Cloudflare Q3 2020 conference call

[wpr101]

Summary
The great results were driven by enterprise customers. Cloudflare Teams switched to paid with strong conversion but did not materially add to revenue. Cloudflare One their new all in one product drove the enterprise growth. Cloudflare Workers has a huge opportunity with regulation and compliance for companies.

Matthew Prince

• Exceptional quarter, many milestones
• 114M revenue, 54% YoY
• crossed 100,000 paying customers
• large customers, added 99
• 736 customers 100k+ ARR, accounts for 47% of total revenue
• antcipate that large customers will make up over half of the revenue going forward
• first 10M customer, fortune 500 software company which started with Cloudflare in 2016
• one of the leaders at this company, he used the free version of Cloudflare on his personal site
• he loved the experience and brought it to work, initially signing a 60k per year contract
• this customer has tightly integrated the product, customized deep into software stack
• terrific patnership that will continue to grow
• great success with go to market strategy, especially with large enterprise customers
• half of revenue this Q came from new logos, half from existing customers
• happy with customer diversity mix, no customer accounts for more than 5% of revenue
• top 20 cusomters remain under 20% of total revenue
• duty to ensure cyber attacks did not disrupt the elections
• 2020 had much fewer cyber attacks than 2016 due to help from Cloudflare
• launched Athenian project with provides enterprise level security to any state, local elections officials
• worked with federal election commission to provide services for free
• half of US states participated with the Athenian project, including both Red/Blue states
• half of the battleground states used Cloudflare for voter registration, poll location, official results
• worked with both presidential campaigns, and many federal campaigns for congress
• big step up from 2016
• team executing in remote environment
• meeting demand for services while staying in CapEx budget
• charge almost exclusively on fixed subscription basis, able to meet gross margin target still
• gross margin 77% without customers getting big bills
• accelerating growth while signing up larger and larger enterprise customers
• accomadating customers during pandemic was plan to get loyalty over the long term
• differentiated must have service by customers
• no pricing pressure, less concessions recently, less bad debt than forecast
• hiring going well, Q2 had 40,000 applications for work, offers to 0.6%
• Q3 had 60,000 applications and offers to only 0.4%
• focused on getting the best people, organically attacting many great candidates
• don’t have to hire third party recruiters and hire from less expensive geographies, operational leverage
• mission to build a better internet
• last four months on a tear of releasing “incredible new products”
• launched more than one product per day around Cloudflare Workers
• have many products less about generating revenue but doing the right thing for the internet
• Cloudflare Teams has new architecture/product: Cloudflare One
• engineering and marketing are “super powers”
• organic inboard interest from perspective customers, inbound leads have doubled
• one more Cloudflare week before end of the year, focused on privacy and compliance
• Teams, launched in January, perfect timing, made Teams free at first till September
• transition to paying for Teams is going well, 75% went from free to paid
• some hard hit companies by covid have been allowed to run Teams for free still
• Teams is very high margin product which doesn’t cost them much
• converted transiton to paying was late in the Q
• seat based pricing, land small and then expand
• these new customers did not result in material additional revenue in Q3
• customers want a holistic solution, much higher quality of service
• packaging services together for comprehensive solution for future of corporate network called Cloudflare One
• Workers, taking off, 27,000 devs wrote and deployed their first worker
• more devs means more likely to win out
• based off GitHub numbers, Workers has more usage than every other Edge computing platform combined
• Workers powered an election news platform to scale with traffic
• Health foods company powered by workers for online ordering
• Online marketing firm customized usage of Workers
• Electronics platform using Workers to bridge on-prem solution with cloud
• innovative startup using Workers to power online crypto scavenger hunt
• more use cases over time, initially cases focused on performance
• much bigger opportunity than performance is with compliance
• governments need data localization, way to manage increasingly complex regulatory environment
• durable objects important development, store state on network
• can define where the data can go on the network, such as this data may never leave EU, or never leave Brazil
• fine grain control of where data can live, helps increasing compliance challenges
• 3 more Fortune 500s they won, industrial consolidating vendors/products into single unified platform
• single plan of glass to figure out what’s going on with network, 1.4M annual contract in Q3 signed
• food and beverage company came to Cloudflare after a security audit, replaced legacy with Cloudflare
• looking to save money over previous vendors and spending 50%+ less, 500k annual contract in Q3
• Pharma company, using Cloudflare One, onboard 47,000 employees and more than 130 applications
• they were impressed with the comprehensive solution as well as ease of use
• reduced IT ticket load massively, 1.5M annual contract in Q3
• hit on all cylinders this Q

Thomas - CFO

• growth in revenue driven by both new logos and existing customer base
• Q3 had a one time catch up of 1.9M due to a customer renewal, would have been 52% YoY revenue
• US and EMEA has strong growth, both increasing 58% YoY
• US is 52% of revenue, international 48% (51%+ YoY)
• 3.2M free and paying customers, 40%+ YoY
• 4,800 paying customers added sequentially
• 285 large customers YoY
• 736 large customers, 53% YoY, particular strength in North America
• of the 736, about half have been on the platform for less than 1 year
• 3Q, 116% NRR, increased sequentially 100 bps but decreased YoY 500bps
• 6 out of 10 of the biggest deals came from existing accounts
• Teams potential tailwind for expanding
• 77% gross margin, in line with target of 75-77%
• operating expenses as a percent of revenue decreased 5% sequentially and 22% YoY
• headcount grew 42% YoY, about 1700 employees
• S&M 51M, 45% of revenue, total spent is growing, but % as revenue dropping
• R&D 23M, G&A 18M
• scaling effeciency, operating leverage improving, operating margins improving over 2000bps YoY
• operating margins improvign 550bps sequentially
• operating loss 4.5M
• hiring and investing aggressively
• net loss of .02
• 1.1B cash
• free cash flow -18M, was previously -33M a year ago
• operating cash flow 2M, was -17M a year ago
• cash flow increased by profitability
• DSOs trended down? (not sure what this is)
• covid impacted customers remains at 7% of customers in Q2 and Q3
• increasing average customer spend
• Q3 acceleration in RPO, 342M 25% sequentially, 81%+ YoY, multi-year partnership agreement contributed to RPO growth
• exclusing the large partnership would mean 73% RPO growth YoY
• strong visability and predictability with revenue
• multiple vectors of growth with Cloudflare global cloud network
• raised guidance for both Q and full year
• Q4, revenue 117M - 118M (40-41% YoY)
• FY2020, revenue 422M - 423M

Questions

• Q3 companies were coming under DDOS, getting initial interest
• Teams has turned into a gateway to get large customers on board
• customers want Teams and the whole suite of tools, differentiator between other zero trust vendors
• Cloudflare One, building future of enterprise network, individual products coming together
• let customers pick products, but they want kaladescope, ease of use, unified control plane
• significantly cost effective for CIOs, CTOs who want to consolidate vendors and address budgeting
• short/medium/long term for Workers, delivering quick fixes now (firewall, load balancer), bulk of new customers
• Teams was built using Workers, platform is growing, Cloudflare uses it internally
• long term, more sophisticated applications, large financial, healthcare, consumer. Compute needs, platform capabilites growing
• 10M customer, DDoS, WAF, grow with them, key partner, can see many other Fortune 500s with similar spend
• prudent guidance because of covid
• move up market, diversified go to market
• serve everyone, build relationships with developers on own accounts, driven a lot of marketing benefit
• developer love, when trying to win large customers
• sales capacity moving up market, direct sales teams coming from other enterprise customers
• stepped on gas with hiring, field sales has great hires
• working with identity companies like Okta, partner with, not compete in this area
• Cloudflare One is emerging opportunity, resonating with the market, customer conservations drove this product
• pricing Cloudflare One components individually, turned an architecture into a bundle
• low end of market allows to get into startups and architecture early one
• large enterprise, can rationalize different vendors and allow to grow with them
• significant ROI with Cloudflare One for customers
• Workers opportunity? TAM? tough to say
• performance of workers is NOT the opportunity, last in heirarchy of needs
• ease of use, affordability, reliability are needs
• how to help companies with regulations and compliance is the priority
• data required to be kept in market for that market, Cloudflare best addresses this
• was drove all the upside if not Teams? seeds planted last few Qs
• strongth growth over all lines, large customer segment is seeing more adoption
• more expansion from the large customers even with the year and doesn’t reflect DBNRR
• Teams are typically annual contracts
• Teams organic grower, and tailwind for NRR, natural expansion
• continuously releasing new products, will have new products all the time
• rate of team is adapting and outstanding, one of many components to drive growth
• Teams fits well with DDoS and WAF product, Magic Transit product is tip of the spear product
• Journey into Cloudflare can come in many different directions
• strong revenue growth across all verticals, nothing stood out
• One is getting interest from Enterprise first, and then pull back down to SMBs
• no competition in self-service pay as you go segment
• leads from One is from the larger end of the customer set
• zero trust network architecture is different way to of doing architecture
• Admired Shopify, a great customer

[WillO2028]

Some of my favorite of CC and a question:

“Turning to CloudflareWorkers, it’s incredibly exciting to see to have the platform is taking off. In Q3, more than 27,000 developers wrote and deployed their first Cloudflare worker, that’s up from 15,000 a year ago.”.

Calling out Fastly-
“In other words, the future of edge computing will be defined as much by intelligent edge storage as it is by computing. And while others are still working to launch their edge computing platforms, we have products like durable objects in market that are defining that future today.”.

What is this product?
“A fortune 500 industrial manufacturing company came to us to consolidate multiple vendors and products into a single unified platform. They replaced discrete network optimization, load balancing and bot management vendors with Cloudflare, in order to in a [indiscernible] have a single pane of glass to understand and control what’s happening on their network. They signed a $1.4 million annual contract in Q3.”

Sounds like a it could compete with?

Jason

[WillO2028]

Not my favorite to pur salt into the wounds of anyone. I lost as much as most on Fastly. But, Pre Earnings I was 17% NET, so .

Jason

[SaulR80683]

Thanks wpr101, that was an absolutely amazing summary of the conference call. We all really appreciate it.
Saul

[RoNerd]

Excellent summary. Thank you!

“these new customers did not result in material additional revenue in Q3”

This means they are sandbagging Q4 guidance.

[AThinkingFool]

I love poker. I even (fleetingly) considered it for a career once upon a time (Texas hold’em). It seems to me that there may be certain similarities between investing and poker. Ok, there is a big element of blind luck/gambling in poker of course, but in the end skill often wins out. You are making the most of what (limited) information you have available to make a decision on where to put your chips/money, and the better your skill, judgement and strategy, the better your chance of beating the house/market and other players.

So in poker, without being able to see other players’ cards, you are looking for ‘tells’ that might help you make a decision. A giveaway, like a shaky voice or freezing when someone is raising (the tell is that person is probably bluffing). Often it is the intangibles, a ‘feeling’, that gnaws at your intuition.

I try and keep my portfolio matched to my conviction at all times. Last week I was contemplating trimming Cloudfare, it was almost 15% of my portfolio and I was considering whether I had that level of conviction going into earnings. I had been recently been burned twice by Fastly with earnings calls, holding an outsized position going into Q3 earnings and ignoring a potential ‘tell’ when feeling ambiguity over Bixby’s evasive answer over whether or not TikTok had been baked into guidance.

I considered that NET’s share price had already rallied about 50% in the month before, it was extended, and a beat was probably priced in. I was leaning towards reducing my exposure to that slightly when I considered this twitter exchange between Muji and Matthew Prince (Cloudfare CEO):

On a thread about Fastly’s lowered Q3 guidance:

Muji, summarising: "Bottom line, I want hypergrowth while I wait for edge compute to take off. If it isn’t getting that, it is a sign to me they are moving too slowly. $NET is advancing their platform/TAM monthly it seems! $FSLY is taking its sweet time … which I think is costly.”

Matthew Prince: ”Daily."
….
Matthew Prince: ”Just getting started."

Full thread: https://twitter.com/eastdakota/status/1320965876623917056

Now I accept this might not seem like much, they are just two sentences, and that maybe we should not read too much into it. But let’s think about it. This is the Cloudfare CEO wading into a thread about its competitor, which has just issued lowered guidance and whose stock is over 30% down since, and making bullish comments about his own company’s prospects, only a week ahead of his own earnings. Would a CEO really do that if he thought there was a chance that his company’s own results a week or two later would also underwhelm the market? It seemed very unlikely. And so, for me, this was a tell.

I wouldn’t advise anyone making big investing decisions based on a couple of tweets and nothing else, but it certainly helped me decide whether or not to trim 1 or 2% ahead of earnings. Investing is a game of sorts, and what information you can gather is fundamental to the decisions you make. Management comments, their sense of confidence or bullishness - the intangibles - can perhaps help inform your own intuition and conviction levels accordingly.

You can sense that enthusiasm throughout Peloton and Cloudfare’s earnings calls, for example.

From Cloudfare’s Q3 earnings call, aside from what’s already been mentioned, what really jumped out at me:

Analyst: But when we think about workers, how do you think about the size of that market? I know, it’s a tough question. But when we think about alternatives there, when it comes to the speed of the Cloudflare network, it is quite unique. How do you think about just – ultimately, I know, it’s small today. But what is the monetization? What is the TAM opportunity there longer-term?

Matthew Prince:
We’ve really resisted, when we put together any TAM forecasts or anything else we’ve resisted. We’ve resisted kind of calling out what that is, because I think it’s tough to say. Maybe this is a little bit heretical. But, I actually think that if the only advantage of workers is it’s a little bit faster that the TAM is not that big. And while, I understand that there’s a lot of excitement around edge computing, and Gartner will throw out a really large number.

If you actually talk to developers, their priorities making something a little bit faster is sort of the last in their sort of hierarchy of needs. Whereas they have other things around ease of use, more affordability and reliability. The opportunity that I think is the biggest one, which I mentioned in the prepared remarks, is really around, how can we help companies with what is an increasingly regulatory compliance situation.

So, if you imagine in the future, that what the folks at TikTok are living through what Facebook is increasingly facing in Europe, that comes to every business that is operating on a global basis, where the data for their customers is required to be kept in market and process in market, then there really isn’t another platform on the market that can provide that solution without cobbling together a bunch of things. And if in the future, you’ve got 100 different laws in 100 different countries, then you need a network that spans 100 different countries. And I think that that’s the real opportunity for workers.

It’s early there. But when we look at our largest, most sophisticated customers, that’s where they’re saying, this is a real opportunity. This is where we want you to invest. And that’s why our team is investing in that area.

This strikes me as a CEO who is not trying to pull wool over our eyes. It would be easy for Prince to capitalise on the ‘excitement around edge computing’ and talk about how indefinitely big the TAM is for Cloudfare workers. But he doesn’t, and he expresses a desire to resist doing that. Instead, he repurposes the question to what he thinks the ‘real opportunity’ is, and how the company is evolving to meet it. The sense I get is that this is someone who is focused on his vision for the company and has a genuine, strong conviction about their prospects. My own conviction is only that much stronger after its Q3 report.