Cloudflare, Inc. (NYSE:NET) Q2 2023 Earnings Call Transcript

Cloudflare, Inc. (NYSE:NET) Q2 2023 Earnings Call Transcript August 3, 2023

Phil Winslow: [abrupt start] 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, and partners, operations, and future financial performance, our anticipated product launches and timing and market potential of those products, our anticipated future financial and operating performance and our expectations regarding future macroeconomic conditions. 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 risks 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 a supplemental financial information referenced a few moments ago. We would also like to inform you that we will be participating in Stifel’s Tech Executive Summit on August 29th, and the Goldman Sachs Communacopia and Technology Conference on September 6th. Now, I’d like to turn the call over to Matthew.

Matthew Prince: Thank you, Phil. We had a strong quarter in spite of continued macroeconomic uncertainty. In Q2, we achieved revenue of $308.5 million, up 32% year-over-year. We added 196 new large customers, those that pay us more than a $100,000 per year and now have 2,352 large customers, up 34% year-over-year. Our focus on go-to-market improvements is already paying off. After we saw sales cycles increase 20% in Q1, disciplined around deals had them return to levels closer to what we saw last year. While our customers and prospects continue to be very careful around their IT spend, our improved execution led to a record quarter in new ACV bookings. My sense, talking to customers is that while the macro environment is still challenging, it is stabilized.

And for the first time in several quarters, sentiment among IT buyers does not appear to be getting worse. Our dollar-based net retention ticked down to a 115%, down 2% quarter-over-quarter. Dollar-based net retention is a lagging indicator. So it will be slower to reflect the go-to-market improvements we are seeing. It’s also important to note that we did not see any new competitive pressure or churn throughout the quarter. Instead, the lower dollar-based net retention is due to slower expansion from some of our existing customers. We expect that our focus on go-to-market operational excellence will improve this metric over time. Our gross margin held stable at 77.7%, still above our long-term target of 75% to 77% and in line with 77.8% last quarter.

We delivered an operating profit of $20.3 million, our fourth consecutive quarter with a record operating profit. We also meaningfully outperformed on free cash flow, generating $20 million during the quarter, which represents a free cash flow margin of 6.5%. I’m proud that our team has proven we can not only execute in good times, but also be disciplined and deliver operational improvements while we’re in more challenging times. We continue to see very strong pipeline growth. Q2 was another record for new pipeline generation. As we discussed last quarter, we made significant changes in our sales team to proactively address underperformance. That went very well, both qualitatively and quantitatively. Our top performers are invigorated. We saw a marked improvement in the average account executive productivity.

At the same time, we’ve implemented robust onboarding, enablement, and training programs. Combined with the record number of applicants we’re seeing for sales roles, this makes for the right formula to build a worldclass sales organization. And our team is armed with great products to sell. Last quarter alone, Forrester recognized Area 1, our email security product, as a leader. IDC recognized us as the leader for two reports, in Zero Trust and network edge security-as-a-service, and we were the only new vendor recognized by Gartner for Secure Service Edge. Our developer platform, Cloudflare Workers, continues its explosive growth. We reached 10 million active Workers applications in Q2, up 250% since December and 490% year-over-year. R2 continues to grow and now stores over 13 petabytes of customer data, up 85% quarter-over-quarter.

We have 44,000 distinct paying customers with R2 subscription, and brand name customers are beginning to adopt it as their primary object storage solution. That seems like a good segue to name some other customer wins in the quarter. One of the fastest growing generative AI company expanded their relationship with Cloudflare, signing a one year $1.7 million contract, less than a year after first starting to use our platform. Like many AI companies in the space, this customer relies on a multi-cloud architecture for training and processing requests. R2 lets them unlock the best prices and performance across multiple cloud providers. In their words, “We see Cloudflare as a strategic foundational glue across all our services. Cloudflare continues to be our best strategic partner of all partners.” That’s great to hear from many customers, but it’s especially fun coming from a company that’s doing such cutting-edge work.

These days feel like membership in the CEO club is predicated on saying AI as many times as possible in your earnings call script. I have to confess, I still find it a bit awkward. When we first pitched Cloudflare to venture capitalists back in 2010, at one point, I described us as, “The first AI powered security company for the cloud.” The eye rolls around the table were so intense that I’m still a bit scared. But more than a decade later, here we are. And by our estimates, Cloudflare is the most commonly used cloud provider across the leading AI startups. They’re using R2 to help arbitrage the lowest GPU cost to train their models. They’re using our security tools themselves powered by AI or what our team would prefer to call machine learning to protect their own AI systems.

And increasingly, they’re using the edge of our network to perform inference. We are continuing to invest in this area and believe that we are uniquely positioned to win the inference market, which we believe will be substantially larger than the AI training market. In Q2, we hosted our Developer Week, highlighting 10 major announcements and features to extend Cloudflare Workers as the preeminent developer platform for the leading AI company. Q3 will feature our annual birthday week, and we have a lot more in store to provide picks and shovels to enable AI companies to build the future. Beyond AI, Cloudflare’s Zero Trust Solutions were another big winner in Q2. A Fortune 500 technology services company expanded their relationship with Cloudflare, signing a three-year $7.2 million contract for 25,000 Zero Trustees.

That brought their annual spend with us to over $5 million. They first became a customer in Q3 last year using our application security products. Six months into the deployment, one of their senior executives said, “Cloudflare is like magic and brought us into an ongoing competitive Zero Trust proof of concept.” Cloudflare’s existing gateway products were chosen over first generation Zero Trust competitors due to our rate of innovation and ability to consolidate all their security onto a single pane of glass. One of the largest online recruiting platforms expanded their relationship with Cloudflare, signing a 25-month $2.4 million contract and bringing their annual spend over $5 million. With more than 90% of their employees remote, they were looking for a comprehensive Zero Trust solution and evaluated us against every leading vendor in the market.

They decided to go all in on Cloudflare with 15,000 seats for access, gateway, CASB, data loss prevention, browser isolation, and Area 1 email security. I’m especially proud of how quickly we were able to onboard them, less than a month to fully replace their first generation Zero Trust vendor. That’s awesome. An Australian technology company expanded their relationship with Cloudflare, signing a one-year $2.2 million contract, bringing their total spend with us to over $5 million. This customer started out on our pay as you go plan in 2016 This quarter, they signed a Zero Trust deal to protect their expanding workforce. They’re also broadening their use of Cloudflare’s developer platform with both R2 and Durable Objects. Sticking down under, a leading Australian healthcare provider expanded their relationship with us, signing a three-year $2.8 million contract.

We are replacing their hodgepodge of first generation Zero Trust vendors with 12,000 seats of access, gateway, browser isolation, CASB, data loss protection, and Area 1 email security. This is another example of a customer looking to consolidate vendors and choosing Cloudflare for their holistic network security solution. Here’s another cool one. A Fortune 500 social network expanded their relationship with Cloudflare, signing a three-year $2.4 million contract. They initially became a customer a year ago, building on top of Workers and using our global network to authenticate the security of one of their messaging products. They approached us again looking to add increased privacy onto another product with our Privacy Gateway solution. They view Cloudflare as a leader in privacy based on our co-development of the Oblivious HTTP standard, and they admire us as one of the only other companies that truly understand scale.

As privacy is increasingly top of mind, we believe there will be more and more of these sort of strategically beneficial relationships. I think I’ve only said AI 11 times so far, putting me way behind Satya. So let me end with one more AI customer win. Another generative AI company expanded their relationship with us, signing a three-year $1.3 million contract. They came to us for our developer platform, signing up as a pay-as-you-go customer. Because their developers loved us, they approached us about a security need and signed a deal to use our application security and Zero Trust products. They’re only 100 seats, but they’re growing like crazy and building Cloudflare deep into their whole stack. Whether you’re a Fortune 500 industrial company that used us for application security and are now hiring AI developers to use our Workers’ platform to drive innovation across your business or you’re a 100 person AI startup that started using our developer platform and then realized you can get the same security as the biggest Fortune 500 companies, that’s what’s really unique about Cloudflare.

We’ve built the cloud that connects the world securely, reliably, and efficiently. With that, I’ll turn it over to Thomas. Thomas, take it away.

Thomas Seifert: Thank you, Matthew. And thank you to everyone for joining us. During the second quarter, I’m pleased to share that we’ve seen improvements in terms of the impact from the external challenges that we highlighted last quarter. Specifically, also still somewhat elevated from historical levels, sales cycles shortened in part due to the implementation of more efficient processes and tactics. Our pipeline close rates have also shown improvement as we continue to refine our go-to-market strategies and operations. Furthermore, we observed a notable uptick in collections on our accounts receivable, which we believe reflects a rebound in customer confidence and financial stability. We also continue to maintain our strong commitment to being fully responsible and act as good stewards of investors’ capital.

We delivered our fourth consecutive quarter of record operating profit. We also prudently allocated capital with a focus on maximizing shareholder value by taking action to retire our 2025 convertible notes during the second quarter. Turning to revenue. Total revenue for the second quarter increased 32% year-over-year to $308.5 million. From a geographic perspective, the US represented 53% of revenue, and increased 30% year-over-year. EMEA represented 27% of revenue and increased 38% year-over-year. APAC represented 13% of revenue and increased 23% year-over-year. We were pleased to see notable performance in the EMEA and APAC regions with both achieving record new ACV bookings in the second quarter. The strength in APAC was primarily driven by large customer deals, and we are seeing security become an even higher priority in EMEA given the geopolitical situation in the region.

Turning to our customer metrics. In the second quarter, we had 174,129 paying customers, representing an increase of 15% year-over-year. We ended the quarter with 2,352 large customers, representing an increase of 34% year-over-year and an addition of 196 large customers in the quarter. In fact, we added a record number of customers spending more than $500,000 on an annualized basis with Cloudflare. And the second quarter was also one of our highest quarterly additions of customers, spending more than $1 million annually, including our largest Zero Trust contract to date. Our dollar-based net retention rate was 115% during the second quarter, representing a decrease of 200 basis points sequentially. Importantly, renewal rates in the second quarter were consistent with the quarterly average in 2022, which was an all-time high for the company.

Instead, similar to the last two quarters, the decline in DNR was again primarily driven by slower expansion in our larger customer cohort. We calculate DNR by comparing the analyzed revenue from paying customers four quarters prior to the annualized revenue from the same set of customers in the most recent quarter. As a result, this will be a lagging indicator of Cloudflare’s underlying business trends. Based on our visibility, we believe the deceleration in DNR is nearing a bottom. Moving to gross margin. Second quarter gross margin was 77.7%, representing a decrease of 10 basis points sequentially and a decrease of 120 basis points year-over-year. Network CapEx represented 11% of revenue in the second quarter. For fiscal 2023, we now expect network CapEx to be 10% to 12% of revenue, underscoring the scalability and efficiency of our network even as we onboard new workloads, including AI.

Turning to the operating expenses. Second quarter operating expenses as a percentage of revenue remained consistent sequentially and decreased by 8% year-over-year to 71%. Our total number of employees increased 11% year-over-year, bringing our total headcount to 3,389 at the end of the quarter. During the second quarter, we addressed consistently low performing sales capacity with a focus on upgrading our customer facing talents to improve growth, increase productivity and drive long-term success. We will continue to pace hiring for the year based on market conditions and remain committed to raising the bar on new high additions given talent opportunities available in the market. Sales and marketing expenses were $125.4 million for the quarter.

Sales and marketing as a percent of revenue decreased by 1% sequentially and decreased to 41% from 44% in the same quarter last year. Research and development expenses were $53 million in the quarter. R&D as a percentage of revenue decreased by 1% sequentially and decreased to 17% from 20% in the same quarter last year. G&A expenses were $41 million for the quarter. G&A as a percentage of revenue increased 1% sequentially and decreased to 13% from 15% in the same quarter last year. Operating income was $20.3 million compared to an operating loss of $891,000 in the same period last year. Second quarter operating margin was 6.6%, an increase of 700 basis points year-over-year. These results highlight our continued focus on becoming more efficient and more productive, not just during the currently uncertain macroeconomic backdrop, but also because operational efficiency is a long-term competitive advantage.

Turning to net income and the balance sheet. Our net income in the quarter was $33.7 million or a diluted net income per share of $0.10. We ended the second quarter with $1.6 billion in cash, cash equivalents, and available-for-sale securities. Free cash flow was $20 million in the second quarter or 6% of revenue compared to negative $4.4 million or 2% of revenue in the same period last year. Remaining performance obligations or RPO came in at $1 billion, representing an increase of 8% sequentially and 36% year-over-year. Current RPO was 75% of total RPO. Before moving to guidance for the third quarter and full year, I would like to begin with our expectations and the provisions we have factored into this outlook. Despite being encouraged by the forward progress we delivered during the second quarter in terms of shortening sales cycles and improving close rates, mixed macroeconomic data points serve as a reminder that we are operating in a business environment that thought showing signs of stabilization, continue to be challenging to predict.

As a result, we remain prudent and cautious in our outlook for the second half of the year and we are fully committed to continuing to adapt our tactics and strategies in response to these external variables. Now turning to guidance. For the third quarter, we expect revenue in the range of $330 million to $331 million, representing an increase of 30% year-over-year. We expect operating income in the range of $20 million to $21 million and we expect diluted net income per share of $0.10, assuming approximately 347 million shares outstanding. We expect an effective tax rate of 11%. For the full year 2023, we expect revenue in the range of $1.283 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 $81 million to $85 million.

And we expect diluted net income per share over that period to be $0.37, assuming approximately 345 million shares outstanding. We expect an effective tax rate of 9% for 2023. After having achieved positive free cash flow in the second half of last year and again, during both the first and second quarters of this year, we anticipate generating significant free cash flow for the full year 2023. For modeling purposes, we continue to expect free cash flow to trend upward on an ongoing basis, but anticipate variability in our free cash flow generation quarter to quarter. 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 continued dedication to our mission, customers, and partners.

And to our shareholders, we greatly value your continued support. 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: Thank you. [Operator Instructions] And we will take our first question from Shaul Eyal with TD Cowen. Your line is open.

Shaul Eyal: Thank you. Good afternoon, guys. Congrats on the results and the outlook. Matthew, can you talk about some of your displacement activity this quarter? And maybe my second part of the question will be, do you see AI is accelerating your displacements and win rates? Thank you.

Matthew Prince: Yeah, Shaul. I really appreciate the question. We’ve had a lot of noise on the line from the operator. So hopefully, we can get things muted. Apologies for that. So I think that when we look at displacement, it really is across three different parts of our business. So the first area is our conditional application security business. And in that space, we continue to place — displace a number of traditional hardware vendors, the people who are providing web application firewalls, load balancers, funding various services that people had in those in those areas. We also see point cloud solutions that are doing just one of those things, getting displaced by us where we can very much pick up a significant amount of their business.

And that — that’s been the case for quite some time. In our — the second part of our business, which is our Zero Trust business, the first is sort of the front door of your business, the second is kind of the back door of your business. The Zero Trust business is about protecting employees and data. In that case, we’re more and more going head-to-head with the other first generation Zero Trust providers. So the Zscalers, Palo Alto Networks, Cisco Umbrellas of the world. And, again, we really like our win rates in this space. And in a number of the examples that I cited, we were specifically, either in competitive solutions there, or in some cases where we were actually doing takeouts, people who have made bets on the first generation of Zero Trust providers and wanted to upgrade to us for, better ROI, a much better user experience, much faster, more performant network.

And I think that that’s one of the areas that I’m the most excited about. The third area is really our Workers’ business, which is our developer platform. And in that in that space, it really depends on what’s going on increasingly, we’re doing takeouts from object store where people are moving data off of more traditional object stores onto R2 which is our object store. But a lot of times, we’re also just moving, individual applications or individual functions, to us. And so it’s not a complete displacement. Oftentimes people will use us alongside a more traditional hyperscale public cloud. But we can see that working together. In the AI space, in particular, I think that, again, it’s such a new space that I don’t know that we’re displacing people as much as we’re just helping AI companies get what they need.

And the two big areas around that are first around training where GPU scarcity is significant and the cost with the traditional hyperscale public clouds and moving data to wherever there’s cheap GPU capacity or even available GPU capacity, makes it cost prohibitive. And so R2, because we don’t charge for egress, has been just a real boon for a lot of AI companies to be able to adopt wherever they can find the cheapest GPU at any moment in time. And that again, it’s an area where a lot of that growth has come from. And then increasingly, we think that the inference market is really going to be fought between two areas. One is going to be on your device itself. If you have a driverless car, you don’t want when a ball is bouncing down the street and the kid is chasing after it, for that decision on whether or not to put on the brakes to have to go out to the network now.

You want that to live in the car itself. And so a lot of inference and models can be run on devices. But we think if they’re not a run on devices, if they have — if they’re too large, if they need too much capacity, from either a GPU or memory or network access space, in those cases, it’s going to make sense to run it in the network itself. And in that sense, Cloudflare is uniquely positioned to win in that inference market for those models that make sense not to run on the device themselves, the more complicated model that makes sense to run in — out at the edge of the network. And that’s exactly what we’re starting to see from more and more of these really innovative AI startups.

Shaul Eyal: Got it. Thank you so much. Speak to you all.