Cloudflare’s fascinating Q1 2024 earnings

Let’s start with how they did versus my prior expectations:

  • Reported Fiscal Q1 2024 on 05/02/24.

  • Revenue expectation: $382M (5.5% QoQ, 31.6% YoY), assuming a 2.7% beat.
    —> $379M (4.4% QoQ, 30.5% YoY), a 1.5% beat.

  • Q2 new revenue guide: $401M (5% QoQ, 30% YoY) which I would interpret as $411M (7.7% QoQ, 33% YoY) expecting QoQ growth will re-accelerate.
    —> $394M (4.1% QoQ, 27.7% YoY), which I now interpret as $402M (6.1% QoQ, 30.3% YoY).

  • I would like to see NRR around 116%.
    —> It came in at 115%.

  • I would like to see total customer growth greater than 4% QoQ.
    —> We got 3.9% QoQ.

  • I would like to see large customer growth greater than 6% QoQ.
    —> We got 4.4% QoQ. Seems to be seasonal and maybe additionally damped due to their recent sales org changes (every change creates some initial, temporary inefficiencies).

  • I would like to see RPO grow more than 6% QoQ.
    —> It came in at 8% QoQ. I interpret that as customers to contract more for longer.

  • I would like to see operating income around $45M.
    —> We got $42.4M.

  • I would like to see a FCF margin greater than 7%
    —> Solid 9.4%.

  • Detailed prior thoughts: Ben’s Portfolio update end of February 2024

From the numbers-perspective, I thought this was an OK quarter - not great, but also not bad. Simply slightly softer than I had expected. I also think they had a fantastic, outstanding Q4 and so maybe it is not too surprising that Q1 was again regressing to the mean (just like the fighter pilot, who after an excellent maneuver rarely manages to repeat that, but instead typically regresses back to the mean).

I also thought this was a fascinating earnings call, especially the Q&A that not so much focussed on the last quarter’s numbers, but rather on the rest of the fiscal year. Analyst after analyst kept pressing them trying to understand their revenue guidance (their FY guide in particular).

First of all, keep in mind that Cloudflare’s average quarterly guidance beat was only 1.2% for the last 7 quarters. So it wouldn’t be crazy to take their quarterly guides at face-value.

Now the issue here that really confused several of the analysts, is that if you take their Q2 guide and combine it with their FY guide (which they just re-iterated, instead of raising it), it implies that YoY revenue growth will continue to decelerate, especially in the second half of the FY. I played through several scenarios where they beat their Q2 guide in-between 0 and 2%, but only meet their FY guide at the end of the year. If you do this you’ll find that come Q4 YoY revenue growth will have decelerated to 26% or less! And while Cloudflare’s revenue growth did indeed decelerate from 50% YoY in 2022 to 32% in 2023 it did actually stabilize in 2Q23 and stayed durable for three quarters at 32% until 1Q24. Why is this significant? Well, because revenue growth durability is king! So the narrative for durability changed twice since 2022 and including their current FY24 guide: From 2Q22 to 2Q23 the narrative was that of revenue growth deceleration. Then it changed in 3Q23 and became again a narrative of durability (at just above 30% YoY growth). And now, if you take their Q2 guide with or without a beat and their FY guide at face value, the narrative changes again and becomes one of revenue growth deceleration.

OK, fine, you might say, so going forward, if Cloudflare will not have the growth durability it had in the last 3 quarters it probably doesn’t deserve it’s premium (hence the after-hours reaction of the stock price). End of the story … But here is the catch that also threw off so many of the analysts during the call: And I am quoting Alexander Henderson here because I couldn’t have phrased it better:

So if nothing is really spooking you here, I’m still struggling with the guidance and the outlook for the back half of the year . You’ve given guidance that – or commentary that you’re seeing significant strengthening of your pipeline . You’re saying your duration stable . You’re seeing solid closure rates . You’re adding more sales capacity . You’re winning large customer deals at an accelerating rate. You’re spending more on hiring people, and productivity in your sales force is significantly improving . Yet your guidance implies with the first quarter beat and the second quarter are above the Street. The back half is much more conservative. So I guess the question is, is that a function of a specific weakness in a particular geography or due to political issues? Or is it just trying to feather in more opportunity for the sales organization to be realigned as Mark comes on and drives things? Because ultimately, it sounds like the mechanics imply an acceleration, not a deceleration .

And here is the reply from Matthew Prince:

Yeah. Alex, I’ll start and then Thomas can give a little bit more color. I would push back on your initial statement, which was that nothing spooks me. A lot spooks me right now. So just because just – and I want to make it clear. We are in a much more uncertain environment , and the signal that we’re seeing is that uncertainty is up . In addition to that, I think you’re correct that whenever you have a sales leadership change, there is risk that comes with it. And so there’s a bit of that. But the primary factor here is that as we look at the signals in the overall macro economy , it is – it feels like a much more – it feels like there’s much more reason to worry in Q1 than there was in Q4 . But that doesn’t mean that it was the same, “sound the alarm bells” that we were seeing back in Q1 of 2022.

So how should we interpret this response? Well, again, I couldn’t have said it better than Alexander Henderson did:

Great. So just essentially de-risked it. I appreciate it. Thanks.

If true, what that means is that they essentially set the bar as low as possible, which of course means that there is a lot of upside as the analyst pointed out listing all those tailwinds in his initial question.

For me, one other big take-way from the call was about AI. One of the questions I personally had going into the call was about how Cloudflare will monetize all the new AI narrative and tailwinds. I got a clear answer: They aren’t - right now. And while that fact will certainly get short-term investors to sell their shares, as someone investing for the long-term, I actually really like how they think about this revenue opportunity. It was nicely summarized by their CFO, in response to a somewhat teasing comment by analyst Tom Blakey who said “That’s great. Well, maybe we’ll look for you breaking out AI or gen AI revenue one of these days.”, to which Thomas Seifert replied by saying “As soon as it is the right thing to do. At the moment, I think we shouldn’t get tired, that the benefit in driving adoption is significantly more important than driving more revenue in the short term . This is why the efficiency is high. We see so many use cases from 2 million developers being on the platform. This far-sighted approach has served us well, and we’ll continue with it”.

Being at the beginning of a new and potentially huge S-curve, I think it makes perfect sense to first get as much traction with this new technology as possible, and then, once they have made everyone dependent on it, start monetizing it. Given Cloudflare’s incredible distributed edge-computing moat, that no other company in the world can match now and is unlikely to match anytime soon, I can totally see why they chose this strategy instead of trying to quickly monetize the new AI narrative.

-Ben

84 Likes

I sold my NET after the earnings pop last Q because I just could not understand the enthusiasm. The impression I get is that investors are charmed by Prince and his optimism, but the numbers don’t back up the story he tells. Rev growth was 32% last quarter, so not much different than this one, I guess I’m not seeing how Q4 was outstanding but Q1 is mixed, unless you’re looking at the price reaction. When I asked the board for its opinion, I thought Raylight had some pretty good responses: Help me understand this reaction to NET earnings - #15 by Raylight - basically the argument is that we won’t know until more time has passed (which by the way, isn’t that convenient for Prince?) because the revenue is suppose to be durable, instead of hypergrowth

There is another explanation (that I’m subscribing to more and more as I follow NET over the years) - they are not able to monetize these flashy new products they are announcing because not enough customers will pay for them over the alternatives out there and everything is just narrative. Think about all of the products and releases they’ve had over the years. Has that translated to hyper growth revenue, when compared to its SAAS peers like CRWD, ZS, etc.? At this point of revenue base, all of those companies were growing much faster. NET deserves to be rated lower with its peers, not at a premium, and its current price doesn’t leave a whole lot of upside.

36 Likes

I finally sold out after this earnings. I guess I’m just tired of waiting for the hype to actually result in performance. Whatever the reason, we just aren’t getting the growth that is supposed to happen. I guess that’s a lesson to me, a reminder to follow the numbers, not the hype.

20 Likes

This sums up my reason for exiting NET as well. The first example of this was the Teams product way back in 2020 (bad positioning IMO since MSFT had a similar-named product). It was a 6-months free product which then became paid. We received one quarter with a firm conversion figure, a second quarter saying “generally pleased”, and then never heard about it again. While I appreciate the gazillion or so developers somehow counted as bumping up against the outskirts of Workers every quarter, it sure would be nice to see an actual dollar trend at some point.

In the end, we’ve essentially never received any kind of material product breakout from Cloudflare despite all the pomp and circumstance when initially introduced. It is a big enough company now that numbers are more important than narrative, and in that respect the numbers have been just OK for a while now.

30 Likes

We were in a completely different environment (ZIRP/stimulus heavy) when those companies were at a similar revenue base than NET currently is. Growth has slowed everywhere and especially in the SaaS sector since the massive/historical increase in interest rates the past few years. It does not make sense to compare NET now to these companies a few years back. This is still not a good environment for these stocks, and it shows as the sector sentiment is terrible and a lot of these stocks are trading near all time low historical valuations.

Discl. Long NET
Bnh

30 Likes

Ben, Wow! That was the best analysis I’ve read in Avery long time, no disrespect to anyone else…I generally keep notes and feebly try to focus on the future of each company. You really brought the present into the future sooo masterfully , IMO.

I also like in the Call when Prince said out loud who will benefit next in reaping AI treasure, “those with more usage based revenue streams”, go Snowflake!

I also think it’s worth noting that Cloudflare announced in the slide deck that they are increasing CapEx beyond their usual 6-8% by an additional 50%, this year.

In response to the other comments here, bhn91 already wrote out my thoughts better than I could have.

Saul, thanks again for this excellent forum!

Lots of Love,

Jason

28 Likes

I exited as well, after already reducing earlier. I feel the same way. Launching a lot of products without a well defined opportunity was innovation for the sake of innovation. I lost patience.

8 Likes

Great discussion so far!

I am completely out after this report, and I’ve been invested since the IPO. I’ve lost my patience with the CEO Prince. This was a terrible report as it basically confirms a number of bear cases,

  • They are priced improperly - Prince was talking about how much their are giving away. Look at this passage from the call,

We’ve been running the Athenian Project since 2016, which provides our services at no cost to anyone who is helping administer an election anywhere in the United States.

We’ve done similar things around the rest of the world. We’ve worked with the White House on a number of initiatives, including Project Cybersafe Schools in order to protect the most vulnerable schools and communities across the country. And that is all the foundation which I think has built an incredible amount of trust and an incredible amount of goodwill in the federal space. And so today, as the world is getting scarier and scarier…

This business is starting to sound like it’s a charity. Why is this much free software being given away?

The basically announced in the call they are not a “strategic vendor” to any major financial services institutions,

Almost all the financial – major financial institutions in the United States use us for something. But I was to say that we’re aren’t a strategic vendor for many of them yet.

  • Their changes to the sales org are completely ineffective. Another revealing passage from the call talking about the new Sales lead,

I think in Mark’s comments, he said that our product is great, but our ability to really sell to large enterprises to understand their needs and drive more of a strategic relationship is something that we are continuing to work on. That is – I think the last 18 months were all about us sort of cleaning up the sales organization. And now with Mark on board, it’s all about now how do we get the real professionals on board, where we can become that strategic vendor for literally every large company in the world.

It has taken 18 months to clean up the sales organization? We were told on previous reports that it was underperforming sales people.

  • Cyber security threats were supposed to be helping Cloudflare, on this call Prince talked about macro concerns extensively such as an increase in war and hackers

Part of the thesis around Cloudflare was these types of events would benefit Cloudflare by stopping more threats. However, the issue is their pricing is a standard flat rate, so increasing threats just puts more pressure on their OpEx and they are not honest with investors about this.

Prince wants it both ways, threats should benefit Cloudflare, but this simultaneously is the reason given for why they are not raising guidance.

  • They guided to 26% growth for the 3rd and 4th quarters. It seemed to me like the CEO Price was trying to run out the clock on even discussing this. As @SlowAndFast called out above it was one of the very last questions on what was a long call. The analyst called them out and said your story is incredible, but these numbers don’t line up.

The first question on the Q&A was about SASE/Zero Trust, and CEO Prince explained the product using a ton of phrases like “for those who are not familiar”

On the next question he is asked about Workers AI, and I was dumbfounded that he was explaining the product longer than I’ve heard any CEO go off on. He literally starting out by saying, “You can stop me if I get boring”. He delves off into the completely irrelevant for an earnings call,

And so my silly example of this is that if you have an AI that’s responding back to a British user and describing what something looks like versus a U.S. user, in the U.K., you want color to be spelled C-O-L-O-U-R. In the U.S., you wanted to be sell C-O-L-O-R, because we can regionally tune that. We can actually correspond all of the local and regional differences all around the world. That’s something that you don’t get anywhere else.

So the way Cloudflare’s AI program is a revolution is that it can know whether to localize for color vs colour?

Even the analyst said “that was an incredibly comprehensive answer”.

These types of answers really are meant for something like their tech day conferences, this type of rambling on about the Workers product has no place in a earnings call.

CEO Prince brought up multiple times throughout the call, the enormous amount of applicants to Cloudflare. Yet there are hints given about the ineffectiveness of the sales force. An analyst asked, did you factor in conservatism to the guidance because of your go to market issues.

CFO Seifert replied,

As you know, conservative is not a word that we use. When we talk about giving guidance, we tend to be thoughtful and prudent about it. And of course, it’s a balance of the tailwinds we see, but also the uncertainty that is out there and every major go-to-market transformation. In our case, it’s actually more an evolution. There is risk, and it’s reflected in our guidance, too.

They can’t just come clean and say this sales transformation is not going as planned. They already had a scapegoat on previous calls of underperforming sales reps. Now to admit they made some mistakes either in hiring of Mark Anderson or in reorganization?

I’ve always thought that ZScaler had a better sales organization but an inferior product, and part of my investing thesis was that if Cloudflare could improve their sales funnel they could outperform. This report proves the product they are selling has systemic problems with sales. The words they used themselves, CFO Seifert,

But without any doubt this business is becoming more complex. And this is then also reflected in some more noise in – from a quarter-to-quarter perspective. But overall, we are really happy with the performance in the quarter.

And all these revelations are after what was a stellar Q4. The only conclusion I can come to is that their sales department is underperforming what it was doing before they made any changes!

Lastly, one more passage which was frustrating to read, CEO Prince,

And so our SASE platform is significantly better and faster than anyone else. And so anyone who’s listening to this if you’re frustrated with the VPN that you have to log into, if you’re frustrated with whatever service it’s providing that, even if it’s a new cloud service, if it’s slowing you down and making it harder for you to do work, give us a call at Cloudflare because we can actually improve that and make it significantly better.

Maybe the most revealing tell of all is for a CEO to ask for orders on a call with investors.

To wrap up there was some numbers that bothered me as well,

  • Operating income this Q is 42M, but the full year guide is for 160-164M, implying worse future quarters
  • Diluted net income of 0.16 this Q, but full year guide is 0.60-0.61, again implying a slow down in earnings

This was a very disappointing earnings report. The CEO and CFO have not been good stewards of investor capital, favoring doing good in the world, and giving away free product over running a business.

33 Likes

These numbers are wrong. From yesterdays earnings PR:

For the full year fiscal 2024, we expect:
• Total revenue of $1,648.0 to $1,652.0 million
• Non-GAAP income from operations of $160.0 to $164.0 million
• Non-GAAP net income per share of $0.60 to $0.61, utilizing weighted average common shares outstanding of approximately 361 million

So Cloudflare reiterated their FY revenue guidance. Raised the operating income guidance by 3.8%. Raised the EPS guidance by 3.4% and you are upset about this enough to sell out when the valuation has dropped 20% overnight? There is nothing thesis changing in this report. Just a bunch of emotions flying around (as usual) on a volatile stock around earnings reports. The stock was up to $116(!!) on the exact same FY revenue guidance and lower operating/EPS guidance 3 months ago.

Edit:
After Q1’23 report Cloudflare FY guidance-
Revenue: $1,280m-$1,284m
Operating Income: $73-$77m
EPS (non-GAAP): $0.34-0.35

Final FY23 result (% + over Q1 guidance):
Revenue: $1,297m (+1.1%)
Operating Income: $122m (+63%)
EPS (non-GAAP): $0.49 (+42%)

So why are you taking their FY operating income and EPS guidance after Q1 report seriously?

Bnh

22 Likes

This is was the direct question from an analyst on the call (bolding mine) where Prince responded by going into detail on some Workers AI use cases. I am confused how you want him to answer the question?

Andrew Nowinski

Great. Thanks very much for taking the question, and congrats on a nice quarter. I wanted to start with a question on Workers AI, because I think it’s one of the most exciting products you have in your portfolio. You mentioned Workers AI and developers are using your platform to build some new AI applications. Can you just give us some examples of maybe what those apps are? And why they chose Workers AI to build on among the many other alternatives out there?

I think we are/were invested in Cloudflare for different reasons as this was one of the most interesting/informative parts of the call for me.

Bnh

9 Likes

I was always wary of the narratives vs facts side of the NET case. Although I exited at around these prices over a year ago and I reconsidered whether I should re-enter, the answer for me is a resounding “nope:”

–The current AI move seems to be all about mass and top quality chips which presumably kicks NET out of the “fourth cloud” narrative.
–For three years now, the NET valuation is a mystery to ME.
–Prince has always sounded like a car salesman to ME.

When a company like META at 1T of market cap is growing at practically the same rate as NET while making massive investments to remain a dominant force in an AI world all at half the valuation, it is hard for me to keep NET on my watch list.

But I still read and follow since to ME this feels like an AMZN or Enron open question, which is not a vibe I get from any other SaaS.

It is certainly an ongoing fascinating story. Best of luck to the shareholders.

12 Likes

You were correct, the numbers I posted were slightly off, and I updated my previous post. Still the numbers imply the operating income and net income going down over the course of the year, or not even meeting the current run-rate of Q1.

42M * 4 = 168M, and full year guide is for 160-164
0.16 * 4 = 0.64/share and full year guide is for 0.60 to 0.61

There is nothing thesis changing in this report.

As I highlighted above, this report revealed:

  • The changes to the sales org are not working and not effective
  • They are not a “strategic partner” to large financial firms
  • They’ve been saying over the years more threats help their business, but then say the uncertain macro is the reason for keeping guidance the same
  • They don’t want to honestly answer the question why the narrative they are telling about becoming a dominant tech company is not lining up with their financials
  • Despite their AI Workers platform gaining market share, it still does not contribute meaningfully to revenue
  • Their revenue cannot keep growth with hypers-scalers because they don’t charge usage based fees on most of their products

This is was the direct question from an analyst on the call (bolding mine) where Prince responded by going into detail on some Workers AI use cases. I am confused how you want him to answer the question?

Look how he responded last quarter to the same question. He brought up some interesting use case with users shopping around for GPU usage. He discussed new and unexpected use cases they had not for-seen. This quarter he is giving “silly” examples as he put it.

The analysts on this call are already familiar with the products, it’s mostly the same firms covering Cloudflare since the IPO.

The answers he have given have never been this long winded. This conference call ran over too, and it was only the last two questions where the analysts asked the real questions - why don’t your numbers line up to the narrative you’ve been telling us, and does your guidance bake in the underperforming sales team.

I know a lot of people on the board found it off putting about a year ago when Prince blamed the underperforming sales people, but now it’s clear this organization has a major problem with sales if their product has become “more complex”, and is in the process of a “18-month” overhaul. Why was the sales team so poorly put together in the first place to need a 18-month overhaul?

7 Likes

What are you using to judge the sales org overhaul is not working? Them not raising FY revenue guidance? Mark Anderson started 3 months ago. It is definitely not firing on all cylinders and I wouldn’t label it as a success, but it is too early to say the changes “are not effective”. CFO on the call:

We are pleased with our execution during the first quarter. Sales productivity improved year-over-year again this quarter, sales cycles were similar to last quarter, and our new pipeline attainment exceeded our expectations.

I don’t really understand how Prince saying almost every financial institution uses Cloudflare for something, but they aren’t a strategic vendor for any of them yet is thesis breaking.

The Cybersecurity sector is having having a bunch of issues right now. FTNT also reported last night and the market was obviously disappointed with their results with their billings miss. PANW started having issues last quarter & ZS billings continue to slow down still (mid 20%'s). The cybersecurity weakness is not specific to NET.

I try to follow Quarterly RepVue Cloud Sales index trends and Cybersecurity was the weakest sector they track. See RepVue Cloud Sales Index | Q1 2024

NET & FTNT are the first of the Cybersecurity group to report, but it doesn’t feel like there will be many stellar Q1 reports right now.

What has changed here that is thesis breaking for you? They have made it clear for several quarters that they will not be monetizing the WorkersAI platform for awhile and are focusing on adoption and getting as many developers in the ecosystem as possible. They have reached 2 million developers using it. What made you think they would start monetizing this this quarter??

Bnh

14 Likes

I’ve already highlighted two specific places which indicate it’s not working well.

The first being where he says this is an 18 month “about us sort of cleaning up the sales organization”, and then says “it’s all about how do we get the real professionals on board”. On previous calls we were told the issue was there was under-performing sales reps and accountability was not being tracked well. Nothing was ever mentioned about needing to overhaul the entire sales organization.

Also, why are the “real professionals” not on board this company already. Prince is talking on many calls about the very high bar they have for hiring with how many applicants they get and the tiny amount of hires they actually make, and what a compelling place Cloudflare is to work. So my question is why were the “real professionals” not onboard already if they have such rigorous hiring standards.

The second specific spot the sales weakness in question and answer,

You’re winning large customer deals at an accelerating rate. You’re spending more on hiring people and productivity. And your sales force is significantly improving. Yet your guidance implies with the first quarter beat and the second quarter are above the Street, the back half is much more conservative. So I guess the question is, is that a function of specific weakness in a particular geography or due to political issues?

Or is it just trying to feather in more opportunity for the sales organization to be realigned as Mark comes on and drives things because ultimately, it sounds like the mechanics imply an acceleration not a deceleration.

CEO Prince answers,

Yes. Alex, I’ll start and then Thomas can give a little bit more color. I would push back on your initial statement, which was that nothing spooks me. A lot spooks me right now. So just because just – and I want to make it clear, we are in a much more uncertain environment and the signal that we’re seeing is that uncertainty is up.

In addition to that, I think you’re correct that whenever you have a sales leadership change, there is risk that comes with it. And so there’s a bit of that.

So when he is saying “there’s a bit of that”, I’m assuming he means the sales leadership change is a risk which is factoring in to the conservative guidance.


  1. I don’t really understand how Prince saying almost every financial institution uses Cloudflare for something, but they aren’t a strategic vendor for any of them yet is thesis breaking.

This is different than the story they’ve been telling which is how critical they are for enterprise level security. Cloudflare is already a fairly mature business at this point, they aren’t startup anymore. I’m questioning why the major financial institutions do not view them as a strategic partner.

I’m not liking this changing narrative to our product has become more “complex”. I also don’t understand what has become more complex? The main products are DNS/WAF, Zero Trust SASE, and Workers AI. I’m assuming the product they are saying is more complex is Zero Trust, but why has Zero Trust gotten harder to sell? They’ve mentioned they are higher in the Forrester and Gartner rankings now, and they have the right sales people in place now.

  1. The Cybersecurity sector is having having a bunch of issues right now.

But AI is red hot right now and they are saying they have the best product on the market for developing AI applications. CFO Seifert last call said he cannot think of an AI company which is not using Cloudflare. Shouldn’t these AI companies be driving revenue acceleration?

They have made it clear for several quarters that they will not be monetizing the WorkersAI platform for awhile and are focusing on adoption and getting as many developers in the ecosystem as possible.

Have you been following what they have been saying about workers over the last year?

Here’s from Q1 of 2023, one year ago,

Traction among developers continues to be strong. We now have 4.92 million Workers applications running on our platform, up 146% over the last 6 months. 33,000 paying customers have activated R2 and are storing more than 7 petabytes of data, up 25% quarter-over-quarter. AI companies, large and small, continue to build on Cloudflare at a breakneck pace. When we ask them why, they cite our neutral position, rapid innovation and modern, nimble development environment.

One last month called us “The first cloud infrastructure company built for the age of AI.” I like the ring of that.

And here’s what they said about Workers in Q2 of 2023, nine months ago,

Our developer platform, Cloudflare Workers, continues its explosive growth. We reached 10 million active workers applications in Q2, up 250% since December and 490% year-over-year. R2 continues to grow and now stores over 13 petabytes of customer data, up 85% quarter-over-quarter. We have 44,000 distinct paying customers with R2 subscriptions, and brand-name customers are beginning to adopt it as their primary object storage solution.

They’ve been talking about these huge qoq and yoy numbers for over a year now, and a few quarters ago the CFO said there was a noticeable tick up in revenue from the Workers, but not enough to break out yet.

However, in this quarter we are no longer getting apples to apples metrics about the number of “Workers applications”, we are getting total developers. Additionally, where are the metrics for R2? There was no significant mention of R2 or any questions about R2, which they used to emphasize on calls. They used to emphasize metrics on Workers but that has stopped, leading me to believe the numbers are not as compelling as they used to be.

I’m frustrated with this report because I’ve followed and been invested in this company since the IPO and believe in their technology and roadmap. However, I believe this business has been mismanaged with it’s pricing by providing way too many services cheaply or even for free to generate good-will.

As others pointed out above, this company was said to have the most predictable revenue of any company and for awhile they almost continuously had 50% revenue growth into the foreseeable future. That 50% number quickly went to 40%, then 30%, and now is at 26%.

I’m seeing Prince come up with scapegoats for the results, the sales team, macro, product is too “complex”, when really it’s the business model that he is responsible for as CEO to create.

As Saul has said before, we should be ruthless allocators of capital. While I still like this story, I don’t see this company as a company which puts profitability as any sort of priority, and no longer see this company as the best place for my money right now.

37 Likes

My perspective on Cloudflare with some broader thoughts on AI:

So my assessment aligns with yours, @SlowAndFast.

Q1 revenue came in slightly below my expectations, and the Q2 guidance was also a bit underwhelming. The customers spending $100,000 or more were okay, though it could have been a bit stronger. On the other hand, they raised the FY operating income guide, EPS guide, and RPO was really strong again, so an 8% quarter-over-quarter increase after already delivering so strongly last quarter.

That definitely instills confidence; a lot of that is driven by the public sector. What’s also noticeable is that the current RPO has decreased, I believe it was previously around 74% or 75% of total RPO, now it’s only 70%, so it seems they’ve entered into some very long contracts, which may not directly reflect in revenue, indicating durable growth. Total paying customers continue to accelerate, albeit slowly, and the commentary on sales cycles and such has also improved.

The problem lies in the full-year guide, the market wanted more because Cloudflare is always priced for perfection.

I think it’s partly because they’ve consistently delivered so strongly, deeply embedded in the infrastructure landscape with a compelling narrative.

So it’s a combination of fundamentals and the story stock aspect; you can see how emotions skyrocket with these types of companies. A lot of it also ties into expectations around this whole AI theme— which are basically large language models, without real intelligence per se; they don’t think on their own.

As AI has become more visible over the past year, there’s this perception, the market or people expect this AI theme to manifest everywhere. It’s my personal theory, and I might be wrong, but I believe, as I had also noted with Nvidia earlier this year, that AI is in a certain hype cycle. Of course, AI is here and will bring about significant changes, but people are expecting too much too quickly.

There’s this saying, ‘We tend to overestimate the effect of a technology in the short run and underestimate the effect in the long run.’

And I believe that applies to the AI theme now, and personally, I also think it will manifest faster than anticipated, perhaps not this quarter, but we might be closer to that point than assumed. And there’s a lot tied up in such stocks.

So, Cloudflare was already trading at a forward EV/S of 18 or so. People expect a lot, and they must always deliver, and the problem was that the full-year guide remained unchanged. And if the full-year guide remains the same next quarter, it might take a hit again.

Personally, I don’t think Cloudflare has any significant problems; I believethey’re on track. Whether they continue to meet the market’s expectations, I’m not entirely sure.

Their management seems honest; when they say they don’t want any surprises with their guides, I interpret that as both an upside and a downside surprise, meaning they want to ensure they don’t have to revise down like they did two years ago or last year.

I don’t remember exactly where they had to revise the guide downward, but they want to ensure they don’t have to do that again. So, I tend to believe they’ll raise the guide next quarter if the macro doesn’t worsen, but that’s also the short-term risk.

Because, I believe the management is honest; they see unclear signs looking forward, and we should take their guidance seriously. Not interpret it as ‘they always guide too low’ and they want to boast afterwards. Yes, that’s part of the game, but I believe we should still take it seriously if they don’t raise.

It simply means, that they honestly don’t see clearly where things are heading, and that’s a certain risk, short and mid-term. Long-term, I believe, Cloudflare is on track, but the longer we look long-term, the more uncertain investments become because a lot can happen, and the market will, of course, price that in again.

So, will Cloudflare be one of the big techs in five or ten years? It’s possible, but not guaranteed.

And with the valuation that Cloudflare, possibly rightfully, has, there’s a certain risk whether you’ll achieve the return you’d like in the long term with this company.

And regarding the AI theme again, you can see from what people write on the internet, etc., how surprised and critical they are about how ‘untruthful’ management is because AI doesn’t manifest directly in these companies. It shows how short-sighted many are and how much they expect in the short term, when it will probably take much longer to manifest. Nvidia is, I believe, an edge case; they were at the right place at the right time and capitalized on the demand that is probably still there.

The hyperscalers are the first to openly use it, and for the rest of the world, the other remaining companies in other layers, it will take time until it trickles down and applications are developed, which also scale up and so on. And that’s why I believe investing–or trying too hard to invest–in “AI” might end up making more people poor than rich.

37 Likes

In the last few questions of the call, Prince, when pressed on guidance, paraphrasing Prince:

  1. Hyperscalars are mostly usage and therefore, they will see a quicker acceleration when things pick up and that’s why they are showing re-acceleration and we are not.
    We are “mostly subscription” and we will thus see the acceleration later than Hyperscalars

  2. We are seeing warning signs that the economy is weakening and we are uniquely alone in this world and able to see this because of the position we occupy in the interwebz. He termed this “crystal ball”. So rather than re-accelerate after the Hyperscalars, we will instead miss that completely?

I sold out of NET back when he threw the sales team under the bus and I outlined then that I thought there might be bigger problems being buried there. Now I’m starting to really wonder about his leadership. Last Q he made it sound like the Sales team was fixed and he went on about how bad it was and he didn’t realize it before.

In the end, I think they will continue along their path (follow the numbers). Good solid results but the numbers do not justify this valuation.

19 Likes

I believe that the primary reason for the lagging uptake in what Cloudflare is selling is due to timing, which of course no one has a grip on. And confirmed in the Cloudflare Q&A, regarding revenue growth associated with AI, going first to Data Center Acceleration then Software Venders with consumption based business models and only then Independent Sofware Vendors with subscription based business models.

Jensen Huang, CEO Nvidia, at GTC (In parentheses is me)
ISVs (Independent Software Vendors:eg.Snowflake, Cloudflare) are “sitting on a gold mine, as they leverage data/expertise to launch specialized copilots”.

Due to the doubts expressed by many here I respect in this thread and specifically by the following exchange during Cloudflare’s Q&A, I argue with this assumption after these quotes, here.

Alex Henderson is probably the best respected cyber-security analyst out there-he has been at Needham for a very long time, Bert Hochfeld.

Alex Henderson So, if nothing is really spooking you here, I’m still struggling with the guidance and the outlook for the back half of the year. You’ve given guidance that — or commentary that you’re seeing significant strengthening of your pipeline, you’re seeing your durations stable, you’re seeing solid closure rates, you’re adding more sales capacity, you’re winning large customer deals at an accelerating rate, you’re spending more on hiring people and productivity in your sales force is significantly improving, yet your guidance implies with the first quarter beat and the second quarter above the Street, the back half is much more conservative. So, I guess the question is, is that a function of a specific weakness in a particular geography or due to political issues? Or is it just trying to feather in more opportunity for the sales organization to be realigned as Mark comes on and drives things? Because ultimately, it sounds like the mechanics imply an acceleration, not a deceleration.
Matthew Prince
Yeah. Alex, so I’ll start and then Thomas can give a little bit more color. I would push back on your initial statement which was that nothing spooks me. A lot spooks me right now. So just because — and I want to make it clear that we are in a much more uncertain environment, and the signal that we’re seeing is that uncertainty is up. In addition to that, I think you’re correct that whenever you have a sales leadership change, there is risk that comes with it. And so, there’s a bit of that. But the primary factor here is that as we look at the signals in the overall macro economy, it feels like a much more — it feels like there’s much more reason to worry in Q1 than there was in Q4. But that doesn’t mean that it was the same just sound the alarm bells that we were seeing back in Q1 of 2022.

Prince says, “a lot spooks me” and “we are in a much more uncertain environment”. He later says that the back half of the year is being guided as being “much more conservative”, “primarily” due to “the overall macro-economy”.

I’m thinking, likely too paranoid, that the reason I sold out of all security names, in my portfolio, may be the reason Prince says, “…a lot spooks me”. This reason has to due with the fact that Nvidia has added in Zero-Trust to every Accelerated compute Instance in the Data Center. And I don’t know what that’ll mean going forward.

I don’t have a lot of detail on that. I did post here in Zscaler thread here…” NVIDIA has developed its own Zero Trust platform, which combines three technologies: NVIDIA BlueField DPUs, NVIDIA DOCA, and the NVIDIA Morpheus cybersecurity AI framework. This platform is designed to bring the power of accelerated computing and deep learning to continuously monitor and detect threats, and isolates applications from infrastructure to limit lateral breaches, at speeds up to 600x faster than servers without NVIDIA acceleration. This infrastructure aims to keep users and data safe, while maintaining a seamless user experience. The NVIDIA Zero Trust platform is a result of NVIDIA’s efforts to enhance security in data centers by leveraging its expertise in accelerated computing and AI technologies.

How will this change purchasing decisions by the Enterprises currently pay Cloudflare for Zero-Trust needs?

Too many unknowns here, for me. If I were to completely sell out of Cloudflare, a holding of mine for more than 4 years, It would be due to my further consolidating around my highest convince positions, in another defensive move due to the phase change disruption occurring around AI these last 18 months.

Presently I continue to own a ~4% position in Cloudflare, due to the present numbers being good enough and I like the above expression of humility by Mathew Prince, CEO of Cloudflare.

I have never sat on the fence, between buying and selling, as much as I am now regarding Cloudflare (I consider holding equivalent to buying, as Saul says, “If you wouldn’t buy at this price why would you hold unless it’s due purely to allocation, …as allocation relates to conviction level in a company not to share price.”).

Because I have learned here not to concern myself with the Macro-Economy and how it may effect a companies revenues…. I’m asking again in this thread for any information regarding the effect Nvidia may have on the sales of present Zero-Trust providers, given that Nvidia has already moved substantially into the Zero-Trust market. Any assist in this will be greatly appreciated.

Long Nvidia, Tesla and Snowflake.

Best,

Jason

21 Likes

My understanding is that Nvidia’s zero trust product is for hardware only and does not compete with Cloudflare/ZScaler for Zero Trust login products. It’s confusing because they are both using the same term “zero trust”.

This answer comes from Perplexity AI but links to some sources,

Cloudflare and NVIDIA both offer zero trust security solutions, but their approaches and product offerings differ significantly, catering to different aspects of network and data security.

Cloudflare’s Zero Trust SASE Product

Cloudflare’s approach to zero trust security is integrated within its Secure Access Service Edge (SASE) platform, known as Cloudflare One. This platform combines various security functions such as Zero Trust Network Access (ZTNA), a method that denies access by default and only grants access to specific applications based on the user’s authenticated identity. Cloudflare One is a cloud-based solution that emphasizes flexible access, security from a service edge, and integration of security directly into a global network infrastructure. It aims to provide comprehensive security controls without the need for traditional on-premise solutions, focusing heavily on secure access and data protection across the network.

NVIDIA’s Zero Trust Product

NVIDIA’s zero trust solution revolves around its hardware and AI/ML capabilities, particularly through the use of NVIDIA BlueField Data Processing Units (DPUs) and the NVIDIA Morpheus cybersecurity AI framework. NVIDIA’s approach is to offload and accelerate security tasks traditionally handled by CPUs to their DPUs, enhancing performance and security. The Morpheus framework utilizes AI to analyze network telemetry data in real-time, identifying and responding to threats and anomalies. This setup aims to reduce user friction by minimizing the need for continuous re-authentication and enhancing the detection capabilities through advanced AI analytics.

Comparison and Competition

While both companies offer zero trust security solutions, they target different components of network and data security:

  • Cloudflare focuses on a cloud-centric model that integrates networking and security into a single platform, suitable for businesses looking for a unified approach to secure their internet-facing services and internal applications.
  • NVIDIA emphasizes a hardware-accelerated security approach, suitable for environments that require high-performance computing and real-time AI analytics to secure data centers and enterprise networks.

Given these differences, Cloudflare and NVIDIA are not direct competitors in the zero trust space. Instead, they provide complementary solutions that could potentially be used together in a layered security architecture. Cloudflare offers a more traditional SASE cloud service, while NVIDIA provides a unique blend of hardware acceleration and AI-driven security, each addressing different needs and scenarios in the broader cybersecurity landscape.

Here are some links if you are looking to dive deeper on these,

Nvidia

Cloudflare

16 Likes

Great discussion here. It has forced me to really look at the company in a new light and perspective.

Like others here, I have also owned Cloudflare for many years. I have been a pretty strong believer in the company and expected them to grow for years to come. In my opinion, there are clearly chinks in the armor and I am starting to question this belief.

There is a lot of gold in this thread which aligns with how I am starting to think about things such as

These quotes summarize how I am starting to feel about Cloudflare. Ultimately, rubber has to meet the road eventually and Cloudflare seems to be piling one excuse on top of another. As the posters above point out, the narrative is deviating from the numbers.

My biggest complaint this quarter is the fact that leadership decided to point to the uncertainty with the macro environment for not raising the full year guide. This feels like a bit of BS to me. A year ago I would have had no issues with this statement but it feels out of place today.

For example, the word macro was not mentioned once during either the Google or Microsoft earnings calls. Cloudflare claims they have a good sense for the macro environment since they are so ingrained with the internet but I would argue these trillion dollar businesses probably have their finger on the pulse of the economy a bit better and they don’t seem to have any issues with the environment.

In summary, it feels like I am taking off the rose colored glasses and looking at Cloudflare in a new light. I used to give the CEO Prince the benefit of the doubt but the cars salesman comment is starting to feel more accurate given all the talk and not so much walk.

One other interesting tidbit with my Cloudflare allocation - I have not added to my position since late 2022. Meanwhile, I have added to nearly every other stock in my portfolio within the last year as I like to add when I see things going in the right direction or what I see as a good price. Point being, I haven’t felt that way about Cloudflare in some time and have reduced the position greatly over the last couple years.

I expect to further reduce my stake as I am questioning just how dominant this company will become. If they can’t grow meaningfully at this scale with all the new additions of the AI tailwinds, what does that foretell for the future?

Rex

P.S. Management has also been real quiet about their goal of achieving a $5B run rate by late 2027. I think we can throw that out of the window…

30 Likes

First of all, I was hoping to get some engagement in this thread and I was not disappointed. So thank you all for sharing your perspectives!

I wanted to address one specific criticism that kept coming up. I’d summarize it as a criticism about how Cloudflare’s leadership is running their business and that there might be a castle in the air narrative that’s not backed up by the numbers.

First, let me point out that this is not the first time the board has criticized Cloudflare for “just wanting to make the internet a better place”. Just a few years ago Cloudflare’s management was criticized by some for “never wanting to make a profit” (that was when they were still unprofitable). Looking at today’s numbers, that criticism was clearly not justified. And yet, here we are again, with very similar arguments. Arguments that the narrative is deviating from the numbers. Well, the good news is, why argue if we can look at the numbers?

As @stocknovice said:

I certainly agree with the first part of that sentence and everyone should make up their minds about the second part. To help us do just that, and since Cloudflare’s willingness to make profits is questioned here, let’s compare the numbers to some of the world’s best companies in the data and/or cybersecurity business:

Let’s start with operating income and operating margins of Cloudflare, Crowdstrike, Datadog, Zscaler and Snowflake as a function of their corresponding quarterly revenues:

Judging from that, I would argue that Cloudflare is on par with Crowdstrike, which by itself is already quite an amazing feat. Next, let’s have a look at net income:

At it’s current revenue, Cloudflare has already overtaken Crowdstrike, Zscaler and Snowflake.

Finally, let’s have a look at free cash flow, and I am plotting TTM (trailing-twelve-months) here because it is fluctuating much more QoQ than the other two profitability metrics:

Now, here Cloudflare is clearly the laggard. But I think there is a good reason for this:

The way Cloudflare “pays” for this advantage is through purchases of property and equipment which is the main line-item of which net cash provided by operating activities is reduced by, to arrive at free cash flow. In case you wonder how far Cloudflare’s FCF margin might go, I can’t tell for sure, but management’s long-term model says they should exceed 25% FCF margin. I think the narrative here is that all those initial Capex dollars will eventually pay off. Again, we don’t need to guess here, because the numbers tell a clear story:

Here I am showing you TTM FCF as a function of TTM network Capex. Remember the time when critics questioned Cloudflare’s ability to increase FCF without increasing network Capex? Well, that was during the what I call “Initial Investment Phase”, highlighted above. As you can see, once the hardware was installed it just needed to be sustained at a fixed cost level, while free cash flow started sky-rocketing. And in the last two quarters TTM Capex even dropped while TTM FCF kept going up.

Now, if this doesn’t look like a money-printing machine to you, then I don’t know what will…

Just think about this for a second. Cloudflare has proven, that they are able to scale FCF without having to increase their infrastructure investments! That means they can literally print money and given the efficiency I see here I don’t think 25% FCF margin is the limit.

So, what comes next? Well, management told us, in order to seize the opportunity of future AI revenue and AI FCF, they are going to increase their network Capex spend to 10-12% of revenue in FY24 - I guess mainly in order to increase the computation power to maximize AI model inference capabilities in their one-of-a-kind worldwide distributed edge network. How this will turn out is anyone’s guess, but the fact that they have shown their business model can not only work, but do so with incredibly high efficiency gives me quite a bit of confidence in their business model.

-Ben

60 Likes