Cloudflare, Inc. (NYSE:NET) Q4 2022 Earnings Call Transcript

Cloudflare, Inc. (NYSE:NET) Q4 2022 Earnings Call Transcript February 9, 2023

Operator: Hello, everyone, and welcome to the Cloudflare Q4 2022 Earnings Call. All lines have been placed on mute to prevent any background noise. After today’s remarks, there will be a question-and-answer session. . I would now like to hand the conference over to Mr. Phil Winslow, VP of Strategic Finance. Please go ahead, sir.

Phil Winslow: Thank you for joining us to discuss Cloudflare’s financial results for the fourth quarter 2022. With me on the call, we have Matthew Prince, our Co-Founder and CEO; and Thomas Seifert, our CFO. Michelle Zatlyn, our Co-Founder, President and COO, is unable to join us on the call today as she is in Asia being with prospect customers. 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 Web site. As a reminder, we’ll 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.

These statements and other comments are not guarantees of future performance, and are subject to risks and uncertainties, much of which are 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 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 Web site. For historical periods, a GAAP to non-GAAP reconciliation can be found in the supplemental financial information referenced a few moments ago. We’d also like to inform you that we will be participating in Baird’s 2023 Silicon Slopes event on March 2, the Morgan Stanley Technology, Media and Telecom conference on March 8, and William Blair’s 7th Annual Tech Innovators conference on March 14. Now before wrapping up, I would also like to invite you to join us for our Investor Day on Thursday, May 4, which is being held in conjunction with our user conference Cloudflare Connect in New York City. A live webcast will also be accessible from our Investor Relations Web site.

Now with that, I’d like to turn the call over to Matthew.

Matthew Prince: Thank you, Phil. It’s great to have you on this side of the table. We had another strong quarter in spite of continued challenging macroeconomic conditions. We generated $274.7 million of revenue, up 42% year-over-year. We achieved a record operating profit of $16.8 million, representing an operating margin of over 6%. While we continue to invest to capture the huge market ahead of us, we believe that during economic slowdowns, like the one we’re in the midst of, it’s important to show discipline and optimize for efficiency. We have our hands on the levers of our business and are adjusting them based on the macroeconomic conditions. Our free cash flow in the quarter was $34 million, representing a free cash flow margin of 12% and allowing us to generate $29 million of free cash flow in the second half of 2022.

While there will be some variability in our free cash flow quarterly, we expect to be free cash flow positive in 2023 and in the years after that. We achieved a gross margin over 77% above our long-term target range of 75% to 77%. Our dollar-based net retention ticked down to 122%, while our gross renewal rates remain as high as ever, like others in the industry, we’re seeing customers take longer to sign new and expansion deals with us. Procurement departments are definitely in the mode of measure two or three times before cutting one. We still see a clear path to dollar-based net retention over 130% as we ramp seat-based products, like Zero Trust and storage-based products like R2, and we won’t be satisfied until we get there. We added 134 large customers, those who pay us over $100,000 per year, and now have 2,042 large customers, including 33% of the Fortune 500.

Revenue from large customers grew 56% year-over-year, and they now contribute 63% of our total revenue. We were fortunate that given our visibility into the overall Internet traffic and e-commerce trends, we started to see a slowdown in the economy all the way back in December of 2021. Based on that, around this time last year, we began slowing our pace of hiring to ensure we didn’t get over our skis. That paid off and kept us from having to take more drastic actions like many of our peers. It’s also given us the ability to sensibly invest in our team as amazing talent comes on the market. To give you some sense, in 2022, we have over 400,000 people apply for approximately 1,300 positions at Cloudflare. That demand to work at Cloudflare has allowed us to continue to hire incredible talent while remaining disciplined in overall compensation.

We are committed to incremental equity compensation dilution well below many of our peers targeting less than 3% net burn rate annually. Tough economic times like these make you assess your strengths and weaknesses. Cloudflare has long had a product and engineering team that delivered an innovation engine that is the envy of the industry. Jen Taylor, who leads that team, briefed me recently on everything we have lined up for the year ahead, and the engine is definitely not slowing down. Our next innovation week is in March with security week, where we’ll be launching a number of new products and feature enhancements, especially around our Zero Trust products. While our innovation engine is the best in the industry and has unlocked $125 billion total addressable market we have ahead of us, if we’re honest with ourselves, our go-to-market organization hasn’t yet been fully optimized.

As our product become more complicated and we are selling to larger and larger customers, it’s increasingly clear that we need to step up our game in marketing and sales. I introduced Marc Boroditsky who joined last quarter to lead our sales organization. Last week, he briefed me and Michelle on his first 100 days. My initial reaction, if I’m honest, was embarrassment over some of the basic things we should have been doing better. But my second reaction was excitement as there are so many opportunities for us to improve. In addition to Marc, Brent Remai joined us last quarter to lead our marketing team. Brent was previously CMO at FireEye and CMO of Core Services at AWS. His career perfectly prepared him for Cloudflare’s delivery of cloud security services.

We’ve seen early results of Brent’s team generating pipeline in Q4 and January Q1, coming in ahead of our targets. We’ve been leaders on the product and engineering side. Now we’re focusing on becoming a leader in the go-to-market side as well. I hear the excitement from our existing sales and marketing teams at the rigor and discipline Marc and Brent are bringing to those teams. And what I’m watching carefully is another important pipeline, the pipeline of new sales talent. We’re seeing incredible people from the leading sales team in the world apply to work at Cloudflare. We aim for nothing less than to build one of the leading sales organizations in the world. That’s all exciting. And while I believe there’s a substantial opportunity for us to improve our go-to-market engine, I’m also cognizant that these efforts can take time.

That’s why we’re not relying on any improvement in sales or marketing efficiency or any rebound in the economy as we look at the year ahead and formulate our guidance. So focusing on the present, let me highlight some customer wins from the quarter. A Fortune 500 energy company signed a three-year $1.6 million deal that was a takeout of a first-generation Zero Trust networking competitor. We are placing both their Secure Web Gateway and Zero Trust network access products. Because the competitor’s network is actually broken into multiple distinct clouds as compared with our unified network, their reliability and performance were underperforming the customers’ expectations. We were able to replace the competitor’s feature set and more. The customer ultimately purchased gateway, access, remote browser isolation and DNS filtering.

The customer was attracted to our better pricing, performance and ease of use as well as the single pane of glass manageability of our platform. We worked with a large channel partner to win and service this customer and expect we’ll be doing more with them going forward. A Fortune 500 financial services company expanded their relationship with Cloudflare, signing a three-year $1.1 million deal, a Cloudflare customer since 2014 using our core application services. Like we’re hearing from many of our customers, they wanted to consolidate vendors, reduce costs and have more flexibility and control over their traffic flows as well as implementing a Zero Trust architecture. They wanted to move away from legacy on-premise hardware to modern cloud-based services.

The customer loves that we have a single pane of glass solution and that our technology is built from the ground up on a single platform rather than a Frankenstein solution bolted together through M&A. They purchased access, gateway, remote browser isolation, Magic WAN and Magic Firewall. They’re a terrific customer. A Fortune 500 telecom signed a $400,000 one-year deal to bring a portion of Cloudflare’s Zero Trust services to their consumer base. They’re bundling Cloudflare’s DNS content filtering into their consumer security bundle. After evaluating competition, they found Cloudflare solutions to be the most secure and reliable in the market. This deal is not only valuable for the obvious reasons, but also because it will feed data back to our Zero Trust security products to further extend their lead over the competition.

A leading generative AI company signed a one-year $1 million deal. The company had been a user of our free tier since 2017. And this deal originally started out as a relatively small gateway DNS opportunity to replace Cisco Umbrella. However, when their browser-based application debuted in late November, demand for the company’s AI-generated content absolutely exploded with unprecedented rates of adoption. Their Azure Front Door had quickly proved insufficient at handling the massive load on their services from legitimate users as well as keeping fraudulent users from exhausting their resources. They started off with CVM, DDoS, bot management, gateway DNS and more. We are actively exploring various paths for expansion to support their incredible growth as well as emerging use cases of their AI models and applications with Cloudflare Worker, API Shield, imagery sizing and more.

We saw success with other AI companies in the quarter as well. Given the resource constraints they all face as well as how attractive they are as a target to fraudulent users, Cloudflare security solutions are an obvious choice for all of them. But many of them came to us for other reasons as well. AI companies, in particular, need to find wherever it’s most cost effective to run their models across multiple different cloud providers. They are, by their very nature, multi-cloud, but the data egress policies make it prohibitive to move large training sets between the clouds. Enter Cloudflare Worker. What we’re finding with these AI companies is that R2 and other workers’ products naturally become the glue at the center of a multi-cloud ecosystem.

R2 has become the natural neutral place for these AI companies to store their training data in order to make sure it can be inexpensively and efficiently accessed from anywhere. It’s obvious in retrospect. But it’s a use case we didn’t anticipate. Today, our largest R2 customer is another AI company using us for exactly the purpose of being a neutral place to store their training data. And, of course, being a neutral network super cloud that stitches together the traditional public cloud isn’t a problem exclusive to AI. A European financial services company signed a five-year $1.8 million deal, replacing a dozen different security and network vendors with Cloudflare. This company settles hundreds of millions of securities transactions annually for the largest banks and governments in the world.

As a result, security and regulatory compliance are paramount for them. They wanted to consolidate and simplify their numerous point solutions into a single pane of glass solution. After receiving regulatory approval, the customer signed on for multiple solutions across our core application services portfolio as well as both Zero Trust and network services in Cloudflare One, including access, DNS filtering and Magic Transit. In addition to consolidating their spend across multiple point solution vendors on to Cloudflare’s broad platform, our data localization suite, in particular, won them over. Competing vendors simply do not have an equivalent solution. As companies increasingly face localization and data residency requirements becoming law in various geographies, our differentiated data localization suite is becoming more and more critical to customers.

A public utility company in Africa signed a $2.8 million 75-month deal to help support a really cool industrial IoT rollout. They’re using Cloudflare’s intelligent network to monitor 3,300 sensors, tracking shipments of materials. This is another use case of Cloudflare’s network we wouldn’t have imagined on our own, but one we’re uniquely positioned to deliver for the customer and now opens even more markets and opportunities. The state of North Carolina signed a three-year, $3 million deal. The state had originally come to us under our Athenian Project for free help with election security. They learned the power of Cloudflare using us to protect their elections infrastructure and signed the deal to expand Cloudflare’s protection across 50 state agencies.

Finally, I’m happy to report that after our longer than expected wait at the proverbial DMV, we officially received Cloudflare’s FedRAMP certification. The certification covers nearly our full suite of products with a notable exception of Area 1 e-mail security product, which we acquired after we started the FedRAMP process, but we expect to add it to our certification at the FedRAMP renewal. Our first federal contract after our certification was a great start. We were awarded the $7.2 million, five-year deal to operate the .gov registry. We were awarded the contract because of our modern infrastructure, technical prowess, relentless innovation and proven ability to defend against the largest cyber attacks. Every e-mail sent to the White House, every agency’s webpage and most of the other ways the U.S. government connects to the Internet now depend on Cloudflare and our network.

We’re proud to have won this business, but the public sector space is only 3% of our revenue today, so we believe it’s only the beginning of what we’ll be doing in the future. 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. I want to take a moment to welcome Phil Winslow, our new VP of Strategic Finance, Treasury and Investor Relations to the team. As an influential equity research analyst who has been following Cloudflare even before our IPO, Phil brings a wealth of knowledge, expertise and relationships to his role at Cloudflare, and we are excited to have him on board. Turning to the fourth quarter. Economic uncertainty resulted in businesses being more cautious with their spending, leading to longer decision making processes and ultimately longer sales cycles during the quarter, pressuring revenue growth across the technology industry, including Cloudflare. However, we remain focused on controlling what is in our control, which is to maintain our commitment to the efficient unit economics of the business and to prudently allocate capital with a focus on maximizing shareholder value.

As a result, we delivered a record quarter in terms of operating profit, operating margin and free cash flow. I’m particularly proud of our free cash flow performance during the fourth quarter, and we are committed to continuing to scale free cash flow generation going forward. Turning to revenue. Total revenue for the fourth quarter increased 42% year-over-year to $274.7 million. From a geographic perspective, the U.S. represented 53% of revenue and increased 44% year-over-year. EMEA represented 27% of revenue and increased 42% year-over-year. APAC represented 13% of revenue and increased 40% year-over-year. Turning to our customer metrics in the fourth quarter. We had 162,086 paying customers, representing an addition of roughly 22,000 paying customers in 2022 and an increase of 16% year-over-year.

We were pleased to see retention improve in the pay-as-you-go customer base in the fourth quarter returning to the levels we achieved in the late 2020 through early 2022. Turning to large customers. We ended the quarter with 2,042 large customers, representing an increase of 44% year-over-year and an addition of 134 large customers in the quarter. During the quarter, we also added a record number of net new customers paying us more than $500,000 a year. As Matthew mentioned earlier, we are also pleased to see large customer revenue contribution increase again sequentially to 63% of revenue, up from 57% in the fourth quarter last year. For fiscal 2022, large customers represented 61% of total revenue compared to 54% of total revenue in 2021 and 46% in 2020.

For the full year, we are also breaking out large customers into cohorts of those who spend greater than $500,000 and $1 million. We ended the year with 222 customers that spent over $500,000 with us, an 83% increase year-over-year. We ended the year with 85 customers that spent over $1 million with us, a 52% increase year-over-year. Our dollar-based net retention rate was 122% during the fourth quarter, a decrease of 200 basis points sequentially and a decrease of 300 basis points year-over-year. We’ve not experienced elevated churn. Instead, similar to last quarter, the decline was primarily driven by less net expansion in customers spending less than $100,000 worth Cloudflare as well as pay-as-you-go customers. Conversely, our large customer net expansion was flat quarter-to-quarter and remains consistent with our average quarterly DNR for this customer segment since the end of 2019.

We continue to expect DNR to trend upward over time to our long-term target of 130% plus. Also, we anticipate some variability from time to time particularly as customers are more cautious in their near-term spending, which, as I mentioned before, has impacted sales cycles. Moving to gross margin. Fourth quarter gross margin was 77.4% and 78.2% for fiscal 2022, both of which remain above our long-term target range of 75% to 77%. Network CapEx represented 10% of revenue in the fourth quarter. For full year 2022, network CapEx represented 11% of revenue as compared with our guidance at the beginning of the year at 12% to 14%, which demonstrates the flexibility, elasticity and scalability we have achieved in our network. For fiscal 2023, we expect network CapEx to be 11% to 13% of revenue.

Turning to operating expenses. Also their economic challenges for every business currently, we again took proactive measures during the fourth quarter to improve operational efficiency and control discretionary spending. As a result of these actions, fourth quarter operating expenses as a percentage of revenue decreased 1% sequentially and 7% year-over-year to 71%. Our total number of employees increased 32% year-over-year bringing our total headcount to approximately 3,220 at the end of the quarter. We’ll continue to pace hiring for the year based on current market conditions to deliver consistent results with a keen focus on allocating our talent to key strategic areas of the business to help us achieve our objective of $5 billion in annualized revenue in five years and to do so profitably, predictably and productively.

Sales and marketing expenses were $113 million for the quarter. Sales and marketing as a percentage of revenue remained consistent sequentially and decreased to 41% from 44% in the same quarter last year. Research and development expenses were $49.4 million in the quarter. R&D as a percentage of revenue remained consistent sequentially and decreased to 18% from 19% in the same quarter last year. General and administrative expenses were $33.3 million for the quarter. G&A as a percentage of revenue decreased by 1% sequentially and decreased to 12% from 14% in the same quarter last year. Operating income was $16.8 million compared to an operating income of $2.3 million in the same period last year. Fourth quarter operating margin was 6.1%, an increase of 490 basis points year-over-year.

These results underscore our responsiveness to market conditions and our ability to scale up or scale down our spending as needed to meet demand, highlighting the efficiency and elasticity of our business model which remain key elements of Cloudflare’s success. Turning to net income and the balance sheet. Our net income in the quarter was $21.6 million or a dilutive net income per share of $0.06. Tax expense for the quarter was $2.3 million. We ended the fourth quarter with $1.6 billion in cash, cash equivalents and available-for-sale securities. Free cash flow was $33.7 million in the fourth quarter or 12% of revenue compared to $8.6 million or 4% of revenue in the same period last year. Operating cash flow was $78.1 million in the fourth quarter or 28% of revenue compared to $40.6 million or 21% of revenue in the same period last year.

Remaining performance obligations, or RPO, came in at $907 million, representing an increase of 9% sequentially and 45% year-over-year. Current RPO was 74% of total RPO. Before moving to guidance for the first quarter and full year, I would like to begin with our expectations and the provisions we have factored into guidance. We performed rigorous scenario analysis across multiple vectors from pipeline and ACV growth to productivity in order to understand both our company-specific opportunities as well as the risks from the current economic uncertainty. In our guidance, we have not factored in any improvement in the macroeconomic environment or from our go-to-market initiatives. Specifically, despite a notable improvement in our pipeline exiting 2022 as compared to with the first half of the year, we have assumed the increase in sales cycle, which we observed in the second half of last year, continues in 2023 and have, therefore, incorporated close rates below recent historical lows.

Furthermore, as Matthew discussed earlier, we believe sales and marketing can be broken down into a series of processes that can be organized, measured and continuously optimized. Marc and Brent are establishing a consistent structure, model and process that simplifies how we operate and how we interact with prospects, customers and partners. Because of the new leadership team we have already assembled has successfully executed these go-to-market playbooks before at other companies, we are confident in the ramp of implementing these models and tactics which we expect will ultimately improve revenue growth and productivity. However, we have not incorporated any improvement in sales productivity in our guidance for 2023, embedding in fact productivity levels below our recent historical lows.

Now turning to guidance for the first quarter. We expect revenue in the range of $290 million to $291 million, representing an increase of 37% year-over-year. We expect operating income in the range of $11.5 million to $12.5 million, and we expect diluted net income per share of $0.03 to $0.04, assuming approximately 342 million common shares outstanding. We expect an effective tax rate of 36%. For the full year 2023, we expect revenue in the range of $1.330 billion to $1.342 billion representing an increase of 37% year-over-year at the midpoint. We expect operating income for the full year in the range of $54 million to $58 million, and we expect dilutive net income per share over this period in the range of $0.15 to $0.16, assuming approximately 344 million common shares outstanding.

We expect an effective tax rate of 36%. Beginning in 2023, Cloudflare is subject to be the minimum tax, which is the primary driver for the increased tax rate year-over-year. After having achieved positive free cash flow in the second half of last year, we anticipate being free cash flow positive for the full year 2023. While we expect free cash flow to trend upward on an ongoing basis, for modeling purposes we anticipate near-term variability in our cash flow generation with the first half of 2023 expected to be relatively breakeven. We remain confident in the elasticity and durability of our business model, and we’ll continue to pursue the enormous opportunity ahead of us while raising the bar on our operational excellence. In closing, I’d like to thank our employees for their continued dedication to our mission, customers and partners.

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, sir. . We will take our first question from Matt Hedberg, RBC Capital Markets.

Matthew Hedberg: Great. Thanks for taking my questions, guys, and congrats, Phil, on your new role. Looking forward to working with you on that side of the table. I guess one of the questions I’m getting is around the conservatism in your ’23 revenue outlook. Obviously, Tom, you talked about some of the levers of conservatism. But I guess with 37% growth for both Q1 and the full year, obviously, your comps ease as the year progresses. But is there something that perhaps kicks in during Q2 or the second half of the year, maybe like the price increase you announced last year, or maybe a large customer renewal that would drive linearity this year?

Thomas Seifert1: I think we stick to our rule of trying to be prudent and thoughtful how we think about the future, especially in a rather uncertain environment. I think that the important takeaway in the guidance that we put forward is that we did not assume any help from the macroeconomic environment. We did not plan that things would get better. And we have a lot of initiatives that will accelerate sales productivity and accelerate growth, things that we can control. But we’ve been rather conservative there too in terms of what we anticipated in the guidance we gave. So I think it was our goal in a world where there are a lot of variables that shift around to find some ground of stability from which where we can build on moving forward. But I think prudent is what we said during COVID and thoughtful is what we said during COVID, and I think we stick to that philosophy, keeping our hands on the steering wheel as Matthew would call it and work on what we can control.

Matthew Hedberg: Great. And then maybe just a quick one, Matthew. Within your security portfolio, you noted some nice wins in your prepared remarks. I’m wondering, can you talk about maybe just some of the win rates specifically on your enterprise-grade customers within Zero Trust deals, I guess, specifically against some best-of-breed customers that you noted on the call?

Matthew Prince: Yes. I think that we are really happy with our win rates. What I think our challenge is in the Zero Trust space is not winning customers that know about us, but making sure that customers that are in the market for Zero Trust services are aware that that’s something we do. The frustration that I still have is when I’ll meet with a customer and oftentimes they’ll literally say, you should build something that is in the Zero Trust space, competing with Zscaler or Palo Alto Networks. And so when we’re in those deals, we find ourselves winning very often. I think we are especially successful with very technical rigorous companies that measure performance and care about making sure that they have the best possible end user and especially developer experience.

But our challenge now, and what Brent and Marc are really focused on, is how in that space do we increase our awareness? And I think you’re going to see a lot of us doing that. But when we’re in the deal, we tend to have very, very strong win rates that rival what we see from our other products.