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
