Greetings and welcome to the F5, Inc. First Quarter Fiscal Year 2023 Financial Results Conference Call. This conference is being recorded. It is now my pleasure to introduce your host, Suzanne DuLong. Thank you, Suzanne. You may begin.

Hello, and welcome. I am Suzanne DuLong, F5's Vice President of Investor Relations. François Locoh-Donou, F5's President and CEO; and Frank Pelzer, F5's Executive Vice President and CFO, will be making prepared remarks on today's call. Other members of the F5 executive team are also on hand to answer questions during the Q&A session. A copy of today's press release is available on our website at f5.com, or an archived version of today's audio will be available through April 24, 2023. Visuals accompanying today's discussion are viewable on the webcast and will be posted to our IR site at the conclusion of our call. To access the replay of today's webcast by phone, dial (877) 660-6853 or (201) 612-7415, and use meeting ID 13735357. A telephonic replay will be available through midnight Pacific Time, January 25, 2023. 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 François.

Thank you, Suzanne, and hello, everyone. Thank you for joining us today. Against the backdrop of a continued tough environment, our team delivered first quarter revenue at the midpoint of our guidance range and earnings per share above the high end of our range. We came into Q1 expecting we would see deteriorating close rates and that the dynamics concentrated in EMEA and APAC in Q4 would spread to North America. In Q1, we experienced heightened budget scrutiny and more pervasive deal delays across all geographies. The dynamics are particularly challenging on larger transformational-type projects, which for us tend to be software-focused. Like last quarter, new multiyear subscriptions were most affected. We noted last quarter that we were not planning on year-over-year growth from new software business this year. However, in Q1, it was down a double-digit percentage year-over-year. Based on customer feedback, we believe we are seeing the impact of financial decisions resulting from broader economic uncertainty, pervasive budget scrutiny, and spending caution as opposed to technological, competitive, or architectural decisions. In contrast to what we saw on new software business, software renewals performed largely as expected in the quarter. At the same time, improving supply chain conditions aided our hardware revenue, making it possible for us to ship systems to waiting customers. In addition, our Q1 maintenance renewals were particularly strong, which in the past has correlated with customers' increasing focus on their existing investments. Despite the environment, we continue to expect 9% to 11% revenue growth for the year, albeit with a different mix than we initially forecasted. Given the demand trends of the last quarter, it is challenging to predict our revenue mix with precision. However, with supply chain improvements and the benefit of our system redesign efforts coming to fruition, we continue to see a second-half acceleration in our systems revenue. In addition, based on the solid maintenance renewals we experienced in Q1 and our forecast for Q2, we expect global services revenue will be stronger than we initially anticipated for the year. As a result, we expect the combination of stronger systems revenue and global services revenue to offset software headwinds this year. We also continue to expect non-GAAP earnings growth in the low to mid-teens for FY '23. We are committed to maintaining double-digit non-GAAP earnings growth this year and on an annual basis going forward, and we will continue to evaluate our cost base and take further action as needed to achieve this goal. In the current environment, customers are focused on minimizing their spend and optimizing their existing investments while also continuing to drive revenue. We are confident that we are well-positioned to help them do exactly that. For instance, during Q1, we closed a significant multi-cloud networking win with a Tier 1 North American service provider. The customer selected F5 Distributed Cloud Services as the core for its next-generation managed service offering based on the platform's ability to deliver a scalable, agile, and dynamic infrastructure. This is the second such win for the platform. F5 Distributed Cloud Services makes it possible for service providers to monetize their substantial network investment, including investments in 5G. The platform enables a managed service offering that solves critical challenges for enterprise customers, like simplifying the deployment and operations of applications across multi-cloud and edge environments. Customers also remain focused on application security, and F5 Distributed Cloud Services is winning security use cases. In Q1, a healthcare customer selected our managed web application firewall and API protection solution after a proof-of-concept evaluation against both their incumbent CDN provider and a cloud-native solution. The customer selected F5 Distributed Cloud Services because it proved more effective against threats while also being easier to manage. Our solution also met the customer's stringent regulatory requirements. Finally, customers are focused on total cost of ownership. As a result, we continue to drive good traction with our next-generation hardware platforms, rSeries and VELOS. These next-generation platforms can dramatically reduce customers' total cost of ownership by offering cloud-like benefits for on-premises systems. Clearly, the enterprise spending environment has changed from six months ago. That said, the breadth of our portfolio positions us well. The number of applications continues to grow, and those applications and the infrastructure needed to deliver, secure, and manage them continue to get more complex. Customers need a partner like F5 who can help them simplify their total cost of ownership and make the most of the budgets they have. Our broad solutions portfolio, combined with the consumption model flexibility we offer, squarely addresses these requirements. Now I will turn the call to Frank. Frank?

Thank you, François, and good afternoon, everyone. I will review our Q1 results before I speak to our second quarter outlook and provide some additional color on our FY '23 expectations. We delivered first quarter revenue of $700 million, reflecting 2% growth year-over-year. Global services revenue of $360 million grew a strong 5% in part due to the high maintenance renewals François mentioned and also reflecting previously announced price increases. Our revenue remained roughly split between global services and product, with product revenue down slightly year-over-year, reflecting softer demand across all geographies and representing 49% of total revenue in the quarter. Continued supply chain improvements enabled systems revenue of $173 million, down 4% year-over-year. Q1 software revenue grew 3% to $168 million, against a tough comp last year. Let's take a closer look at our overall software growth. Our software revenue is comprised of subscription-based and perpetual license sales. Subscription-based revenue, which includes term subscriptions, our SaaS offerings, and utility-based revenue, totaled $129 million or 77% of Q1's total software revenue. Perpetual license sales of $38 million represented 23% of Q1 software revenue. Within our subscription business, as François noted, new multiyear subscriptions performed significantly below plan in Q1, while renewals performed largely as expected. Revenue from recurring sources contributed 68% of Q1's revenue. This includes revenue from term subscription, SaaS, and utility-based revenue as well as the maintenance portion of our services revenue. On a regional basis, revenue from the Americas was flat year-over-year, representing 57% of total revenue. EMEA grew 14%, representing 26% of revenue, and APAC declined 7%, representing 16% of revenue. Enterprise customers represented 62% of product bookings in the quarter, service providers represented 21%, and government customers represented 17%, including 6% from U.S. Federal. I will now share our Q1 operating results. GAAP gross margin was 77.9%. Non-GAAP gross margin was 80.4%, in line with our guidance for the quarter and below where we expect to be for the year. GAAP operating expenses were $454 million. Non-GAAP operating expenses were $378 million, in line with our guided range. Our GAAP operating margin was 13%. Our non-GAAP operating margin was 26.5%. Our GAAP effective tax rate for the quarter was 24.5%. Our non-GAAP effective tax rate was 21.4%. GAAP net income for the quarter was $72 million or $1.20 per share. Non-GAAP net income was $149 million or $2.47 per share, above the top end of our guided range of $2.25 to $2.37 per share. EPS was aided in part by currency gains related to a weaker U.S. dollar in the quarter. I will now turn to cash flow and the balance sheet. We generated $158 million in cash flow from operations in Q1. Capital expenditures for the quarter were $13 million. DSO for the quarter was 62 days. This is up from historical levels, primarily due to strong service maintenance contract renewals in the quarter and, to a lesser degree, back-end shipping linearity resulting from ongoing supply chain challenges. Cash and investments totaled approximately $668 million at quarter end, reflecting the paydown of approximately $350 million in term debt remaining from our Shape acquisition. During the quarter, we repurchased approximately $40 million worth of F5 shares or approximately 263,000 shares at an average price of $152 per share. Deferred revenue increased 12% year-over-year to $1.76 billion, which is up from $1.69 billion in Q4. This increase was largely driven by particularly strong service maintenance renewal sales reflecting the trend of customers optimizing their existing infrastructure while recalibrating budgets. Finally, we ended the quarter with approximately 7,050 employees. I will now share our outlook for Q2. Unless otherwise stated, my guidance comments reference non-GAAP operating metrics. We expect Q2 revenue in the range of $690 million to $710 million, with gross margins of approximately 80%. We continue to expect our gross margin will improve in the second half of the year for two main reasons. First, we expect some of the ancillary supply chain-related costs like expedite fees will begin to abate; second, with our engineering efforts to redesign around some of the more challenged components nearing completion, we expect to be less dependent on the broker market where costs for critical parts have been exorbitant. We estimate Q2 operating expenses of $368 million to $380 million, and our Q2 non-GAAP earnings target is $2.36 to $2.48 per share. We expect Q2 share-based compensation expense of approximately $64 million to $66 million. Given our Q1 results and our Q2 expectations, I also want to elaborate on our FY '23 outlook. We continue to expect revenue growth of 9% to 11% for the year. Given the demand trends we have seen in the last four months, we expect our FY '23 revenue mix will reflect revenue contribution weighted more towards hardware and services and less towards software than we expected a quarter ago. Our FY '23 software growth is likely to be lower than the 15% to 20% we initially expected due to budget scrutiny and project delays, pressuring new software contracts. This is offset by the probability of stronger systems growth given supply chain improvements and the benefit of our system redesign efforts coming to fruition. In addition, based on the strong maintenance and forecast for Q2, we now expect Global Services growth of mid-single digits, which is up from low to mid-single digits growth we forecasted previously. As François noted, we continue to expect non-GAAP earnings growth in the low to mid-teens for FY '23. We remain committed to maintaining double-digit earnings growth this year and on an annual basis going forward. We will continue to evaluate our cost base and take further action as needed to achieve this goal. I will now turn the call back over to François. François?

Thank you, Frank. In closing, I would ask you to take away three things from this call: Number one, that despite the environment, we remain committed to delivering double-digit earnings per share growth this year and on an annual basis going forward; number two, while we believe 9% to 11% revenue growth for the year is achievable, if we get demand signals that tell us it is not, we will exercise operating discipline and adjust our cost base in order to achieve our earnings goals; and number three, we have built a strong business model with nearly 70% recurring revenue, product revenue that is split 50-50 between hardware and software and global services revenue that has proven durable. The result is a diversified and resilient revenue base, which when combined with operating discipline enables us to drive revenue and earnings growth in this environment. Operator, please open the call to questions.

Our first question is from Sami Badri with Credit Suisse.

Thank you for the opportunity to ask questions. I have two. First, could you break down the growth in services revenue? You mentioned price increases and maintenance renewals. Can you provide details on which component contributed more to the reported number? The second question is about the shifting IT landscape. Many investors, including myself, are curious about potential risks to demand throughout the year. Specifically, if demand signs worsen, how would that affect F5's business and results? For instance, if conditions decline, will that lead to cancellations of product orders in the backlog? I would like to hear your thoughts on these two questions.

Sure, Sami. So I'm going to start with your first question, and then I'll let François take the second. It's Frank. So we didn't give an exact split out, but I would say it's roughly even between the two. I think the renewal rates continue to go up, particularly on those services business, and we've seen less discounting, given the environment that we see of people continuing to sweat assets, putting focus on that, and taking the price increases that were put in place a couple of quarters ago, and we're starting to see the benefits of that come through to the services revenue. So I'm not going to give you the exact split, but I would think of them as roughly equal between the two, and I'll let François refer to your second question.

I mean in terms of the overall environment, yes, the overall IT spending environment has deteriorated quite meaningfully over the last six months. And we're seeing that mainly in terms of softer demand than clearly what we were seeing six months ago. Now the way you would see that in our results, it's not in order cancellations, because the appliances that our customers buy from us are typically mission-critical to deliver on applications that actually need the capacity. So we haven't seen any trend in order cancellations nor do we expect to see any of that. In fact, our customers have been pressing us to ship to them the backlog that we have built over the last couple of years and a lot of the orders that displaced that we haven't delivered on. And so we continue to work hard on our improvements in the supply chain in order to be able to meet that. Where you are seeing this different environment in our results, and clearly, we're seeing a number of software projects that have been delayed, a lot more scrutiny on deals, and that is actually affecting our software growth rate, and you're seeing that in the results. And we've seen it, frankly, across the board in terms of softer demand in software, but also softer demand in hardware this quarter than we had a quarter a year ago.

Our next question is from Tim Long with Barclays.

Could you discuss the software businesses and identify which areas are experiencing more impact than others? Are there specific aspects of the SaaS businesses or perhaps the term deals that stand out? Additionally, why is there still a need to differentiate between hardware and software? It seems that your solutions don't really align with that distinction. Could you provide an update on this?

Thank you, Tim. I will address your two questions. Regarding the softer demand in software, we can differentiate between existing contracts with renewals or expansions and new contracts. The renewal business for existing contracts performed largely as we anticipated. However, the softer demand was primarily in new contracts and new projects. In the past three years, our new software business had seen significant year-on-year growth, but we expect it to remain flat this year. In the first quarter, we experienced a decline in new software projects, down double digits compared to last year's first quarter. The pressure was evident across product lines, but the most significant impact on quarterly revenue stemmed from multiyear term subscription deals. As for the hardware-software distinction, it's an important question. Last year, we faced substantial demand that we couldn't fulfill due to supply chain issues. This year, we are working to improve our supply chain and expect to ship all orders from our backlog. We've made significant progress in this area. Many of our customers utilize both hardware and software, and we believe this trend towards a software-first environment will continue as customers prefer this consumption model for technology. When assessing the total performance of the company, we prioritize driving earnings growth, particularly double-digit growth, which remains our commitment regardless of the hardware-software dynamics.

Our next question is from Alex Henderson with Needham.

Great. helping you address a little bit about what your backlog in systems looks like. I think it was running 40% to 50% of four-quarter product sales in systems. And I was hoping you could give us some insights there in terms of what the backlog is at? And then second, obviously, getting the rSeries out in March of last year was an important milestone, but there was a lot of application functionality that you needed to get built into it in order to solve individual customers' needs in order to replace the iSeries. And I was hoping you could give us an update on where you are on that? And do you think that, that then creates post, say, the June quarter, a refresh cycle on the large installed base of iSeries?

Yes. Alex, let me start with the backlog question. I'm going to turn it over to François for your second question. So on backlog, what we've talked about is that we will disclose that once a year if it's material, meaning more than 10%, but we weren't going to talk specifics in any one given quarter. I will say similar to Q1 last year, where we talked about percent move up, we were down a bit more than 10% this quarter in backlog from where we ended in Q4, and that was largely a result of our ability to ship based off of some of the product redesigns that we were able to achieve. And so we were quite happy with seeing that reduction in backlog from a customer satisfaction standpoint. And then François, I think we'll talk to your second question.

So Alex, on the rSeries, there have been two factors that have sort of gated the ramp and growth of the rSeries over the last several quarters since we launched it. First is what you mentioned, the number of use cases and applications that rSeries could cover relative to the iSeries. And second was our ability to build and ship rSeries, which has been significantly constrained with some of the components. The good news is both of these factors are going away over the next couple of quarters. On the supply chain factors, we are seeing better component availability and also access to broker markets where we are still constrained. We still have constraints on rSeries. We still had in Q1, and we are still having those, but a lot of the redesigned efforts that we have already done will be complete by the end of our second quarter. We are seeing lead times on rSeries will be improving in our second quarter and beyond. And then the second aspect in terms of the application, the number of use cases that rSeries can cover will pretty much be at parity with iSeries, if not in the June quarter, in the September quarter. So in both cases, there's a lot of progress. There is a lot of demand for rSeries. And I think you should expect that rSeries will certainly grow into FY '24 to become the vast majority of what we ship in terms of appliances.

Our next question is from Samik Chatterjee with JPMorgan.

I guess for the first one, if I can, François, ask you to sort of share a bit more color on in terms of budget scrutiny, which regions as well as customer...

Samik, we're having a hard time hearing you. You may want to speak up.

Can you hear me now?

Yes, much better.

Yes. So first question was really more about François' comments on the budget scrutiny that you're seeing, which regions and maybe customer verticals as well, are you seeing the most sort of scrutiny from? And where do you stand in relation to like as you sort of are in the early days of fiscal 2Q in terms of either quantifying it in terms of a sales cycle or conversion cycle? Are you continuing to see those sort of conversion cycles get extended or timeline get extended? Or are you starting to find a sort of levels set to a longer duration in terms of the conversion cycle? And I have a follow-up.

Thank you, Samik. So in terms of where we saw softer demand in software, it was across the board in terms of verticals and geographies. So if you remember in Q4, I said the international EMEA and Asia Pacific, in particular, were quite affected. We actually did see that clearly in North America as well this quarter. And it was also, I would say, across most of our verticals. I think it was more pronounced in the technology sector, large tech companies going through substantial revisions of their budget and to some extent, I would say, financial services. These are perhaps where the effects were more pronounced. In terms of the rest of the year, it's too early to have full visibility on the rest of the year. I would say our expectation is that the dynamics that we have seen in our first fiscal quarter as it relates to software will largely continue in our second fiscal quarter. But beyond that, it's too early to speak to the visibility.

Thank you for that, François. Regarding your follow-up, you mentioned that customers are utilizing their assets more, which indicates that you are gaining some traction on the services side. However, considering the demand for systems and the associated supply chain factors, how do you view the potential increase in system demand, especially as some software transformation projects might be delayed, leading to a higher utilization of hardware appliances that have historically delivered strong performance? How do you expect to quantify that potential increase in system demand?

I believe that, in terms of system demand, we noticed a decline this quarter. This has affected budgets and led to increased scrutiny from our customers, impacting both software and hardware demand to some extent. The increase in hardware revenue we anticipated for the year is, as we mentioned at the beginning of the year, primarily a shipping forecast. The stronger performance we expect in the second half regarding hardware is largely due to our enhanced capacity to ship more products. Consequently, we anticipate a significant rise in our hardware revenue in the third and fourth quarters compared to the first half of the year, thanks to our improvements in the supply chain. Regarding demand, I do not think the current pressures on software will consequently lead to a higher demand for hardware at this time. Our customers are focused on maximizing their existing assets and trying to manage their capacity. However, this situation can only last for so long before they need to invest in additional capacity. As supply chains improve and lead times decrease, we will likely see some pent-up demand that has been restricted due to our inability to fulfill orders placed several months ago. Many customers have been unable to implement our solutions or place new orders, but as we address these shipping issues, we should observe an uptick in demand from these customers.

Our next question is from Amit Daryani with Evercore.

I guess I have two as well. François, maybe just going back to this product systems discussion a little bit. Yes, the risk of the fear folks would have is listen, if the macro remains soft and IT budgets remain under pressure, why wouldn't customers push out or sweat the appliances more. And so then maybe just about how do you have confidence that this appliance or systems business recovers in the back half if the macro remains challenging and the backlog can remain strong.

I believe we have strong visibility regarding our ability to meet revenue forecasts for hardware. We don’t necessarily require a significant recovery in hardware demand to achieve this, thanks to our visibility on revenue and shipping capabilities, including our backlog. It is challenging to predict when demand will recover. However, the core factors driving customers to purchase hardware or software remain intact. These factors are linked to the growth of applications, which continue to rise in complexity and are increasingly utilized in hybrid and multi-cloud environments. Although demand may be suppressed for several quarters, we are confident that it will rebound as the underlying drivers of our business and customer behavior are still present and will persist. Additionally, security concerns around applications will continue to drive demand. Our adaptability with consumption and deployment models is also beneficial, as some customers face CapEx constraints while others experience OpEx pressures. This flexibility contributes to the resilience we're seeing in our business and operating model.

Got it. That's really helpful. If I could touch on the software side, I know you mentioned that the growth will be below the 15% to 20% range discussed earlier. Can you provide any updates on what the new range might be or the trajectory of software through fiscal '23? Additionally, does this change your long-term expectations for the software business beyond this year?

Let me begin with the last point. It does not change our long-term outlook, Amit, due to the factors I just outlined. We believe our customers will continue to utilize our software in cloud and hybrid cloud settings. The architecture is shifting towards multi-cloud solutions, which strongly supports this. Reflecting on five years ago, when customers believed everything would concentrate in a single cloud location and questioned the need for an F5 ADC, we now see that today's architectures are moving towards multi-cloud. We are well-positioned in these discussions. What we are not witnessing is a migration away from F5 from an architectural standpoint; rather, we are seeing financial decisions and pressures. Thus, we are confident that the key drivers for F5's long-term software growth—security, modern applications, and multi-cloud environments—will persist and lead to the 20% growth we have discussed in the long term. In the short term, we have indicated that reaching the 15% to 20% growth range we mentioned earlier seems less likely. There is a pathway to achieve this, but it has narrowed compared to a quarter ago since it would require a significant change in demand patterns for software in the second half of the year. It remains uncertain whether there will be a quick rebound allowing us to see that growth, which is why we believe delivering 15% to 20% growth is less probable. However, I want to highlight that the improvements we've made to our business and operating model, particularly in our supply chain, may provide opportunities for increased hardware and services revenue. Overall, we feel our revenue target range of 9% to 11% is still attainable.

Our next question is from Meta Marshall with Morgan Stanley.

I have two questions. First, could you clarify what the larger new software deals are typically associated with? Are they related to cloud migrations, security upgrades, or hybrid architectures? This would help us understand what indicators to consider when assessing the return of new software growth. Second, regarding product gross margins, they seem to be remaining low for a bit longer. How are you planning to handle the reduction of supply chain costs or broker fees this year, and how long do you expect it to take to return to the product gross margins we have seen previously?

Thanks, Meta. I'll take the first question. Frank will address the second one regarding gross margins. The large software projects are related to various factors, primarily focusing on infrastructure or application modernization. These projects typically involve companies that have utilized our hardware and are now transitioning, either partially or fully, to a software-centric environment. This can include private or public cloud implementations involving lift and shift strategies. Often, these companies are establishing a new software environment while still maintaining parts of their application systems on hardware. They select specific applications for modernization to transition them to a more automated environment, whether in public cloud or their private cloud, allowing for faster time to market and improved deployment timelines. This is representative of the kind of project involved in the larger multiyear subscription agreements. Additionally, we have several projects with NGINX, primarily focusing on new modern applications that are moving from test and development into production, where there is a need for strong networking and security capabilities that NGINX provides, complementing solutions like Kubernetes orchestration. We're observing an increase in these types of projects. With our Distributed Cloud offerings, we're also introducing SaaS solutions, which is an area we've been missing. This model typically encompasses a range of applications that previously would not have had a traditional ADC deployed in front of them. Customers are now opting to safeguard those with our SaaS security solution for F5. These represent three types of implementations, with the multiyear subscription primarily being anchored in the first model I described.

Meta, in relation to gross margins, particularly product gross margins, our view of that for the year has not changed. And we talked about the supply chain improvements starting to benefit our product gross margins really in the latter half of this year, even all the way up into Q4. But the real benefit that we're going to see is going to be in FY '24 in terms of product gross margin improvement. We still had the purchase price variance and expedite fees that we're working through the components that make up our box builds through this year, and we still have a few critical components where we are having to go in the broker market. So largely, we will start to see improvement in Q4, but more of it you will see in FY '24.

Our next question is from James Fish with Piper Sandler.

On the software numbers, I don't understand the hesitation to provide a figure at this stage. I realize we are short of the 15% to 20% target, but that seems to be the main inquiry we're receiving after hours. Any clarity on that would be appreciated, Frank. Should we expect the decline in new recurring software business to persist for the rest of the year, or do you anticipate improvement as the new business comparisons become easier in the second half of the year? I have a quick follow-up after that.

Sure, I appreciate the question, Jim. As François mentioned earlier, we are not updating our 15% to 20% guidance because we still see a path to achieve it, although it may be more challenging. We do not expect significant changes in the environment. One reason for not updating our outlook for the second half of the year is the uncertain visibility regarding demand. When we started the year, we indicated that over 50% of the revenue contributing to that 15% to 20% growth was anticipated to come from new business activity. While we didn't expect that figure to increase, we were not prepared for the decline we experienced in Q1. With the current lack of visibility, we do not have a new range to provide today, and it seems less likely that we will reach that initial range.

Okay. And then François, I'm surprised no one's asked about it at this point, but on the strategy side with this Lilac deal. Why Lilac? What's the competitive advantage? And is it hope more to align with product overlap against some of your kind of newer competitors like Akamai or Cloudflare is it more to be able to offer that SaaS-like experience inside a customer's environment? And just trying to understand why couldn't this get done with NGINX and Volterra already?

Thank you, Jim. Regarding the Lilac acquisition, we bought Volterra a couple of years ago and launched the platform with our security offering about a year ago. We've seen strong traction with Distributed Cloud Services over the last 10 months, and we want to build on that momentum. We recently introduced a CDN offering in the Distributed Cloud Services platform, which was made possible through an OEM agreement with Lilac. This acquisition was intended to bring in that technology and team to secure our offering for the long term. We are also collaborating with this team to enhance the offering and deliver more innovative edge services on the Volterra platform. We are quite excited about the team's integration with us and their ability to help accelerate our innovation. This acquisition rounds out our offerings, including web application firewalls, API security, DDoS protection, anti-bot services, and now CDN within our suite of services for Distributed Cloud.

Our next question is from Simon Leopold with Raymond James.

This is Victor Chiu in for Simon Leopold. You noted that the fundamental demand around F5 software is still largely intact. But are there specific factors that you can point to that gives you confidence that the slowing isn't a reflection of more secular headwinds like cloud migration versus the cyclical slowing that you're noting?

Yes, Victor. I think it's interesting because I would say that migrations to the public cloud, if you want to call them like lift and shift tech migrations, we have seen that to be more of a tailwind to F5 than a headwind. But even more than that, what we have seen over the last couple of years is that customers are not migrating applications to a single cloud. Increasingly, customers are leveraging multiple different environments for their applications, multiple public clouds, private clouds, and on-premise. That actually is an architectural model that is ideally suited for the portfolio that we have built, which is essentially an infrastructure-agnostic portfolio of application security and delivery services. We feel very strongly that as that trend accelerates in large enterprises and that multi-cloud and hybrid cloud becomes more and more the mainstream deployment way of that enterprises deploy their application portfolio, it is going to drive growth for F5 and specifically for F5 software and SaaS services. So that's where our confidence comes, and I mentioned those drivers earlier: multi-cloud environments, security, modern applications. All three will contribute to the long-term growth of our software, which is why we feel our views on that are absolutely intact. What we are seeing right now, again, it's not an architectural or a competitive issue; it is largely a macro-driven, very cautious spending environment that is kind of indiscriminate across product lines.

Prior to the macro headwinds we began experiencing, did you notice any of the trends related to multi-hybrid cloud that you mentioned, and do you believe that those trends will return once conditions normalize?

Yes, Victor. We noticed those trends, which is reflected in our software growth of about 37% in 2021. In the first three quarters of 2022, before the market shift, our software growth was nearly 40% as well. This growth stemmed from three key factors: an increase in the deployment of modern applications supported by NGINX with Distributed Cloud Services, a greater demand for security in front of applications provided by our security solutions including Shape Distributed Cloud and BIG-IP, and more deployments in multi-cloud settings with our larger customers.

Our next question is from Tom Blakey with KeyBanc Capital Markets.

I have a question about software as well. The numbers you've provided suggest strong double-digit growth in the renewal and true-up business for the quarter. Is there anything one-time in that figure? Or any indication that we might not see similar growth in fiscal '23?

Yes, we did not experience any one-time benefits. Regardless of how you view the perpetual business in comparison to the subscription business, there was nothing unusual in the quarter.

Yes, I'm just focusing on the subscription business regarding renewals and true-ups. And then, as you mentioned, sorry, Frank, go ahead.

No, no, no. Absolutely, Tom.

Okay. Regarding the perpetual side, you've been performing a bit above the trend line over the past few years. What visibility do you have into this perpetual business line and its pipeline? François, can you share your thoughts? Additionally, can you explain how this relates to your comments about a pause and a slowdown in spending, especially since you've been exceeding expectations in the perpetual license area over the last few quarters? That would be helpful.

Yes. Tom, let me start with that, and François wants to add; he certainly can. Again, we think some of the power of our model is the flexibility of the way customers want to consume. In some cases, people have OpEx budgets, and in other cases, they have CapEx budgets. In certain instances, I think they'd rather consume on a CapEx basis, and some of that will come through perpetual. It's not something that we try to spend a ton of time forecasting the split between the two. We're happy when revenue falls in either. For the last couple of quarters, you may have seen that tick up from what was sort of a low $30-ish million a quarter business to the upper $30 million, low $40 million. But generally, those are customer preferences and how they want to consume our solutions.

Our next question is from Jim Suva with Citigroup.

Your commentary about the hardware being stronger especially with your outlook and such and the mix shift to more towards that, which will impact things. I understand it all, but the question is, is that impacted at all due to the supply chain issues during the past year or two in that maybe customers are absorbing some of the orders that they did and then this is going to face a headwind? Because normally, I would think about customers buying both the hardware and software kind of together.

Yes, it is affected by the supply chain. We had many orders that we couldn't ship last year, but we've made significant improvements in our supply chain, both with our suppliers and through our own redesign of platforms. This gives us better visibility on what we can ship to customers in the next three quarters. We've always wanted to fulfill these orders as quickly as possible and reduce lead times, which we believe will boost demand once we can do that. So, it is indeed impacted, and that's part of the soft performance we see in hardware this year. However, our current view of shipping capabilities has improved compared to three months ago.

Okay. That makes a lot of sense. And then just given the macro cautiousness, how should we think about capital deployment, stock buyback, M&A, any changes there? Are you kind of holding up, not holding up, reserving a little more for organic functions? Or how should we think about capital deployment versus maybe six, 12 months ago?

Yes, Jim. Our outlook on capital deployment remains unchanged. We still plan to utilize 50% of our free cash flow for share repurchases this year. As we mentioned earlier, we paid down the term loan debt from the Shape acquisition, which involved cash expenditure of just over $350 million in the quarter. This payment has impacted our cash balance, along with the $40 million in share repurchases we completed in Q1. We also announced the acquisition of Lilac for an undisclosed amount, which was a small acquisition made today. The overall strategy for how we intend to allocate our capital has not shifted, and we do not foresee any changes in the near future.

Our next question is from Fahad Najam with Loop Capital.

I want to revisit the software issues again. If you look at perpetual, it's growing fairly steadily. So can you maybe help us understand in terms of the renewals, what the net retention rate saw, maybe anything cohort analysis that you said it was in line? So maybe if you can just elaborate a little bit more? And then furthermore, I guess the question also is how should we be thinking about your exposure to legacy applications versus new modern applications? And if there's anything you can share with us on how that mix is trending.

All right. Let me start with the legacy and modern applications and how the mix is trending. I would say it's actually trending in line with the population of applications overall, which is that legacy applications are growing, I would say, in the single-digit percentage range in terms of the number of these applications out there deployed in the world. Whereas modern applications, we think are growing in the 30% range in terms of the number of them that are going into production on an annual basis. And so over time, there will be a lot more of the more modern applications than the legacy applications. But where this gets blurred though is that we're also seeing a number of legacy applications get modernized where folks are adding modern components to an application that is already in production and has already been generating revenue. This is where I think F5 has a specific advantage is that, yes, we play in modern applications with components like NGINX and excluding our Distributed Cloud Services. Yes, we play in legacy or traditional applications with platforms like BIG-IP. For a lot of our customers, they want to have implementations that involve modernizing a legacy application, and especially in an environment where customers are looking to consolidate vendors to simplify their operations, our ability to deliver on both these requirements and actually deliver a single commercial vehicle where you can have both your modern and legacy application services is critical. Over time, it will skew more towards modern applications as they grow faster.

And we're not offering any new metrics on software like net retention rates. I will say that as we mentioned for the renewal side of the business, which includes the SaaS business is the true forwards associated with the business, and some of the second terms of our multiyear subscription agreements largely came in as we expected. The shortfall that we experienced was largely due to the new software business that just didn't drive growth in the way that we would have expected it in Q1.

I have one more follow-up. François, now that you've had a few years since the NGINX and Shape acquisitions, can you provide an update on the progress of integrating these acquisitions into F5? Are you able to sell and integrate these acquisitions and upsell your solutions? How has the integration of these assets gone, and what should we expect for fiscal '23?

Yes, certainly. Let me address those points in order. Regarding NGINX and Shape, we have largely completed the integrations. For NGINX, the integrations are finished from both a product and capability standpoint. We have successfully transitioned from F5 or BIG-IP to NGINX, enabling us to provide security features on NGINX. We are increasingly offering our customers a unified platform for visibility across both NGINX and BIG-IP deployments. Additionally, we have completed the integration from a go-to-market perspective, empowering our marketing and sales teams to effectively promote and engage with customers regarding NGINX. We have made significant progress with Shape as well, nearing 80% completion. Shape is now fully integrated into BIG-IP, allowing our customers to enable Shape and quickly enhance their capabilities. It's also available in our Distributed Cloud platform as a standard anti-bot defense solution. We have made substantial strides in go-to-market integration, which is critical as it has helped us improve our operational efficiency in sales and marketing. Our sales and marketing expenses were about 31% of revenue in 2020, and this has decreased to around 29% in 2022, despite facing revenue pressures due to supply chain issues. This reflects positive operational leverage. Our overall operational expenses as a percentage of revenue have decreased from approximately 54.5% in 2020 to an implied 50% to 51% in our FY '23 guidance. The integrations have also allowed us to achieve the right synergies and operational leverage. Regarding Volterra, we are still progressing with that integration, but we have already deployed many of our security capabilities onto the Distributed Cloud platform. We are gaining considerable traction, as we aim to provide our customers with a single console to manage all their security policies and gain visibility over all their F5 deployments, whether they are hardware, software, or SaaS, and across both legacy and modern environments. In that context, we are positioning ourselves as a unique provider capable of covering all these models in an infrastructure-agnostic manner.

Due to time constraints, we will be taking our last question from Ray McDonough with Guggenheim.

Just two if I could. I understand you're not giving any new software metrics right now. But can you talk about how contract duration trended on renewals? I understand you were selling three-year term license deals in that cohort. It's really the first cohort of renewals that you're seeing this year. Are you seeing any contraction of contract duration? And then the second question would be I appreciate the comment around double-digit EPS growth and the commitment there. But how should we think about cash flow growth and cash flow margins normalizing as you kind of lap the change towards more annual invoicing terms this year?

Sure. Ray, I'll address both of your questions. Regarding changes in contract duration, we are closely monitoring that, and so far, we haven't noticed any significant changes in the duration of second-term renewals or the primary contracts we are establishing. Therefore, this hasn't affected us at this point. As for our commitment to double-digit EPS growth and cash flow, we anticipate benefiting from a slowdown in new flexible consumption programs, which will result in more actual cash in the latter half of the year since we aren't recognizing as much revenue upfront compared to the cash received. We expect to start seeing some normalization in this area. Additionally, we will benefit from the resolution of supply chain issues and the reduction of extra purchase price variance and expedite fees, which will enhance our cash flow from operations. I believe both factors will contribute to a return to normalcy, although it remains one of the more challenging aspects to forecast going forward.

Thank you. This concludes today's question-and-answer session. This is the end of today's conference. You may disconnect your lines at this time. Thank you for your participation.