Cloudflare - Zero Trust related deals

Investment Analysis Clubs Saul’s Investing Discussions
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Continuing the discussion from WSM's portfolio 30 Apr 2023:

Using this as an entry point. I don’t find Cloudflare to be more speculative than many other companies discussed here. I’m also quite confident that their innovation is moving the needle, and significantly so. Quite a stark contrast, so what gives?

I’m inclined to believe that one’s perception of Cloudflare will depend a lot on what information is being looked at. Since I happen to have a table lying around, I’d like to share one piece of information I’m tracking, that I hope someone might find useful.

The following is compiled from the last seven quarters’ earnings calls. I’ve gone through the calls and included deals where “Zero Trust” is explicitly mentioned, implied by context, or where I’ve been able to infer by knowledge or cross-referencing with other bits and pieces of information. Note that “Zero Trust” is a concept rather than a product/service, but I’m using it here for simplicity.

The table was originally meant to be part of a reply regarding the “Descaler program” - looking at traction (or lack of traction). As such, “ZT” denotes a reasonable mapping to a product offered by a competitor like e.g. ZScaler.

To be clear: This table is not about “Act 2 + 3” vs “Act 1”.

Seats
        Q3 2021 (transcript)
F500 pharmaceutical company $600k expansion deal ZT. Total contract now $2m. “expanded their use of our Cloudflare One platform”. “a competitive deal and our unified approach beat out all other Zero Trust vendors with their narrow point solutions”. (ZT = point solution.)
F500 manufacturing company $500k 2y contract Unknown. “adopted Cloudflare One to protect its 50,000 employees”.
Large European software company $600k 3y deal ZT. “Evaluating Cloudflare versus other leading Zero Trust solutions, …”
        Q4 2021 (transcript)
Prominent social network >$1m annually ZT. “chose Cloudflare One as their Zero Trust solution”. (Note: mentioned in Q3 call)
Global F500 telecom company $1m annually >100k ZT. Likely this company.
F500 media company $250k annually >10k ZT. “was a competitive deal …”
F500 financial services company $900k 3y expansion deal Bundling. ACV now up to over $1.5m. “They described it as ‘future proof’. It’s an example of us bundling our platform…”
F1000 shipping and logistics company ? expansion deal Bundling. More than doubles 3y contract value to $3m. “…single vendor they could turn to deliver the future of their corporate network”.
        Q1 2022 (transcript)
F1000 trucking company $385k 2y deal 7.5k ZT-related. (Area 1, e-mail security) Possibly this company. If so, ZT on roadmap for 2023.
Midwestern US state $5.1m 3y deal 75k ZT. “competitive deal”. “example of a sale in partnership with a major systems integrator”.
Large Indian media platform $150k >5k ZT. “chose Cloudflare over Zscaler and Palo Alto Networks”
European F500 automotive company $320k per year ZT. “adopted Cloudflare’s Zero Trust approach to help manage their global fleet of more than 10 million vehicles”
F500 software company $15m expansion Total annual run rate. Unknown what’s included.
F500 financial services company $1.5m 3y deal “went all-in on Cloudflare”. “ripped out a number of legacy vendors and consolidated a number of network services behind us.” “sales cycle was around four months.”
        Q2 2022 (transcript)
F500 retailer in Europe $1m 3y deal Multiple products. “now talking to them about expanding to be their ZT provider, too.”
F500 energy company $784k 3y deal ZT. Had been using Zscaler. Found Cloudflare easier to use, more performant, integrated …
… “As I said last Q, we like our win rates when we go head-to-head with Zscaler and Palo Alto Networks because our product is better and can scale to meet the needs of complex organizations like this one. And while we’re still relatively new to the Zero Trust space, we’re going head-to-head against them more and more often.”
F500 industrial company $1.3m 5y upsell ZT. (Implied). “first adopted Cloudflare in Q1 of 2022 and is already seeing ways they can use more of our platform.” “example of us increasingly working with channel partners” “in Q2, we successfully signed up half of Zscaler’s top channel partners [as CF partners]”
The state of Arizona $770k 1y expansion deal Likely ZT-related. (Implied by context)
One of the world’s largest advertising conglomerates $1.7 million 1y deal ZT. “…expanded their engagement. This was yet another competitive Zero Trust deal against other leading Zero Trust vendors”. Likely this company. If so, ~50k users at that point in time.
One of the largest online recruiting firms $5.5m 3y deal Likely ZT. “… an extremely technical buyer who put our entire platform to its bases.”
        Q3 2022 (transcript)
F500 technology financial services company $2.8m 1y contract Security. “and are now evaluating us to be their Zero Trust provider as well.”
F500 consumer products company $292k 1y expansion deal ZT. “brings their total spend with us to nearly $1 million per year. They are using our Zero Trust product, and we worked with a large channel partner to win…”
F500 life sciences conglomerate $745k 3y deal ZT opportunity. “handing traffic directly to our network, completely replacing their ISP. We’ve signed an MSA with them, and believe there’s a significant opportunity to expand across their other 20 subsidiaries.”
F500 apparel company $1.1m 3y deal Maybe ZT. “bought our full set of security services, as well as Cloudflare Workers.”
large building materials manufacturer in Europe $1.2m 31-month expansion deal ZT. “They have broadly adopted our Zero Trust products across their 25,000 employees”
        Q4 2022 (transcript)
F500 energy company $1.6m 3y deal ZT. “takeout of a first generation zero trust networking competitor.” “We worked with a large channel partner to win and service this customer…”
F500 financial services company $1.1m 3y deal ZT. “expanded their relationship”. “They purchased access, gateway, remote browser isolation, magic Web, magic firewall.”
F500 telecom $400k 1y deal ZT-related. “to bring a portion of Cloudflare’s zero trust services to their consumer base. They’re bundling Cloudflare’s DNS content filtering into their consumer security bundle.”
European financial services company $1.8m 5y deal ZT. “replacing a dozen different security and network vendors with Cloudflare.” “the customers signed on for multiple solutions across our core application services portfolio, as well as both zero trust and network services in Cloudflare One, including access, DNS filtering and magic transit.”
The state of North Carolina $3m 3y deal Unknown. “signed a deal to expand Cloudflare protection across 50 state agencies.”
Public utility company in Africa $2.8m 75-month deal Unknown. “help support… industrial IoT rollout.” “They’re using Cloudflare’s intelligent network to monitor 3,300 sensors, tracking shipment …”
African infrastructure company

(From CIO Week. Might be same company as above.)		 ? ? ZT. “existing … vendor, Zscaler, insisted on a significant price increase … threatened to turn off the system … Instead, this … company already trusted our network for their Internet properties and decided to rip out their existing SASE vendor in favor of Cloudflare One.”
Large American data analytics company ? ? ZT. (CIO Week) “10,000 person research publication company”. “selected Cloudflare One over Zscaler and Cisco.”
        Q1 2023 (transcript)
F500 media company $840k 3y deal ZT. Total annual spend now $2.1m / year. “expanded into our Zero Trust portfolio … for thousands of its contractors, displacing 2 Zero Trust competitors and even turning down 3 licenses from one of them.” “This contract is only the tip of the iceberg with the customer, which plans to potentially roll zero trust out to all their tens of thousands of employees”
Leading e-commerce technology company in Europe $780k 3y deal ZT. “Responding to our descaler campaign” “going all in on Cloudflare One, Gateway, Access, CASB, DLP and Magic WAN.”
Global industrial machinery manufacturer $648k 3y deal ZT. “is also going all in on Cloudflare One with Access, Gateway, Area 1 and Magic WAN, displacing multiple competitors”
Leading IoT security company $4.2m 3y expansion deal ZT. Two deals. “One for its commercial business and a FedRAMP one for its government business.” “has been … since 2020 … application services”. “now using over 25 products across application services, Zero Trust and our developer platform, including R2”

There are a lot of things to note here, including early signs of being able to displace competitors. But to restrict myself to one important thing that relates to selling and to throwing out new products: They’re actively signing deals that include products that haven’t even existed for long. Or put differently, innovation translates to revenue.

This is (part of) one data point I’ve been looking at to check how their “Act 2” is doing. Investor day provided details that, in my view, confirmed that Act 2 (+ Act 3) is growing fast, and has grown from a small to a significant portion of their revenue.

For Act 3 (developer platform), however, I believe it’s important to note that their strategy is to push for adoption and let revenue follow. (Part of an overall strategy, but especially important here.)

Note that my goal here is to share a bit from how I approach and analyze NET, and put forth something else than yet another fancy product announcement.

Hope this is useful. Part of this was a desire not letting a lot of effort keep gathering dust and go to waste. The table can be selected and copy-n-pasted directly into Excel.

(Disclosure: I have an outsized position in NET. I’d caution against outsized positions.)

Edit: Clarified intent, added links to transcripts, completed Q1 2023 with an additional deal.

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Has it grown to be significant, though? A 3 year, $1 million deal provides $83,000 of revenue per quarter. That is 0.03% of their quarterly revenue. A hundred such deals would provide 3% of their revenue.

Bear

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I think it’s important to note why they’ve been sharing such precise figures, instead of “an x figure deal [of unknown duration]” that doesn’t say much. They’ve put focus on that as part of a way to describe how they’re doing. Where the wins are, how big they are, in what verticals and so on. There’s somewhat constant number of deals highlighted every earnings call, covering various areas.

The motivation behind the table is to compress a lot of information regarding deals related to “zero trust” into something much more accessible. It took half an eternity to put together, but hopefully someone might find it to be useful compared to trying to wade through and parse seven quarters’ worth of earnings call transcripts.

You’re correct that it would take a lot of such deals to reach a material amount of revenue. However, if you did the same that I did, but instead tried to single out another area - say “legacy”, you could reach a similar conclusion. So I don’t think deal size and duration in isolation will tell you much.

Also, two things to note:

  1. This is an isolated look at “zero trust”, i.e. a part of “Act 2”.
  2. For Q1 2023, I haven’t dug deep enough to pick apart and include a larger more complex deal.

On investor day, they shared a slide that gave a rough view of ACV by act. (Act 2+3 vs act 1.) Here’s my transcript of this part of the CFO’s presentation:

And this is to reflect that in the ACV structure. It’s a chart we added after some feedback from last week. If you look at ACV contribution by product wave you can see that the momentum of the second and third act is reflecting in the numbers. Last year already, more than a quarter of ACV was contributed by act two and act three products. You can see the trajectory. You can see where this is going.

I did some calculations based on that, but left it at “in my view, confirmed […] grown from a small to a significant portion of their revenue”.

One reason is that it’s a rough approximation, another that I can’t fully reconcile the slide with “more than a quarter”, yet reason that I’d run the risk of someone wanting to point out that there’s a difference between revenue and ACV.

But here’s what I would like to ask:

On what basis can it be shown that their wave of innovative products doesn’t move the needle? I would love to see information that can provide support for such a scenario. Because, that’s how we can learn from each other.

// Raylight

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There’s never been any doubt about Cloudflare’s innovative nature. It’s the fastest-moving company I’ve ever owned in that respect. From day one part of NET’s thesis has been all those free goodies turning into paid business. Like these ones from this week:

So in essence, Cloudflare is going to storm into AI with a bunch of free services that will eventually turn to paid. How long will that take? Your guess is as good as mine.

Have they had success with that approach in the past? Certainly. Has it moved the needle? Well, NET wouldn’t be over $1B in revenue if it wasn’t doing something right. Has it or will it move the needle enough? That we can’t tell because NET has never broken out any of its other efforts in any meaningful fashion. That’s always put Cloudflare’s narrative slightly ahead of its numbers. IMO that gap widened this quarter due to numbers that fell short of even management’s expectations.

Is this a minor blip a new CRO can turn around quickly like ZS a couple of years ago? Or is this a more fundamental issue of slogging through the creation of a top-down sales motion to better sell these new products? That seems to be the bet with Cloudflare right now.

Sorry for all the questions above. However, I’d say NET has as many questions surrounding it now as it ever has in three years of owning it. NET’s always had an attractive “could be”. The difficulty is its “is” isn’t quite as sturdy as it was just a few quarter’s ago.

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Great question. Probably depends on how you define “move the needle.” If it was ~25% of the value of contracts signed in the last year, and that continues, that is certainly something. But what if you’re hoping it won’t just budge the needle a bit? What if you’re hoping for total revenue to re-accelerate to 40%+ and maybe even above 50% in the next couple years? Well that would require this Act 2 / Act 3 revenue to quickly grow to be half of revenue, and then 75% of revenue, etc. That doesn’t seem likely in the next year or two. It doesn’t look like it has grown much as a percentage of the total in the last couple years, based on the contract values in your chart.

Bear

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RayLight, I know that you have a overly large position in Cloudflare, and I used to have a very substantial position in it too, and I think that StockNovice and Bear did as well, so we are not predisposed to dislike Cloudflare, but we all seem to feel that something is not going right with the company.

After all, this is a company that innovates like mad, but for years it could never get it’s growth rate above 54%, or become really FCF positive while many of our other SaaS companies were routinely growing at 60% to 100% and broke into positivity some time ago.

Let me compare it to another of our companies that is also innovating itself into new fields and compare some statistics.

Monday and Cloudflare both had revenue in roughly the same ballpark last quarter ($162 million and $290 million), although Cloudflare was larger.

Monday turned its innovation into 50% growth, Cloudflare into 37%.

Monday had a record number of new enterprise customers added, while Cloudflare had the lowest numberof new enterprise customers added that they had added in any of the last eight quarters.

Monday, with only $162 million in revenue, just 56% as much revenue, as Cloudflare, had $39 million in FCF, for a 24% FCF Margin. And the $39 million wasn’t a fluke. Monday had $30 million the quarter before.

On the other hand, Cloudflare, with $290 million in revenue, just squeezed out $14 million in FCF, for a 5% FCF Margin.

Monday also announced “we now expect to achieve adj operating profitability in FY’23, two years ahead of our prior expectations." Now that’s the kind of results that we should be looking for in our companies, instead of them having to restate guidance down.

Clearly, something isn’t working right at Cloudflare at present. That doesn’t mean that it won’t at some time in the future, but something needs to be fixed, and we feel that there are better places for our money.

And speaking of valuation, Monday has an EV/S of 10.7 while Cloudflare’s EV/S is at 14.8

Just sayin…

Saul

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Saul,

I actually enjoy the current mixed sentiment around Cloudflare. :slight_smile: I owe a ton of gratitude to this board (and to finding it at an inconvenient time), because it’s been of tremendous help for me to evolve. (And is.) Yes, I hold an overly large position, but wouldn’t recommend it, and it should be noted that I have a source of income.

My motivation behind this topic was really just to try to give something back.

PS. Monday happens to be my other favorite holding.

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What a neat coincidence! :grinning::grinning::grinning:

But I’m still not clear why you are overweight in Cloudflare, except “hoping” for a turn around, I guess.

Saul

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Saul,

Not to speak for Raylight… but investment timeframe’s are important. There is no doubt that Monday is performing well right now and Cloudflare is working through some issues in their Sales org. Monday looks like it should give better returns over the rest of 2023.

But not all investors are looking at the next few Q’s when determining their position sizes. Especially with a company that has expected cash flows as far out as Cloudflare. Cloudflare is front-loading CapEx due to owning their own infrastructure & building out their own network, unlike Monday who rents it from the hyperscalers. This is causing NET’s present cash flows to appear suppressed vs. the Companies that rent compute from AWS, Azure, GCP, etc. There are many long term advantages to doing this & I believe NET’s long term FCF margin can be ~30% (management just increased their target to 25% at the investor day). It’s not really fair to compare the present day FCF of NET vs. companies that are renting their compute.

As somebody who owns both Cloudflare & recently bought a small position in Monday this is just my opinion & why I continue holding a much larger position in NET… The long term outlook for these two businesses are different. Monday has a product that is doing well in a crowded space and it is much harder to tell what they will be doing more than a few Q’s out. I.e. myself (& the market) still believes that Cloudflare’s long tern growth durability is much more likely than it is for Monday regardless of the short term differences in company performance.

Bnh

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Because I’m not hoping? :slight_smile:

I assessed the situation, recalculated multiples to get valuation metrics, spent a weekend on deciphering an earnings call, found it to be extremely oversold when it touched $40 and added based on my preliminary conclusion, took in everything from investor day, looked at earnings calls from a few other companies, and so on, and well… feels like I’ve spent two weeks analyzing and that Matthew Prince owes me a vacation.

Such an amount effort might be a good reason not be overweight in a stock, though. :wink:

Of course, NET have a problem with staying put, so eventually it forced me to trim it back a bit. Whether it’s “the best place for money” where it sits now is another question.

I have a strict requirement for anything with high allocation, namely passing my test for “what if just forgot about my portfolio for five years?”. So I take multiple timeframes into account, and also put emphasis on “know what I’m holding”.

In short, I’m holding it based on my current assessment and understanding.

Edit:

Found this reply to be unsatisfactory, so expanded on it with an actual assessment. Adding a link to it, since it’s buried in a long thread:

https://discussion.fool.com/t/cloudflare-s-use-of-databases/92465/8

Also, a clarification: “found it to be extremely oversold when it touched $40” didn’t come out right. It was meant to refer to investor day - i.e. a point in time, and to capture that I did no longer view this to be a case of disastrous results. “Oversold” was a poor choice of words.

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