounced. We have mentioned some substantial deal activities in fiscal year '19 that have repeated this year, and this has always been part of our expectations, even back in November 2020 when we considered our Horizon 2 outlook.

Yes. Regarding your question about whether a recession in 2023 would impact our software business, I have some thoughts. Historically, during recessions, people tend to stick with what they know rather than initiating new projects. This could mean that customers who rely on hardware might choose to continue with it instead of starting new architectures or projects. This would likely benefit our hardware business more than our software business in terms of the opportunities available. However, most of our software revenue comes from subscriptions, and we believe many customers would prefer to transition to a more operational expense model instead of making large capital expenditures. This shift would be advantageous for our software business. Overall, we believe we have developed a resilient business model that can adapt to various customer needs, whether they prefer hardware or software solutions, term subscriptions, perpetual licenses, or even SaaS and managed services. If customers want to enhance their security capabilities while minimizing expenses through a pay-as-you-go approach, our SaaS offerings are already gaining traction and would benefit in 2023. In summary, we are confident that our business model can effectively meet customer needs in any economic environment, including a recession.

Perfect. And then if I could just follow up on the system side. You made some comments on fiscal Q1 in '23 will be the low point of systems revenue. Was that an absolute revenue statement or a signal that you're already declining peak over there? And then really if I look at all the stuff you have on the system side from the backlog with the price increases and we have the pent-up demand, is there a reason why you don't see your hardware business show positive growth next year?

So yes, let me start with that and let Francois. So, we were giving an absolute in terms of revenue dollar value for when Q1 would be the low point in our systems revenue. And that is truly a result of the components that are needed to ship when we see those schedules coming in. As Francois mentioned, the volatility associated with decommits has gone down from what we have experienced in recent quarters. That having been said, the commitments that we have will show that, that will be the low point of what we can actually produce to that volume. And so that's why on a dollar basis, we expect Q1 to be the low point.

Regarding your second question, Amit, we do expect hardware to show positive growth next year, provided we achieve the recovery profile for supply availability that we've discussed. Currently, we are on track with that profile. If confirmed, I anticipate our hardware revenues will exceed this year’s figures. Even in a recessionary environment, with a significant backlog, we would still be able to generate more revenue than we currently are, even if demand diminishes. However, I won't comment on next year's hardware demand due to many uncertainties in the macro environment. Specifically, regarding hardware revenue, I believe it could be positive assuming supply is available.

And Amit, I want to reaffirm what Francois mentioned last quarter. The first quarter will be a low point. We will see improvement in the second quarter as some of the redesigns and components become more available. We expect the third quarter to be even higher, as we will be able to further increase production on the new platforms. By the fourth quarter, we may actually start to reduce backlog due to improved availability. However, we anticipate a steady increase in revenue for systems next year.

Your next question comes from Jim Suva of Citigroup. Please go ahead.

And I just have one question. Francois, in your prepared comments, you mentioned additional signatures and a little bit more time to get deals to be completely approved. I'm wondering, does this also allow the CTOs more time or more contemplation to do virtual instances, more software, VM type of production orders from you? Or is it kind of the cadence of what they're looking at as you expect? I'm just kind of wondering what the elongated closing time, does it actually allow them to kind of take a step back and look at the whiteboard a little bit more about the solutions that they're buying from you?

Thank you, Jim. Today, our expanded portfolio allows us to engage customers with various offerings, including SaaS, software, and hardware, or any combination thereof. This flexibility is fostering strategic discussions with our customers early in the project cycle. By the time a project has been defined and is moving through the approval process, it's not typically about the CTO reconsidering everything. Initially, during the pandemic, there was a rush to add capacity, resulting in quick approvals for incoming orders. Now, with the potential for a recession on the horizon, organizations are ensuring the appropriate approvals are in place, which means they are taking their time. When decisions are made, they tend to be final and comprehensive. So, this reflects more of a thoughtful approach rather than a reconsideration of architecture. These discussions are occurring early with both our customers' technology teams and our own technical teams.

Ladies and gentlemen, due to time constraints, we will take our last question from Simon Leopold of Raymond James. Please go ahead.

I wanted to get a quick clarification and then a broader question. On the clarification front, Francois, you indicated growth towards the high end for the software business for the year. And I think that might imply a sequential decline from the systems business in the September quarter. And I want to verify that if it is down sequentially, I just want to get a better understanding of why because it sounds like supply chain constraints are somewhat better or the same. So not sure on that point. And the broader question, I wanted to see if you could talk a little bit more about unpacking your enterprise verticals. In the past, you used to disclose more detail about the composition of your enterprise customers. And in light of the concerns about a potential recession, I think it would help to get a better understanding of the profile of these enterprise customers in some sense that you have very little to no exposure to the SMB market within that enterprise vertical and where your vulnerabilities might be. Thank you.

Let me start and then Francois can continue with the latter part of your question. As you know, we generally do not provide specific details on the mix of our product revenue components. I mentioned last quarter that we anticipate either Q4 or Q1 to be the lowest point for our systems revenue, mainly due to supplier commitments and shipping capabilities. Therefore, I won't comment on whether we will see a sequential decline in dollar revenue quarter-over-quarter. However, I still believe that Q4 and Q1 are likely to be the lowest points, with Q1 potentially being lower than Q4. I did not specify how Q4 will compare to Q3. Regarding the supply chain situation, you are right that we’re noticing some stabilization for most components. However, we still face constraints with certain components critical to our production, which we refer to as the Golden Screw component. If these constraints are resolved, which is not our expectation, we could perform better, but we don’t want to create that expectation. Broadly speaking, the supply chain is improving for most components, but we still have some specific components in our builds that remain constrained. We have indicated that fiscal Q2 will show improvement, not because suppliers will provide us with more shipments, but due to redesign efforts that will likely take effect in the latter half of our fiscal Q1, which will assist in boosting our production in Q2.

In response to your second question, we have minimal exposure to the SMB segment. Our primary focus is on large enterprises, as well as service providers and government. These are the three key areas we serve, and within the enterprise sector, we concentrate on large enterprises globally.

Ladies and gentlemen, this concludes your conference call for this afternoon. We would like to thank you all for participating and ask that you please disconnect your lines.