Software Infrastructure Earnings Summaries Q2 2022 - FFIV, NOW, FIVN
As quarterly earnings season is beginning for software infrastructure companies, I like to monitor the results of providers in adjacent categories for signals about the overall demand environment for companies that I own. While not a direct replacement, these related software companies can reveal how enterprise spending is trending and raise any warning flags or surface potential tailwinds. Additionally, in the segments in which smaller providers compete with the hyperscalers, we can understand where the large public cloud vendors are consolidating share and where spending trends are benefiting all companies. The reports thus far have been instructive, showing that enterprise spend on software and cloud is slowing, but seems to be surprisingly resilient given the macro backdrop.
In this post, I will go through the take-aways of interest from F5, ServiceNow and Five9. For these posts, I won't rehash all the performance for a particular company, as some include categories of IT spend that aren't relevant. Rather, I will summarize and cherry-pick the items that are applicable for software infrastructure and security providers. This supplements a prior post I published recently reviewing the performance of the hyperscalers in Q2.
F5 has been out of the spotlight for a while, as cloud-based services have replaced many of their legacy hardware products in DNS, load balancing, WAF and DDOS mitigation. Like most hardware vendors, F5 has evolved over the years and now offers a software-based version of their product through a virtual machine that can be deployed onto a customer's servers in a cloud or on-premise environment.
Recently, they began offering a set of cloud-based software services that perform functions like DDOS protection, WAF, bot mitigation, API security and app-app network transit. They even have a global network of about two dozen PoPs co-located within hyperscaler data centers. These deliver about 10+ Tbps of peered capacity across four continents, with private backbone capacity and dedicated connectivity for cloud and SaaS providers.
As such, F5 provides a reasonable proxy of demand for network and application security functions. They reported their Q3 FY2022 results on July 25th. The overall performance was lackluster, with total revenue growing 3.5% y/y to $674.5M. This beat the analyst expectations for $667.8M. Additionally, Q4 (next quarter) guidance for revenue was roughly inline at $680-700M versus analyst consensus for $690.7M. The midpoint of Q4 revenue would represent about 2.4% sequential growth over the prior quarter. While low, this does demonstrate that spending is continuing, with presumably some upside on top of that. The stock was up about 3.5% the following day, indicating that the market was reasonably pleased with their results.
The highlight of the report, however, was 37% year/year growth in their software revenue, increasing from $129M to $179M year/year. The majority of this software revenue is based on subscriptions and is recurring in nature. For the full year (which includes Q4), they also reiterated their target for 35%-40% software revenue growth. Software growth is representative of demand for a self-hosting or cloud-delivered version of the application delivery and security functions mentioned above.
This software growth was in contrast to the Big-IP hardware appliances that must be physically delivered to a customer. Revenue for these systems actually decreased by 18% year/year. F5 has been experiencing lengthy delivery cycles for their hardware products, due to supply chain issues. They have been working through these, by identifying alternate sources and making design changes, but still expect elongated delivery timelines.
High demand for the software version of F5's services in DDOS, WAF, application security and network transit does bode well for sustained demand for similar services from Cloudflare, Akamai, Fastly and Zscaler. Additionally, the general constraints around physical hardware system delivery will likely accelerate the enterprise migration to modern cloud-based solutions.
ServiceNow reported Q2 FY2022 results on July 27th. Their financial results were mixed, ultimately disappointing investors and resulting in a stock price reduction of about 3% the next day. However, as I write this, the stock has recovered and is above the closing price before reporting results. With that said, we are still about 7% below the price before the CEO appeared on CNBC on July 11th and warned about the impact of currency fluctuations on general software provider results. Those comments sunk NOW stock by 13% the next day, and pulled down other SaaS providers.
In terms of ServiceNow's results, Q2 revenue was $1.75B, up 24% year/year as reported or 29.5% on a constant currency basis. This was slightly below analyst expectations for $1.76B, but did beat their Q1 estimate for 29% growth on a constant currency basis for subscription revenue. For Q3, they are projecting subscription revenue of $1.75B - $1.755B for 23% growth as reported or 27.5% on a constant currency basis. At the high end of the range, that would represent 5.9% sequential growth over Q2, demonstrating that enterprise spend is expected to increase.
For the full year, however, they did reduce their projection for subscription revenue to $6.915B - $6.925B, from their prior range of $7.03B - $7.04B, or about 1.7%. This would represent about 28% annualized growth on a constant currency basis. Additionally, they projected cRPO growth of 23.5% for Q3 on a constant currency basis. This represents a deceleration from 27% cRPO growth in Q2.
The reduction to the full year revenue guide and cRPO growth were the cause of the market's reaction and the tepid stock performance. The market's expectation was likely not for a beat, but at least that these forward measures might fall inline. ServiceNow leadership tried to dilute the full year guide by reminding investors that they are "simply returning to the outlook we originally set for you in January of this year on a constant currency basis." Additionally, they strongly reiterated their longer term projections for $11B+ in revenue by 2024 and $16B+ by 2026, even with the revised guidance for the full year. These targets would represent about 50% growth over 2 years and 120% growth in 4 years from the roughly $7.3B in revenue targeted for 2022.
Management attributed the lowered sales expectations to elongated sales cycles with large enterprises. In the last couple weeks of June, they saw some deals delay their targeted close, due to higher levels of spending authority having to approve them. They also experienced that effect more in Europe than in other geographies. On the flip side, management did mention that a lot of those deals closed in July, and some even resulted in higher spend than expected. According to ServiceNow leadership, a few C-level enterprise teams decided to increase their spending level after considering the potential ROI from their IT investments. However, ServiceNow management wanted to be conservative and extrapolated the slowdown in June through the year.
Customers are still committing to large deals with ServiceNow. Leadership reported an increase of 61 customers in Q2 with $1M+ in ACV, up 22% year/year. For larger customers, they reported over 100 customers now paying more than $10M in ACV in Q2 2022, up more than 50% year‑over‑year. Additionally, ServiceNow is continuing to hire, even while other technology companies pause or slow down their hiring pace. They emphasized that continuity in hiring reflects their bullish long term view.
Considering the macro environment, I thought these results were reasonable. As several of ServiceNow's product lines represent enterprise SaaS for HR Service Delivery, Customer Service Management and Financial Services Operations, enterprises might be inclined to pause some of that spend. For ServiceNow's product lines tied to application development, management highlighted strong demand. This included their observability and incident response offering through Lightstep (a recent acquisition), which is engaging with "some of the world's most innovative companies."
"With artificial intelligence, robotic process automation, process mining and low-code capabilities all embedded in our architecture, we make hyper automation about people. With 750 million net new applications being built on the horizon, ServiceNow is leading the low-code revolution, our born in the cloud suite of applications stretches across the enterprise end to end." ServiceNow Q2 2022 Earnings Call
Management also emphasized the demand they are seeing for application development on their low-code platform. Similar to commentary for Azure from management at Microsoft, ServiceNow is observing sustained interest from enterprises to create operational efficiencies and launch new customer channels through application development. This demand should funnel to other software infrastructure companies that provide supporting services for app development. The direct corollaries would be in observability (Datadog, Dynatrace), transactional databases (MongoDB) and DevOps tooling (GitLab). Additionally, application security and delivery services would be needed to protect applications once built (Cloudflare, Fastly, Akamai).
Five9 is a cloud-based contact center solution provider. Their intelligent cloud contact center enables customers to engage with consumers on multiple channels to streamline business interactions. The Five9 solution applies AI and automation to generate efficiencies for enterprises in customer management. Five9's platform is exclusively focused on delivering its services in the cloud, disrupting the large market of legacy on-premise contact center systems.
Five9's growth provides an indication of enterprise willingness to continue investment in digital transformation and cloud migration. Most of their customers have a legacy contact center solution in place, which may be less efficient, but is a sunk cost. The transition to Five9 is generally driven by a desire to improve customer engagement through more advanced features and increased flexibility in how and where customer service agents can be deployed. With an existing solution in place, these enterprise system upgrades could be considered discretionary.
Yet, Five9 reported strong results for Q2 FY2022 on July 28th, with record revenue of $189.4M growing 31.7% year/year. This beat analyst estimates for $180.1M by about 5%. In Q1, revenue growth was 32.6%, so roughly inline sequentially. Enterprise subscription revenue grew at a faster rate of 41% over the prior year. They also reported record bookings and strong growth of the forward sales pipeline. New enterprise deal highlights included a Fortune 200 company for $7.3M in ARR, a Fortune 100 company for $4.5M in ARR and a state agency at $2.8M in ARR. A parcel delivery service company increased their ARR by $12M to reach a global total of nearly $50M.
With this strong demand, Five9 leadership was comfortable raising forward guidance. For Q3, they are expecting $193M in revenue, slightly above the $192.3M expected by analysts. For the full year, they raised guidance to $781.5M at the midpoint, from their prior guidance of $771.5M and beating consensus for $771.2M. Profitability measures were increased as well. With these beats and forward guidance raises, the stock reacted favorably, popping nearly 10% the following day.
I find these results encouraging for two reasons. First, as with other companies discussed, they indicate a willingness for enterprises to continue investing in software solutions that improve operations and drive efficiencies. This is in spite of having an existing contact center solution in place, in theory making it easier to delay. Second, hyperscalers have entered the cloud contact center market. AWS offers Amazon Connect. Microsoft recently released their Digital Contact Center Platform, which is an amalgamation of their Nuance acquisition, Power Platform and Teams. The fact that Five9 continues to thrive in spite of competition from the hyperscalers supports the premise that independent software providers can share in enterprise spend and preserve their slice of the market.
Overall, I thought the results from these three companies provide further evidence of the durability of enterprise spend on application development and cloud migration. Spending levels are softening due to pressure on IT budgets from the macro environment, but don't seem to be impacted more than we would expect. Some deals are being extended for additional spending approvals, which is normal under these financial conditions. It is encouraging that they do ultimately get approved and in some cases at even higher spending levels upon further review.
Another trend worth highlighting is the heavy constraint on any network and security products that are hardware-based. Multiple companies, including F5, Arista, Nutanix and others, have commented on extended delivery cycles and challenges in securing parts for hardware shipments to customers. These effects appear to be ongoing. Some providers have found temporary work-arounds, but few are able to ship hardware at the rate and consistency that they prefer.
This trend will likely benefit those network and security service providers that don't have a dependency on shipping a hardware product, by offering their solutions over their existing cloud-based network. While these companies may be somewhat challenged in rapidly increasing their underlying infrastructure due to the same hardware constraints, most have sufficient capacity in place and use alternative sources for building out their data centers.
As the CapEx investment has already been made, these companies are well-positioned to welcome new enterprise customers that become frustrated waiting for a hardware-based firewall, router, load balancer, DNS or VPN server. With fairly straight-forward on-boarding, companies like Cloudflare, Akamai, Fastly and Zscaler could see an uptick in customer engagements as enterprises accelerate their migration off of physical hardware or even virtual instances (that still require server procurement). This effect could provide a tailwind for these companies with cloud-based deployments.
Looking forward, we will continue to see the impact of these different forces on the results of independent software providers. Thus far, at least, the results from the hyperscalers and ancillary service providers seem to indicate a softening of IT spend, but not an abrupt halt. In the near term, this trend will introduce volatility for individual software infrastructure companies, but could also provide some opportunity for investors when spending returns to normal levels.