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
- Revenue Q4’22 : Total revenue of $274.7M, or 42% YoY.
- Revenue FY’22 : Total revenue of $975.2M, or 49% YoY.
- Guidance seems to be very prudent: 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.
- FY’23:
- Expect network capex to be 11% - 13% of revenue in 2023.
- Expect revenue at $1.330B - $1.342B, or 37% YoY at the midpoint.
- Expect operating income at $54M - $58M.
- Q1’23:
- Expect revenue of $290M - $291M, or 37% YoY.
- Expect operating income of $11.5M - $12.5M.
- FY’23:
- Non-GAAP gross profit of $212.5M, or 77.4% gross margin, compared to $153.3M, or 79.2%, in Q4’21.
- Non-GAAP income from operations was $16.8M, 6.1% of total revenue, compared to $2.3M, or 1.2% of total revenue, in Q4’21.
-
Record Cashflow:
- Cash Flow: Net cash flow from operating activities was $78.1M, compared to $40.6M in Q4’21.
- Free cash flow was $33.7M, or 12% of total revenue, compared to $8.6M, or 4% of total revenue in Q4’2021.
- $1.6 billion in cash, cash equivalents and available-for-sale securities (remains unchanged).
- DBNRR is down to 122%, however, they are confident about long-term 130% after new products get traction and are not seeing elevated churn, rather customers downgrading.
-
Customer activity:
- Total customers:
- sequentially up by 15,7%, totaling paying customers 162,086. Representing a slow-down sequentially from 24,3%, 19,8%, 17,8% in the quarters before.
- Large customers: (<100k)
- +134 large customers, totaling 2,042 large customers, incl 33% of F500
- Revenue from large customers grew 56% year over year, contributing 63% of total revenue (up from 61% previous quarter) —> nice trend that their effort in targeting larger customers seems to be moving in the right direction.
- XXL customers (<500k):
- Total of 222, up 83% YoY. Representing a very nice increase from 70% the year before.
- XXXL customers (<1M):
- Total of 85, 53% YoY, slowing down from 75% in the previous year.
- Total customers:
Notes from Earnings Call
- We have our hands on the leverage of our business and are adjusting them based on the macroeconomic conditions . —> Nice to have a business that can respond to the market situation as needed.
- While there will be some variability in our free cash flow quarterly, we expect to be free cash flow positive in 2023 and the years after that. […] We anticipate near-term variability in our cash flow generation with the first half of 2023 expected to be relatively breakeven—> Great news, NET is finally committing to becoming and remaining Cashflow positive, without compromising important investments into infrastructure, etc. (Though, to be noted, capex and R&D spend were slightly lower than historically).
- The pricing increase went smoothly, with no elevated churn, most users are switching to annual billing, so the effect goes rather to the bottom than topline.
- Commented on prudent hiring, no lay-offs, and a very promising pipeline of talent to power their product development engine.
- New feature enhancements, esp. around Zero Trust products, promised for innovation week.
- While our innovation engine is the best in the industry and has unlocked the $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 products 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. —> While they are quite satisfied with their R&D, they see room for improvement in selling complex products to larger customers. Addressing this with a focus on S&M and new leaders in the area, who are reaping some “low-hanging” fruits.
-
On competition and their winning R&D strategy:
- Unlike their [Zero Trust] competition, their unified network reliability and performance were a winning argument.
- On competition Zero Trust Enterprise with best-of-breed suppliers: 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 do know about us […] 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.
- The customers love that we have a single payment 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 keep mentioning this and I think it is only a fair point (makes me think of bill needing to unify their platform experience).
- NET is also winning with several AI customers, most notably with ChatGPT (thick started many years ago as a free tier user): 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. Why?
- Again, multi-cloud capability and R2 for storing their training data in a neutral place, where it can be accessed from basically “anywhere”. technically speaking. (Revenue opp: Since R2 is consumption-based, they expect much more upside here with expanding training sets of AI data, but not necessarily in the very short-term).
- NET’s security (revenue opp: subscription-based, but so many AI companies yet, so not a big driver right now).
- Data localization is highly performant and compliant, esp. in regulated markets like the EU: 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.
- They now officially received FedRAMP certification (excl. their Area 1 product). Won first $7.2M 5-year deal to operate the .gov registry. Public sector is only 3% of their revenue today, so they believe there is a lot of future potential. Revenue from that deal will be recognized ratably.
- No concrete outlook to future here, but they are addressing public sector in US, but also quite heavily in Europe.
- Continuous innovation and NET ”stacking curves on behind another.”: *And so, I always think of sort of our application services products as sort of our first act. We think of our Zero Trust products as our second act. And we think of our worker’s products as our third act. And so, I think that they’re maturing at rates that are – that continue to make us very excited and happy and we’re seeing more and more new use cases that are coming from that. […]*But: You’ll start to see as those new products come online, that those will be positive. But remember that D&R only starts to kick in for a customer that’s been with us for an entire year. So, for those products that are new, they – even if they are wildly successful, the expansion won’t actually show up in our numbers until 12 months after the products were actually in the market.
- Area 1 Email security is a great entry feature to expand customers on their Zero Trust products.
- Cloud Workers: 1M+ developers now building on cloud workers.
- On their incredible product moats:
- And it [the network] is not something that you can just throw money at and buy your way into it’s not something that even some of the large hyper-scale public cloud has. And so, we hear regularly from companies like Microsoft that they’re like, wow, you guys have something very special in the network you’ve built, and it is very different than anything else that’s out there. What is somewhat counterintuitive a bit about our network is that as we expand into further corners of the universe, whether that’s opening an additional data center in St. Louis or going into Djibouti. Any of those things actually help us lower our costs because it drives down the cost of delivering all of our services.
- Single network (aka uniform and organically grown product), allowing them to deliver them incredibly quickly, incredibly efficiently, and anywhere in the world, and that is paying off today by allowing us to continue to scale as efficiently as possible.
- Reiterated their 5 billion goals. Last quarter I wrote that I hope they don’t trade-off revenue and profitability too much, but I am pretty happy with how they react in an agile way and don’t sacrifice revenue growth, needed investments into S&M, or their R&D & capex spending to drive innovation further.
- On channel expansion:
- *We are winning in cooperation with a channel partner. And those initial wins help unlock future wins going forward. And then the second thing that we’re seeing is that in our ACT-3 products, a lot of times, we’re seeing as customers are coming to their partners to say, we’re looking to consolidate vendors we’re looking to save money on some of our cloud spend […], like from S3 to R2 [*comment: S3 is an AWS product, so they are moving from public cloud providers like AWS to NET].
- Palantir Partnership: They were driving a lot of their customers to their cloud solution. They saw how much money was wasted in some of the public clouds and have built a tool to help people understand what their cloud spend was they came to the conclusion that oftentimes if customers could move more of their workloads to Cloudflare workers that were a real money saving for them. And again, that’s been – it’s early days, but we think that that’s definitely saving money, consolidating vendors.
- They are also harnessing the trend of, especially startups, to build on their cloud computing platform workers instead of on hyperscaler clouds or CDNs (however, this only works for more modern companies and certain programming languages like JS).
- No more comments around currency headwinds internationally (as mentioned in previous quarterly results).
- They are still seeing “businesses measuring twice before cutting”, but there was much less emphasis on elongated sales cycles than in the previous results.
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:
- Multi-cloud. It keeps popping up as a winning argument for different of our companies (incl. also e.g., DDOG) and seems to become increasingly important to customers.
- R2: Neutral storage, supports multi-cloud and serves very well for AI companies à NET can benefit from increasing workloads of their new and future AI customers.
- World-wide infrastructure in combination with their unique core technology: very hard to replicated, strong moat, supports data localization and compliance regulations and many locations.
- One organically grown technology, no separate stuff stitched together.
- Continuous releases, extremely fast pace of development, agile mindset in iterating on new capabilities (such as Zero Trust products right now)
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! 