Revenue 274.7M (up 42% y/o/y, up 8.2% q/o/q) - in-line with guidance
Cash from operations in Q4 78M (up hugely)
Guidance
Q1 at 290
Full year at 1336, up 37%
Valuation (priced at close of market)
P/S on current quarter annualized revenue 17.4
P/S trailing 19.6
P/S at guidance midpoint 14.3
I’m pretty impressed. NET is a model of consistency. I appreciate how they have dialed-in some cash flow which before they had struggled to do.
Stock up 11% as of writing.
Rob
I checked the numbers before looking at the AH movement and was pretty surprised to see such a positive move in the price (that being said, I’ll be happy if it holds).
Caveating that AH price is noisy, my best guess as to why these numbers were well received are based on the positive cash flow and profitability metrics, combined with the full year guide.
Their Q1 revenue guide implies a bit above 5% growth, which when annualized is only low 20’s growth. However, the full year guide shows expected 37% YoY growth, so they must be assuming better performance as the year goes on? It’ll be interesting to hear on the call how they’re thinking about their guidance through the year.
My notes from NET Q4 FY22 earnings call that concluded a moment ago
Analyst Q/A and Off-Script Comments By CEO & CFO
02/09/2023
Matthew Princer, CEO
Thomas Seifert, CFO
NET anticipates being positive FCF for all of FY 2023.
DBNRR at 122% down from 124%: Not experiencing churn, but less net expansion and pay as you go customers and customers not spending as much as in previous customers. They anticipate returning to 130% DBNRR when the macro subsides.
RPO came in at $907M, which is a 9% sequential growth rate and 40% y/y.
As data localization and data residency becomes law in many places, the NET data localization solution is becoming more and more attractive to customers.
NET received Fedramp certification on all their products. They just received a $7M federal contract. Federal is just a 3% portion of their revenue, so they are excited to expand their revenue in federal contracts.
Longer sales cycles, pressuring revenue growth across the tech/software industry including at NET, but they are confident in their ability to continue to scale their business and specifically to continue to scale their FCF in the quarters to come.
AI companies need to find out where It’s most cost effective to operate. AI companies use R2 as the natural neutral place to store their training data. This is a use case they didn’t anticipate and see this taking off in a significant way in the long term rather than in the short term.
NET’s strategic goal of $5B in annual revenue in the next 5 years remains on track.
NET can scale up or scale down to adjust to macro as they successfully demonstrated this quarter.
In 2022, NET started slowing their pace of hiring so they didn’t get over their skis.
Company took actions to decrease operating costs in Q4, in anticipation of macro pressures.
Despite a notable improvement in their pipeline, they anticipate simplifying how they operate and are modifying their go to market strategy, however they have not included these changes in their guidance.
Next innovation week is in March, where they’ll be focusing on security.
Q Conservatism of 37% revenue growth.
A Trying to be prudent and thoughtful of how they think of the future as they put forward their guidance. They did not anticipate that macro will get better in their guidance. (sjo here: I take this to mean, it can only get better). Work on what they can control.
Q Win rates in enterprise grade customers in zero trust base.
A Making sure customers who are in the market for zero trust, know they provide this. When they’re in these deals, they win these very often. NET’s challenge now is how in this space do they increase their awareness. When they’re competing for this, they have a very high win rate.
Q AI use cases. How does the revenue opportunities for these customers ramp with your subscription model vs. if it were a useage based model.
A There really aren’t that many AI companies yet. However, in the cluster of AI companies, they have a different use case that’s more likely to use foreward leaning technology to get as much as possible out of it. AI training sets with big clumps of data – R2 and workers products are a way they can access R2’s neutral position of R2 and use it across multiple different clouds. As AI data sets get larger, they (NET) anticipates they’ll be able to grow revenue with them.
Q How much AI revenue is baked into guidance?
A Very little if any AI revenue is baked into guidance.
Q Commentary re: R2 and the challenging sales environment. Decline in Operating income in the quarter.
A Happy with the ramps of the new products. NET stacking S-Curves one after another with each of their products. Products are maturing at a rate that continues to keep them very excited. Trade-offs around DNR, how they did cash collections and converting customers to pay up front. They want to optimize and collect cash up front as much as possible. As new products come online, it will be positive. Remember that DNR will not show up in their numbers until 12 months after their product has been in the market.
Q Shopify speeding up their storefront based on NET’s Workers product.
A SHOP has been a terrific customer for NET. To turbocharge Workers w/ customers who have an ecosystem that can be optimized using developers. Incredible to get more customers with engineering teams like at SHOP, they’re excited about what NET’s products can do to help them.
Q Area 1
A Area 1 was not included in the numbers. If NET can get customers to migrate to email security portfolio, the customer can do so with one simple click, once it’s been done, then they can upsell the customer and expand NET’s offerings with the customer.
Q Barriers to entry (competitors) for NET and your top priorities to grow the business. How difficult is it to provide the services that you do.
A NET is fundamentally a network. As NET expands and adds a data center in St. Louis or other locations internationally, it drives down their cost to deliver their service. Lot of customers who switch from ZS to NET, say speed of NET is great. Adding locations allows NET to scale more efficiently. Very difficult to replicate what NET has done. All of NET’s products rely on their network. They experience significant improvements due to the networking effect, using security bundle improves their (NET’s) security, which catalyzes the network effect and everyone wins.
Q Will $7M fed deal be recognized in the next 5 years? What may be down the road?
A No expansion baked into the deal and NET’s guidance. Not linear over the contract period. For modeling purposes, a ratable disbursing over the 5 years is a good assumption.
Q Increase in resellers of NET.
A Both traditional retailers and resellers of NET are helping to unlock future wins as they go forward. Net is well-positioned to help their partners help their customers.
Q How many coders are currently working on your platform?
A 1 million developers working on Cloudflare Workers. Partnerships w/ SHOPify who have their own developers in-house really facilitates this. It scales beautifully on Cloudflare Workers. Seeing more sophisticated applications doing this w/ NET’s Workers.
Q Magnitude of pricing lever in 2023.
A NET was hesitant to raise pricing, as NET is fundamentally infrastructure and they want to be reliable. If customers pay up front, they can keep the same pricing structure. If they pay as they go, the price increased. Pleasantly surprised that NET’s customers have said that NET has added so much value that they were happy to pay up-front. Went from $20 to $25 price increase and did not see elevated churn.
This is more of a tailwind to cashflow than a tailwind to revenue, as most customers have opted to pay up-front.
Q Public sector business. What held you back up to now? Expanding Sales and Marketing.
A Federal business is a very local business. NET has made great progress both in Europe and in the US. Hesitant to give a specific growth number, however they are very excited about this opportunity.
sjo
While Cloudflare was not spared from the difficult Q4 that SaaS experienced (evident with their 0.1% beat), there is ample evidence for better days ahead.
–
SALES MOTION
-Despite that, Cloudflare added a healthy 170 enterprise customers; coincidentally the same number that they added in Q4’21. I was pleased to see evidence of their top-down sales motion, evident by their breakdown of >$500k and >$1M customers for the first time (growing at 83% and 52% respectively)
-It does look like the ‘expand’ is taking a bigger hit though, with DBNR nudging down to 122% on a quarter that typically ticks up
Key Takeaway #1: I am more surprised with the growth in RPO and enterprise customers, than the decline in DBNR. Looks like Cloudflare is combatting its customers’ scrutiny with a successful sales motion.
–
OPERATIONS
I’m glad to continue seeing Cloudflare grow their FTEs prudently to prioritize efficiency and a “do more with less” mentality. Headcount only grew by 36 sequentially
We’re starting to see the fruits of efficient growth, with non-Gaap OpExpenses growing 30% YoY (notable slowdown from 46% in Q4’21)
Stock-based comp rose 23%, consistent with the prior 5 quarters
Key Takeaway #2: All of these activities are starting to translate to the bottom line, with 12% FCF margin and 6% non-Gaap OpIncome margin
–
FUTURE OUTLOOK
Here’s where it gets really interesting. Over the past few years, Cloudflare’s FY initial revenue growth guidance (that is, the guidance reported in Q4 for the following year) has looked as follows.
2020: 37%
2021: 38%
2022: 42%
2023: 38%
Now, let’s include their actual revenue growth.
2020: 50% (9.7% beat)
2021: 52% (10.7% beat)
2022: 49% (4.8% beat)
2023: ?
Key Takeaway #3: Assuming Cloudflare beats its FY guidance by 3%, it would maintain this year’s 42% YoY growth rate next year! I encourage anyone to correct me because this seems too good to be true in the environment we’re in. It even makes me concerned that management is guiding so aggressively, yet they indicated:
“We’re not relying on any improvement in sales and marketing efficiency or any rebound in the economy as we look at the year ahead and formulate our guidance.”
“In our guidance, we have not factored in any improvement in the macroeconomic environment or from our go-to-market initiatives…We have seen the increase in sales cycle which we observed in the second half of last year, continue in 2023 and therefore incorporated close rates to low recent historical lows”
–
Conclusion: If we give management the credibility they deserve (they’ve never missed a revenue estimate), I see Cloudflare becoming an epitome of the type of companies that led to the creation of this board. Consistent, profitable growth at scale while innovating ruthlessly.
-RMTZP
The two standouts, Free Cash Flow and Free Cash Flow Margin, both increased +/- 7X sequentially.
CEO, Matthew Prince confidently reinforced that NET would reach $5B revenue in 5 years.
| Column1 | Column2 | Column3 | Column4 |
|---|---|---|---|
| NET Earnings Release 2/9/2023 | |||
| Non-GAAP | |||
| **Millions | |||
| Metric | Qtr Ended 12/31/2022 | Qtr Ended 09/30/2022 | % Change |
| Revenue | $274,700 | $253,900 | 8.2% |
| Adjusted Gross Profit | $212,512 | $198,361 | 7.1% |
| Adjusted Gross Margin | 77.4% | 78.0% | -0.8% |
| Adjusted Operating Income | $16,819 | $14,830 | 13.4% |
| Operating Income Margin | 6.1% | 6.0% | 2.0% |
| Adjusted Net Income | $21,600 | $19,100 | 13.1% |
| Adjusted Earnings Per Share | $0.06 | $0.06 | 0.0% |
| Free Cash Flow | $33,660 | $4,600 | 631.7% |
| Free Cash Flow Margin | 12% | 2% | 576.3% |
| Rem Perf Obligs (RPO) | $907,000 | $831,000 | 9.1% |
| DBNRR | 122% | 124% |
Quarterly and full year guidance:
Revenue: $290 million to $291 million or 6% sequential growth and $1.33 billion to $1.34 billion or 36.6% growth for FY23.
Adjusted Operating Income: $11.5 million to $12.5 million or a 4.2% sequential decrease and $54 to $58 million or 77% growth for FY 23.
Adjusted EPS: $0.03 to $0.04 sequentially and $0.15 to $0.16 growth for FY 23.
I completely agree, rmtzp. This is where I am getting caught up. For the first time, I am having a hard time believing Matthew Prince and am hesitant to trust Cloudflare’s full year guidance. Forget beating guidance, I personally am struggling to see how they will meet their FY guidance following the Q1 guide.
Here is where my head’s at when thinking through FY 23:
I don’t see how someone can assume Cloudflare is going to beat their Q1 guide by 3-4% like they did in quarters past considering they beat their midpoint guidance by 0.3% and 1.1% the last two quarters. With this in mind, I am assuming another sub 1% beat next quarter and expect revenue of ~$292M.
There is some seasonality at play - Q1 is always Cloudflare’s weakest so I would argue it is safe to assume their quarterly growth rate will accelerate the following quarters. The question is, what is a reasonable expectation?
For now, I am using 8.2% as a fair estimate for Cloudflare’s quarterly growth rate in quarters 2-4. This would be the exact growth rate Cloudflare has achieved the last two quarters. I would argue this might even be aggressive considering Cloudflare’s sequential revenue growth has decelerated for three straight quarters and next quarter will be their weakest ever my a wide margin. Additionally, every other SaaS company we have heard from is telling us next year will be more challenging and to expect slower growth.
Regardless, if we assume Cloudflare will produce $292M in revenue next quarter and then grow 8.2% sequentially for the remainder of the year, they would produce $1,320M in revenue for the FY, $10M short of the low end of their guidance.
Does this add up to anyone? Perhaps I am in the minority here, but I have a difficult time seeing Cloudflare suddenly accelerate in Q2 and hold that rate steady for the following quarters. Management claims they are not relying on any improvement in the economy but their guidance indicates the exact opposite.
I have owned Cloudlfare for nearly three years and never doubted management but this guidance seems wildly aggressive based on their current business trends. I struggle to see how they can claim this is conservative, especially when you consider the market will expect them to beat and raise each quarter. Cloudflare is an innovation machine, and I have no concerns about them in the long-term, but this initial FY guidance does not compute for me.
Do others see it differently? Do you expect Cloudflare to actually accelerate their sequential growth rate in 2023? I don’t see it happening with the challenging macro conditions and for that reason, I trimmed part of my position this morning at $63.
Rex
Hi rmtzp, since you asked:
They grew 42% for the quarter, but they grew 49% for the year, this year, so 42% won’t at all “maintain this year’s 42% YoY growth rate next year!” It would be a 7 point drop.
Saul
Cheers, all and thanks for sharing your thoughts so far. Here are my takeaways and notes from NET’s earnings report.
NET Q4’22
Fundamentals
Notes from Earnings Call
Bottom line
I was hoping for a bit more revenue growth, around 280M, but hey, what can we expect given the current environment.
At the same time, Cloudflare really nailed profitability and promised to remain cashflow-positive – that is great news for many of use who were waiting for NET to become serious on profits. While the pricing change and some small to marginal savings in capex & R&D might have favored profits, it seems that it is very organic and not driven by trade-offs with important investments and growth. Nice! 
I like how NET is focusing on S&M and large customers now and look forward to them realizing some low-hanging fruits in that area. We saw nice customer activity trends in 500k cohort, the other large customer cohorts were a bit slowed down, but still strong. Next quarters I hope to see the increased GTM efforts on large accounts materialize further, and growth and DBNRR tick up again.
While they are “struggling” a bit on the S&M side, NET continues to be a world-class organization pumping out products and features like mad men. They have a very strong product and a major moat with their hard-to-replicate, worldwide infrastructure and core technologies that meet today’s demands for compliance (Bonjour, European market! There is still much room to grow in EU and US), performance (every tech company worries about performance) and reliability. My R&D favorites in a nutshell:
All in all, I feel comfortable with my 15% allocation right now. I love their R&D spirit and the profitability improvements and hope that growth will beat our expectations and come out close to 50% YoY again. I am also not sure, if NET might guiding aggressively after all (they certainly emphasize they are being very prudent and nothing is baked in, AI momentum, increased large customer focus, S&M efforts, Fedramp/public sector stuff).
Maybe they know something we don’t? Maybe, some positive trends are baked in after all? I don’t know, but I have a hard time to believe that Prince would risk missing their guidance for the first time in history for a !quick win” this quarter. Especially with increased profitability it seems they have no need to sacrifice long-term trust for a short-term stock price bump. Easy comps should make things easier from mid ’23. But then again, I might be completely wrong 
So, I will temper my hopes and will wait for some more reports to get a better grasp over the current situation of our companies and potentially make and portfolio adjustments from there.
Good luck to all of you out there & Happy Weekend ya’ll! 
While I totally agree with this, it’s worth noting that Cloudflare just barely beat their estimate in Q4. If the quarter was one day shorter, they would have missed the estimate and we would be having a different conversation. I’ll emphasize that I’m also trusting management here, but simply worth considering.
My best guess is that their “top down” sales motion is going well, and hence the renewal rates that they’re modeling for that customer cohort are better than those being modeled for their SMB cohort.
We know from Bill’s (and other SaaS) Q4 reports that SMBs are being strongly affected by the current climate.
We also see some evidence of this in Cloudflare’s report, notably with >$100k customers now representing 61% of revenue. The revenue contribution from this cohort grew at 67%, meaning that the small (<$100k) customer cohort (39% of revenue) grew at 27%.
Therefore, if we assume that the large customer cohort grows at 60% next year, and the small cohort grows at 24%, that would put Cloudflare’s FY’23 revenue at $1,422 (6% higher that their initial guide).
I don’t think management would risk being so close to missing an estimate. I’m projecting it to be a little higher, and from there I could see the scenario in which the bigger contracts (as indicated above) pull the sequential revenue growth a little higher.
-RMTZP
Please consider supporting the earthquake devastation in Turkey / Syria
I’m seeing 134 new $100k+ customers vs 156 in Q4 last year.
What am I missing?
Bear
Excellent analysis rmtzp!
As the large customer cohort is growing faster, and thus becomes more and more of the total revenue, the growth rate of total revenue will move upwards, towards the growth rate of large customer revenue, and the large customer revenue will become 67% of total revenue, up from the current 61%.
Thanks
Saul
292m next quarter would just be 6.3% QoQ. If you assume 8.2% for all 4 quarters, they would get to 1343m – exactly 1m more than they guided for. (And by the way that’s just a ~2% beat in Q1.) You make a good point that raises will be expected, and maybe they haven’t sandbagged as much as in the past, but it wouldn’t take a huge change in the environment for them to be able to raise a little. And even if the environment stays not great, a few million dollars worth of extra sales each quarter certainly isn’t a tough ask.
That said, my conclusion was the same as yours. I took advantage of the price increase and reduced my position (to about 3%). Cloudflare is valued much more highly than other companies that have roughly the same growth and maybe better margins, and I’m not sure that is warranted. It’s certainly a good company, and one that I plan to keep owning shares of. But is it up there with Snowflake? Not in my book. Cloudflare’s growth will likely be slower and margins will likely be lower, short term and long term.
Still, if Cloudflare shares go on sale again (say, under $50), I’ll likely start to build the position back up.
Bear
IMO - the reason NET is commanding a higher multiple than other high growth stocks is the durability of its moat. I don’t understand the tech, but based on comments I have read, it would be extremely difficult for another company to replicate what NET has built. Compare that with CRWD - S has proven that if you throw enough money at it, you can create a competitive business. I am guessing that other SaaS businesses are in a similar situation - relatively more vulnerable to competition. With NET there is a physical infrastructure (which I don’t understand) that took many years to deploy. Anyone that wants to directly compete against them would need to replicate that infrastructure. And in the mean time NET is continuing to build it out and expand it.
I have a similar opinion of the moat for TMDX - very difficult for another company to challenge them.
I have been building up my NET position over the last couple months. I bought more after the ER. I think this company is going to grind higher. It may not be as flashy as higher growth, but I’m in this one for the long term and I’m willing to wait for the stock increase over time. I think the risk of a big drop from here is relatively low. This is now my second largest stock holding after TMDX.
And the chart looks beautiful - I posted it earlier, but it seems to have gotten deleted… So, I guess I won’t post it again.
