Cloudflare, Inc. (NYSE:NET) Q3 2023 Earnings Call Transcript

Cloudflare, Inc. (NYSE:NET) Q3 2023 Earnings Call Transcript November 2, 2023

Cloudflare, Inc. beats earnings expectations. Reported EPS is $0.16, expectations were $0.1.

Operator: Good afternoon. My name is Krista and I’ll be your conference operator today. At this time, I would like to welcome everyone to the Cloudflare Quarter 2023 Earnings Conference Call. [Operator Instructions] Thank you. I would now like to turn the conference over to Mr. Phil Winslow, Vice President of Strategic Finance, Treasury and Investor Relations. You may begin, sir.

Phil Winslow: Thank you for joining us to discuss Cloudflare’s financial results for the third quarter of 2023. With me on the call, we have Matthew Prince, Co-Founder and CEO; Michelle Zatlyn, Co-Founder, President and COO; and Thomas Seifert, CFO. By now, everyone should have access to our earnings announcement. This announcement as well as our supplemental financial information may be found on our Investor Relations website. As a reminder, we will be making forward-looking statements during today’s discussion, including, but not limited to, our customers, vendors, partners, operations and future financial performance, our anticipated product launches and the timing and market potential of those products, and our anticipated future financial and operating performance and our expectations regarding future macroeconomic conditions.

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These statements and other comments are not guarantees of future performance and are subject to risks and uncertainties, much of which is beyond our control. Our actual results may differ significantly from those projected or suggested in any of our forward-looking statements. These forward-looking statements apply as of today, and you should not rely on them as representing our views in the future. We undertake no obligation to update these statements after this call. For a more complete discussion of the risk and uncertainties that could impact our future operating results and financial condition, please see our filings with the SEC as well as in today’s earnings press release. Unless otherwise noted, all numbers we talk about today, other than revenue, will be on an adjusted non-GAAP basis.

You may find a reconciliation of GAAP to non-GAAP financial measures that are included in our earnings release on our Investor Relations website. For historical periods, a GAAP to non-GAAP reconciliation can be found in the supplemental financial information referenced a few month ago. We would also like to inform you that we will be participating in RBC Capital Markets Global TIMT Conference on November 14; and the Wells Fargo TMT Summit on November 28. Now I’d like to turn the call over to Matthew.

Matthew Prince: Thank you, Phil. We had another strong quarter in spite of an increasingly uncertain world. In Q3, we achieved revenue of $335.6 million up 32% year-over-year. We added 206 new large customers, those that pay us more than $100,000 per year, and now have 2,558 large customers, up 34% year-over-year. Looking at even larger customers, we added a record number of net new customers year-over-year spending more than both $500,000 and $1 million per year with Cloudflare. Our dollar-based net retention ticked up 1% to 116%. We see this as a lagging indicator and expect that it will take some time for the go-to-market improvements we’re seeing across our team to be fully reflected. During the quarter, we continued to refine these go-to-market strategies.

Our pipeline close rates held steady, our sales force productivity remained constant and linearity was similar to Q2. I think that we have been able to hold things steady while making significant organizational changes and improvements across our sales and marketing organization is very encouraging. Beyond that, we’re beginning to see positive early signs from the sales team members we’ve brought on over the six months to replace underperformers. During the quarter, the pipeline generated by this new cohort was 1.6x higher than those brought on at the same time a year earlier. These new account executives achieved more than 130% of their activity goals for the quarter. That’s great news. And we’re thrilled to have them on board. And while they’re still ramping, I’m encouraged by the performance, and that we’ve been able to revamp as much of our sales team as we have without significant disruption.

Our gross margin was 78.7%, still well above our target range of 75% to 77%, and up from 77.7% last quarter. We delivered an operating profit of $42.5 million, our fifth consecutive record quarter for the company. This represents an operating margin of 12.7%. Operating profit increased nearly 3x year-over-year, underscoring our commitment to operating efficiency and productivity. We continue to generate positive free cash flow. In Q3, we generated $34.9 million during the quarter, representing a free cash flow margin of 10.4%. This is a business that can generate significant cash, and in 2023, we expect we will generate more than $100 million in free cash flow, well ahead of our original goal when we started the year, and the direct result of improved execution across our entire business.

In Q3, we celebrated our 13th anniversary of Cloudflare’s launch, a time we call Birthday Week. We officially entered our teenage years and like many kids, it took us a while to fully understand and articulate the category we belong to. The day before our 13th birthday, we announced to the world, that we realized what we are, a connectivity cloud. Connectivity means we measure ourselves by connecting people and things together. Cloud means the batteries are included. It scales with you. It’s programmable, has consistent security built in, it’s intelligent and learns from your usage and others to optimize for outcomes better than you could on your own. Our connectivity cloud is worth contrasting against some of the other first-generation clouds.

The hyperscale public clouds are, in many ways, the opposite. They optimize for hoarding your data, locking it in, making it difficult to move. They are captivity cloud. While they may be great for some things, their full potential is only truly unlocked for customers when combined with the connectivity cloud that lets you mix and match the best of each of their features. That’s what we hear from customers, that they are multicloud, whether they want to be or not. And that’s what they really need, is a connectivity cloud, to hook all their systems together in a fast, secure, reliable way. The messaging of the connectivity cloud is resonating with customers and helping them understand the full extent of what Cloudflare is able to deliver for them.

We are not any one of our individual features or even as some of them. We are a cloud that helps you get the most out of connectivity, and customers love that and are leaning into it. Speaking of customers, we’ve had some great customer wins in the quarter I’d like to highlight. A U.S. government cabinet level agency within the executive branch, signed a one-year $2 million contract. Cloudflare’s replacing three point solution vendors, including a 20-year old incumbent solution. We’re providing a unified application security for 600 U.S. government applications. They were drawn to Cloudflare’s modern architecture, rate of innovation, robust network and ability to reduce complexity by consolidating multiple point solutions into a single pane of glass.

Another U.S. government agency signed a one year $510,000 contract for Cloudflare’s Zero Trust solutions, including Access, Gateway, Browser Isolation and Data Loss Prevention. We were selected over first-generation Zero Trust competitors due to our ability to consolidate numerous products across both application security and Zero Trust onto a single platform. Our federal business has grown significantly over the last year, and we believe these deals are just at the tip of the iceberg with both of these customers, which we expect can expand significantly. A leading health care company signed a three year $1 million contract for Cloudflare’s Zero Trust solutions, including Access, Gateway, Browser Isolation and Area 1 Email Security. They are a legacy vendor looking to modernize their security posture as they migrate on-prem applications to the cloud.

They experienced a sophisticated e-mail phishing attack mid-process, and with Area 1, we were able to immediately protect them. They chose us over first-generation Zero Trust solutions because of the comprehensiveness of our solution, including e-mail security. The VP of Technology said succinctly, we should have partnered with Cloudflare earlier. A major European consulting company signed a three year $1.6 million contract for Access and Gateway, along with Magic WAN and our data localization suite. They selected Cloudflare over first-generation Zero Trust competitors because of the breadth of our platform. The theme across these examples is customers are looking for a Zero Trust solution, increasingly wanting to protect their entire network.

Cloudflare is the only vendor that can deliver a comprehensive network-wide solution from a single vendor. Switching gears a bit, a Fortune 500 semiconductor company expanded their relationship to Cloudflare, signing a three year $1.4 million contract. The customer was looking to modernize their network security posture. They adopted our Magic Transit product. They were able to consolidate multiple point solutions on to Cloudflare’s unified platform. An African public utility company expanded their relationship with Cloudflare, signing a four year $3 million contract. This company first approached Cloudflare last year, facing multiple under attack situations. We onboarded the customer with Application Security and Magic Transit, stopping the attacks they were seeing.

The customer was so impressed with Cloudflare’s products and performance that they quadrupled their utilization and added additional products, including Magic Firewall. The fact that Cloudflare’s network spans the globe gives us the ability to service clients everywhere. Another international technology company signed a two year $1.8 million contract for Magic Transit and Advanced Application Security. This customer approached us in the midst of a large-scale DDoS attack. Their incumbent solutions were provided by a mix of point solutions and bundled hyperscale cloud mitigation services, neither was sufficient to stay ahead of the attack. In Q3, we saw a significant increase in massive DDoS attacks. To give you a sense, these new attacks are generating nearly as much traffic as the entire Internet generates globally, but pointing it to a single victim.

There are very few networks that can stand up to these attacks. I’m proud of the fact that Cloudflare is architected uniquely for this moment. And as the world becomes more complicated, and these attacks become more common, I think more and more of the Internet will turn to us for protection. A leading ad tech company expanded their relationship with Cloudflare, signing a one-year $720,000 contract. This customer came to us with a technical workers use case. They needed a platform that could help them deliver through traffic spikes, up to 3 million requests per second. Their existing solutions on traditional hyperscale public clouds were expensive to maintain and would encounter errors with even relatively low traffic spikes. Cloudflare Workers was able to support their needs without bringing a sweat.

With this win, we expect they will move more of their applications to our much easier to scale platform. A Fortune 500 technology company expanded their relationship with Cloudflare, signing a one-year $2.9 million contract. This customer approached us to use our connectivity cloud to help them collect AI and machine learning data from their customers, while maintaining the highest level of privacy. They view Cloudflare as a leader in privacy, and we work closely with them to develop the solution. This deal makes clear the importance of privacy and the likely regulatory scrutiny of AI tasks and highlights how Cloudflare’s network, which extends into the vast majority of countries on earth, can help customers take advantage of AI while complying with an increasingly complex regulatory environment.

We continue to accelerate our efforts in AI. We believe Cloudflare is the most common cloud provider used by the leading AI companies. During our birthday celebrations in Q3, we made several announcements with companies like NVIDIA, Microsoft, Meta, Hugging Face and Databricks. We also announced Workers AI to put powerful AI inference within milliseconds of every Internet user. We believe inference is the biggest opportunity in AI and inference tasks will largely be run on end devices and connectivity clouds like Cloudflare. Right now, there are members of the Cloudflare team traveling the world with suitcases full of GPUs, installing them throughout our network. We have inference-optimized GPUs running in 75 cities worldwide as of the end of October, we are well on our way of hitting a goal of 100 by the end of 2023.

By the end of 2024, we expect to have inference-optimized GPUs running in nearly every location where Cloudflare operates worldwide, making us easily the most widely distributed cloud-AI inference platform. We’ve been planning for this for the last six years, expecting that at some point, we hit the crossover, where deploying inference-optimized GPUs made sense. To that end, starting six years ago, we intentionally left one or more PCI slots in every server we built, empty. When the demand and the technology made sense, we started deploying. That means we can use our existing server infrastructure and just add GPU cards, allowing us to add this capability while still staying within our forecast CapEx envelope. And customers are excited. In the five weeks since our AI announcement, thousands of developers have leveraged our new AI capabilities to build full stack AI applications on Cloudflare’s network, processing more than 18 million request through the new features we launched just over a month ago.

The demand has exceeded our expectations and continued to accelerate, increasing 5x since mid-October. We have a pipeline of customers interested in putting hundreds of billions of inference tasks on our infrastructure each month. It’s early days but the interest we’re seeing from customers, large and small, over what they can build with powerful inference capabilities now embedded in one of the world’s largest networks is inspiring. They like how easy it is to use Workers AI. They like how it’s powerful, but close to their users around the world. They like the more efficient and fair pricing model, our serverless implementation delevers. And they like the flexibility of bringing their own models or fine-tuning existing models using the tools that are included as part of Workers AI.

If we’re right, that inference is the big AI opportunity, and that inference tasks that are too big and too complex to run on end devices, will need to run as close to the user as possible, then we’ve got a head start on building the preferred location for inference for the most interesting AI applications of the future. Finally, before I turn it over to Thomas, I wanted to acknowledge that we continue to live in very challenging times. The war in Ukraine continues unabated. Now we have a new war in the Middle East after the attack by Hamas on Israel. We have colleagues in the region who have been impacted directly and indirectly. Our thoughts are with them. And while we see the devastating images of the kinetic war, the online war is also raging.

Cloudflare is committed to providing our services to humanitarian and civil society organizations at no cost, to ensure they can continue doing their important work for all those impacted by the increasingly hostile world we find ourselves in. In our business, we need to stay on top of cybersecurity issues globally and modern warfare continues to include the cyber battlefield. As I look back on the quarter, I’d like to thank our entire team at Cloudflare for all your hard work, innovation, dedication to supporting our customers and the greater Internet. Thank you for continuing to help build a better Internet for us all. And with that, I’ll hand it off to Thomas. Thomas, take it away.

Thomas Seifert: Thank you, Matthew, and thank you to everyone for joining us. During the third quarter, as we continue to refine our go-to-market strategies and operations, our pipeline growth rates have held steady, our productivity remained consistent and linearity was similar to last quarter. We are pleased to see significant growth with general partners, momentum with large customers and strength in the public sector. Importantly, we continue to maintain our strong commitment to being fiscally responsible, and as good stewards of investors’ capital. We delivered our fifth consecutive quarter of record operating profit, increasing nearly threefold year-over-year and significantly outperformed on free cash flow. Turning to revenue.

Total revenue for the third quarter increased 32% year-over-year to $335.6 million. From a geographic perspective, the U.S. represented 52% of revenue and increased 30% year-over-year. EMEA represented 28% of revenue and increased 36% year-over-year. APAC represented 13% of revenue and increased 27% year-over-year. Turning to our customer metrics. In the third quarter, we had 182,027 paying customers, representing an increase of 17% year-over-year. We ended the quarter with 2,558 large customers, representing an increase of 34% year-over-year, and an addition of 206 large customers in the quarter. In fact, we added a record number of net new customers year-over-year spending more than $500,000 and $1 million on an annualized basis with Cloudflare.

Our dollar-based net retention rate was 116% during the third quarter, representing an increase of 100 basis points sequentially. Also, there can be some variability in this metric quarter-to-quarter, we continue to believe the recent decelerating trend in DNR, stabilizing near lease levels. Moving to gross margin. Third quarter gross margin was 78.7%, representing an increase of 100 basis points sequentially, and an increase of 60 basis points year-over-year. Network CapEx represented 8% of revenue in the third quarter as we continue to benefit from our focus on driving greater efficiency from our infrastructure and the uniqueness of our platform to onboard new workloads. Despite having begun to invest in the enormous AI opportunity in front of us, with the planned rollout of GPUs to more than 100 cities by the end of this year, we expect network CapEx to be 8% to 10% of revenue in fiscal 2023.

However, we anticipate network CapEx to return to more normalized levels over time. Turning to operating expenses. Third quarter operating expenses as a percentage of revenue decreased by 5% sequentially and decreased by 6% year-over-year to 66%. Our total number of employees increased 11% year-over-year, bringing our total head count to 3,529 at the end of the quarter. We were selective in hiring during the quarter, as we continue to evaluate deploying AI and automation at scale to reengineer our business processes across the company. Early investments in these areas are already delivering encouraging returns. We will remain prudent in hiring as we continue to invest in broadening and deepening the usage of AI and automation across our operations to drive higher productivity and greater efficiency.

Sales and marketing expenses were $129 million for the quarter. Sales and marketing as a percentage of revenue decreased by 3% sequentially and decreased 38% from 41% in the same quarter last year. Research and development expenses were $54.2 million in the quarter. R&D as a percentage of revenue decreased by 1% sequentially and decreased to 16% from 18% in the same quarter last year. General and administrative expenses were $38.5 million for the quarter. G&A as a percentage of revenue decreased by 2% sequentially and decreased 11% from 13% in the same quarter last year. Operating income was $42.5 million compared to $14.8 million in the same period last year. Third quarter operating margin was 12.7%, an increase of 690 basis points year-over-year.

These results highlight our ongoing focus on becoming more productive and doing more with less, given that operational excellence is a long-term competitive advantage. Turning to net income and the balance sheet. Our net income in the quarter was $55.3 million or a diluted net income per share of $0.16. We ended the third quarter with $1.6 billion in cash, cash equivalents and available-for-sale securities. Free cash flow was $34.9 million in the third quarter or 10% of revenue, compared to negative $4.6 million or 2% of revenue in the same period last year. Remaining performance obligations, or RPO, came in at $1.1 billion, representing an increase of 5% sequentially and 30% year-over-year. Current RPO was 75% of total RPO. Moving to guidance for the fourth quarter and the full year.

With broadening geopolitical uncertainty and increasingly mixed macroeconomic data points across geographies, the business environment in which we operate remains challenging to predict. And as a result, we continue to remain prudent and cautious in our outlook for the fourth quarter. Now turning to guidance for the fourth quarter. We expect revenue in the range of $352 million to $353 million, representing an increase of 28% to 29% year-over-year. We expect operating income in the range of $28 million to $29 million, and we expect an effective tax rate of 7%. We expect diluted net income per share of $0.12, assuming approximately 354 million shares outstanding. Please note that our share count guidance now includes dilution from our convertible senior notes of approximately 6.8 million shares, given that Cloudflare has achieved a level of profitability whereby these securities are no longer deemed and be diluted.

For the full year 2023, we expect revenue in the range of $1.286 billion to $1.287 billion, representing an increase of 32% year-over-year. We expect operating income for the full year in the range of $110 million to $111 million, and we expect diluted net income per share over that period to be $0.45 to $0.46, assuming approximately 350 million shares outstanding. We expect an effective tax rate of 8% for 2023. After having achieved significant free cash flow in the first three quarters of the year, we expect to generate over $100 million in free cash flow for the full year 2023. In closing, our team remains committed to driving operational excellence, ensuring long-term growth and delivering significant shareholder value. I’d like to thank our employees for their dedication to our mission, as well as our customers, for trusting us to help them solve some of the hardest problems that they face when modernizing and transforming their businesses.

And with that, I’d like to open it up for questions. Operator, please poll for questions.

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Q&A Session

Operator: [Operator Instructions] Your first question comes from the line of Matt Hedberg from RBC Capital Markets. Please go ahead.

Matt Hedberg: Great. Thanks for taking my questions, guys. Congrats on the results. Matthew, for you, a lot of exciting news at Birthday Week, including Workers AI and everything else that you guys announced. I guess, broadly speaking, given the focus on [technical difficulty] and all the investments this year and next year, how should we expect to see some of the monetization benefits of generative AI customer spend. Is that something that you’d be able to quantify at some point? Or what are some of the breadcrumbs that we should watch for success there?

Matthew Prince: Yes. Thanks, Matt. I think that there are a couple of different areas where we’re monetizing, and that’s starting to show up in the results. And then there are a couple of areas where I think there’s a longer time horizon and we’re really optimizing for adoption. I think the place where we’ve been positively surprised is with our R2 product. R2 is our object store, and critically, it allows customers to be multi-cloud and to easily move data to wherever – they’re – the resources that they need without charging them an egress tax like some of the other traditional hyperscale public clouds do. That’s a place where a lot of the growth that we’re seeing is coming from AI companies. They love the fact that they can take their data and their training sets and move it to wherever they are GPUs that are available around the world.

And that’s driving, and I think as we see more and more usage of that, that’s driving revenue for us that we’re realizing today. And I think that will be something that will go forward into the quarters to come. I think that some of the areas around inference, it’s early days, but I think that you – I think you’d be likely to hear us start talking about larger customers that are moving significant workloads over to the AI space. I think that the individual developers will be – we’re really going to optimize in that space for adoption, and building out an ecosystem. But as you hear us on earnings calls to come, talk about how people have really moved workloads, and we’ve got customers in the pipeline that are talking about moving billions of inference events per month to our network.

That’s when that starts to turn into real revenue for us. And I think it’s early days, so we don’t know exactly what the time frame on that will be, but the conversations we’re having are very exciting, and it’s a space that I’m definitely bullish on.

Matt Hedberg: Super exciting. And then maybe, Thomas, for you. We still have Q4 to close out here and you didn’t really talk about next year. But given some of the uncertainty out there, you guys are still delivering good results. Are there any building blocks that you’d share as we start to think about or fine-tune our calendar ’24, either growth or profitability estimates?

Thomas Seifert: Well, we won’t talk too much about ’24 on this earnings call, you might expect there will be time for that on our next earnings call. But I think it’s important in mind, to keep in mind that we’ve been talking about how cascading the impacts are in terms of the progress we make and when it hits our books, right? It’s all about building pipeline first, and we have seen strength there in the third quarter, continued in the fourth quarter. How this turns into ACV? This is where uncertainty is. And once it hits ACV, it will take a turn of four quarters before it shows up into revenue. So we have seen good targets, especially at the beginning of this cascade. And as we move through that waterfall of progress, you’ll see results showing up in our numbers in next year.

Matt Hedberg: Thank you very much.

Operator: Your next question comes from the line of Brent Thill of Jefferies. Please go ahead.

Brent Thill: Matthew, you’ve highlighted sales efficiency as one of the top goals for this year. I think Thomas mentioned it was staying consistent or maybe you had mentioned this in linearity, was pretty steady. I guess you mentioned some of the sales improvements. But where do you stand in terms of your overall game plan on the go-to-market? How far are you through this process and kind of what’s left? Is there an easy way to frame this move?

Matthew Prince: Yes. So we’ve talked about how on previous calls, we really looked across our go-to-market functions and recognize that there was an opportunity for us to improve. And what I’m proud of is that we haven’t waffled on that path. We haven’t changed course. We haven’t had significant disruption or distraction as we’ve gone through that. And I think that the caliber and quality of the people that we’re bringing on to those go-to-market teams, the early indications are, and again, they’re still ramping, but the early indications are that they’re doing a significantly stronger job and they’re delivering real results. So that’s a process, and it takes time to work through that. But I think that we’re seeing positive indication.

I think we’re being, we don’t want to lose our marbles and be too aggressive, but we’re being very disciplined. And one of the things I remember, what we’ve always talked about is how we’ve had a business where we invest behind the demand that we see. And I think the same thing is true on the go-to-market side, where we’re seeing that the increased rigor and increased discipline has early signs of paying off. And if that continues and we get more data points along the way, then that’s a place where we’ll be able to invest with, again, new leadership in place and new training and enablement for our sales team. And again, I think we have – it’s early still, but I think that we have good indication, and I’m proud of the fact that we did this so far without significant disruption or distraction within our business.

Brent Thill: Thanks.

Operator: Your next question comes from the line of Joel Fishbein from Truist Securities. Please go ahead.

Joel Fishbein: Thanks for taking my question. Thomas, one for you. It’s a good segue from the last question. Clearly, outperforming on the gross margin and on the operating margin side and frankly, cash flow. Just how are you going to continue to balance profitability and invest in some of these high-growth areas that Matthew outlined? Just, I’d love like some color there. Thanks.

Thomas Seifert: Yes. Just following up on what Matthew said. I think we have the business really well instrumented. And you could see this now managing ourselves through quite some macroeconomic turbulences. So the business is well instrumented. The business model is still in a way that it allows us to have visibility when demand picks up and we will invest behind the demand. We’ve also realized that there is significant scalability and efficiency in the business model. This is what you are – what has been showing up in the financial numbers over the last a couple of quarters really well. So I think the combination of visibility into – is that picking up or not, a well-instrumented business and a lot of elasticity in how we move forward, keeps us confident that we have their hands firm on the rudder, and can control the ramp up really well.

Joel Fishbein: Thank you.

Operator: Your next question comes from the line of Andrew Nowinski from Wells Fargo. Please go ahead.

Andrew Nowinski: Great. Thank you. Congrats on another amazing quarter, please accept my thoughts and prayers for your employees that are affected by the terrorists attack in Israel. So I wanted to ask you guys about the Workers AI offering that you launched, I think it’s really interesting. I was wondering what the early feedback is on it, in particular, the vector database component. And whether the staggered rollout of the GPUs is a potential gating factor, as people kind of wait – maybe to deploy that at scale, or wait for the rollout of the NVIDIA GPUs before rolling out at scale.

Matthew Prince: Yes, Andy, thanks for the question. Again, it’s an area that we’re extremely excited about. I’m proud of the fact that our team has been able to get it rolled out as quickly as they have, our – we thought it was an ambitious goal to be in 100 cities by the end of the year. The fact that we’re in, now over 75 today, and that we’ve been able to deliver that while staying very disciplined around CapEx is important. We’re not seeing that people are waiting for things to be everywhere, for them to be in and testing. I do think that as we are going into various geographies around the world, it creates a real differentiation with us. We’re hearing especially in markets outside of the United States, how they have felt left behind in the AI space.