NET: post-earnings thoughts

NET (7.7% allocation; Q2FY21 5Aug earnings date)

NET launched a flurry of new products over the past nine months. Yet, revenue growth has not accelerated significantly and has remained stuck in the low 50s percent (year over year growth). I’ve been expecting an acceleration for several quarters, but it hasn’t arrived. With all the new products, eventually NET must accelerate growth significantly right? It didn’t happen in the 30Jun quarter. Revenue growth came in at 52% slightly higher than Q1’s 51% and Q4’s 50%. NET has a lower revenue growth rate than just about every other company in the portfolio. Surprisingly (to me), the stock prices has kept climbing (into earnings and after). Owning NET has required patience and that continues to be the case. Then why is NET still in the portfolio? There are reasons to be optimistic.

NET’s large customers (spending $100K or more) increased by 71% and net dollar-based expansion rate has been steadily increasing and is now at 124%. Only half of NET’s customers use more than one product so there’s a lot of available growth opportunity. NET also landed significant business from the U.S. federal government, but revenue from these contracts likely won’t appear in the numbers until 2023; NET needs to invest heavily to support this new government business, but those investments should also enable the support of any other customer in the world. So we won’t be seeing any profits from NET until 2023 as management will plow everything back to support future growth. I’m optimistic that growth could begin to accelerate in 2023. I also still believe that NET’s available target markets are huge and NET has the chance to capture a fair chunk. I’ll continue to patiently hold NET (albeit at a lower allocation given that there are other companies in the portfolio that have proven themselves).

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Chris,
It was your monthly update that shook me out of my complacency regarding Cloudflare. After taking a harder look I found myself in agreement with your observations. I had been holding calls that I bought when most of the stock we hold which were up a great deal. I decided now was a good time to take the gains as I would have to incur the taxes this year, it was just a matter of when.

The majority of the proceeds were used to purchase more Upstart stock which moved into my number one position. Now with the recent surge in Upstart stock price I find myself contemplating your stated opinion that not a single share is to be sold. My position in Upstart now exceeds 30% and under most normal circumstance any position over 20% makes me uncomfortable.

So far, I’m inclined to maintain this outsized position in that no matter what angle I choose, Upstart continues to look like a phenomenal investment. I just can’t see a downside, but it’s not like I’m the most perceptive investor in the world. The only thing that makes me uncomfortable is my confidence in my own analysis.

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Hi Chris,

I appreciate your sharing your portfolio and each of the three related posts. I am holdingCloudflare at 16% of my portfolio. In my investment thesis, I weigh heavily the following two facts. One, that Prince stated, 88% of contracted customers have four or more products. I know that Cloudflare stated in the prior quarter’s conference call the they consider Cloudflare a core to a customers business when that business utilizes four or more Cloudflare products. And two, as far as how Cloudflare believes their company progress should be measured, they stated on the call this quarter that they’d point to RPO, that being +77% YoY. I find these two points interesting and try to follow the advice of Stocknovice when he points to specific metrics that each company states is how they measure their success. I wonder how heavily you weigh them in your judgment to hold hold Cloudflare in your portfolio?

I think maybe I’ve missed something that you’ve picked up on or vice-versa. When you wrote-
“NET also landed significant business from the U.S. federal government, but revenue from these contracts likely won’t appear in the numbers until 2023; NET needs to invest heavily to support this new government business, but those investments should also enable the support of any other customer in the world. So we won’t be seeing any profits from NET until 2023 as management will plow everything back to support future growth. I’m optimistic that growth could begin to accelerate in 2023. In my notes I have Prince stating , ,Cloudflare will breakeven at Q1 2022. IMO, they were talking about the entire company becoming profitable no later than Q1 2022. I do believe the buildout of their network explains why R&D increased to $41M (from $28M a year ago). As a long term investor I am OK with this increased expense. Perhaps even if it did take till 2023; but, I’m just wondering were you got that date from?

Also, I do believe Cloudflare has stated that they are no longer reporting total number of customers and instead focusing on those spending >$100k/year. Cloudflare has stated as much in their calls that their doing this because they don’t expect many of the free tiered customers to be converted to the >$100k level and that’s where their focus is. Do you think I have that right?

Best,

Jason

Long NET 16%

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Jason,

My comments regarding 2023 were supposed to read 2022. I was a mistake and I’ve corrected it on my website’s blog post. Thanks for bringing it up!

Regarding what metrics I weigh, it’s a good question, and it’s not the same for each company.

  1. Top line growth is the most important to me. Sometimes that just means revenue growth but sometimes (depending on the company) it also includes other metrics. Management will often tell investors which is the best to follow.

  2. Another very important thing that I weigh is the future growth runway. It’s basically what they have now as a percentage of what they can still get (TAM is commonly used here). But TAM can also increase as a company can enter new markets and adjacencies. I like companies that can have hyper growth far into the future.

  3. Next, I look at the path to generating cash. Some measures that I look at are net income, FCF, progress toward the stated long-term operating model. I look at the recent trajectory, the stated end long-term operating model (if they’ve given us one), and how far the away from their long-term model. NET isn’t doing as well here as some of my higher conviction companies like CRWD, DDOG, DOCU.

  4. I also like companies that are dominating in their markets. Look at ZM, DOCU, CRWD, SNOW. NET is likely doing that but isn’t, IMO, quite as good as the others. I use a combination of metrics to assess this and this combo of metrics might be different across companies.

Regarding NET specifically, I think NET is not quite where I’d like it on #1 and #3. I like #2 for NET and I think #1 and #3 will likely improve. So I had a similar allocation to yours (about 16%) recently, but, given what they’ve delivered (and their stock price run-up which I didn’t think was fully deserved yet), I thought my 16% allocation was too high. So I cut it in half.

Also, I do believe Cloudflare has stated that they are no longer reporting total number of customers and instead focusing on those spending >$100k/year. Cloudflare has stated as much in their calls that their doing this because they don’t expect many of the free tiered customers to be converted to the >$100k level and that’s where their focus is. Do you think I have that right?

What I heard on the earnings call is that NET has introduced a number of new products that aren’t applicable to the total customers metric but only a subset of customers. So I think they are not reporting total customers anymore because it’s not longer a really good metric. I think they may come up with another metric eventually.

GR

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