Cloudflare (NET) Q2 2023 Earnings Review

Following a disappointing Q1 earnings report highlighted by challenges in the go-to-market effort, Cloudflare demonstrated renewed momentum in Q2. The sales reorganization is progressing well. Large enterprises expanded spend, adding to multi-product subscriptions across several categories. In parallel, profitability measures continue to improve with growing operating margin and cash flow.

With a mission statement to help make a better Internet, Cloudflare’s product strategy is grounded in disruption. By owning and operating a network of data centers in 300+ cities worldwide, Cloudflare enters product categories with the assumption that they can deliver better service than incumbents through lower cost, improved performance and greater customization.

This messaging appears to be resonating with new enterprise customers. In Q2, Cloudflare landed their largest Zero Trust deal to date, pushing paid seats in a single customer deployment past 25,000. A critical requirement to land new enterprise Zero Trust deals is to have existing ones as reference customers. Several major Zero Trust customer wins in Q2 may provide the tipping point for future large enterprise adoption.

The developer platform (Act 3), is starting from a smaller base, but is experiencing rapid growth. The number of Worker applications reached 10M in Q2, quadrupling since Q3 of 2022. R2 usage accelerated to 85% sequential growth in Q2, up from an impressive 25% q/q rate in Q1. These products are showing up in new customer wins, contributing to near record additions of $100k, $500k and even $1M ACV customers.

As part of Investor Day, the leadership team showed how Cloudflare’s largest customers are also those adopting multiple product subscriptions. Similar to peers in software infrastructure that report on customers paying for 4+, 6+ and even 8+ products, Cloudflare is demonstrating that an expanding product offering can drive incremental revenue. Over the last four years, the attach rates for customers with 8+, 9+ and 10+ product subscriptions have more than doubled. These customers now contribute the majority of Cloudflare’s annual revenue.

For fast-growing start-ups establishing a software and security stack from scratch, Cloudflare’s platform appears particularly appealing. This is evidenced by the rapid uptake from many of the leading AI companies. As developer-led organizations, Cloudflare’s bottoms-up sales motion naturally resonates. A new CRO with enterprise sales experience will help Cloudflare win business where a top-down approach is needed as well.

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The combination of these factors may bring momentum back to Cloudflare’s stock, which trades at about the same level as a year ago. In this post, I review the results from the Q2 earnings report and identify some trends that may support a resurgence in growth. I also loop back on recent product announcements and what we can have to look forward to for the rest of the year. With Birthday Week coming in late September, there are likely some big product announcements teed up.

Cloudflare’s Product Strategy

I have written extensively about Cloudflare’s product strategy in past blog posts. Foundational to Cloudflare’s platform and their inherent advantages over incumbents is the extensive network they have built. During their history, they have committed to several architectural decisions that make the platform unique in its ability to deliver lower costs, better performance and more customization than competitors.

This implementation also creates a longer path to growth and market penetration. These design principles run counter to prevailing approaches taken by the latest breed of SaaS companies that simply build their services on top of hyperscaler infrastructure. While that strategy reduces time to market, over the long term, this dependence on hyperscaler infrastructure will limit their ability to match Cloudflare’s pricing, performance and feature set for the products that Cloudflare selectively targets.

Cloudflare’s design tenets can be summarized as follows:

• Owned and Operated. Cloudflare built and manages data centers in proximity to 300+ cities across 100+ countries. This puts a data center within 50ms of 95% of the world’s population. They have also assembled a global network with over 12,000 network interconnects with cloud providers, ISPs and enterprises. While this required significant CapEx and technology investment, Cloudflare is decoupled from reliance on other parties for their infrastructure. They incur little incremental cost to launch new services on their existing network (like Zero Trust and object storage), often reusing capacity that is already available.
• Run Everywhere. Every one of Cloudflare’s products runs on every server on every data center in parallel. This ensures that critical functionality is as close to the end user as possible and allows any excess capacity to be leveraged across the full network. Competitor approaches often involve backhauling traffic to central data centers or separating out products onto different networks. While Cloudflare’s topology is more complex, it provides the best performance and most efficient use of resources.
• Composability. Because Cloudflare chose to build a developer runtime (Workers) directly into their network, all services can be customized and even combined with other products. This work can be performed by developers within the customer organization, versus requiring professional services support from Cloudflare or a third party. Composability has also been a driver of new product offerings internally, as previous capabilities are extended to meet the requirements of new product categories or customer needs. Most competitors in security services, for example, do not have a development environment built into their platform.
• Free Tier. While Cloudflare has over 174k paid customers, they offer services to millions of free users. With usage caps, these users consume a small amount of capacity. However, their benefit far outweighs the cost, as these users are leveraged to test new features and provide signals for product preferences. For security use cases, these millions of users represent a valuable source of real-time threat intelligence. Over 22% of the world’s top million busiest web sites are on Cloudflare’s backbone, allowing Cloudflare’s network services to avoid the public Internet when handling enterprise employee traffic.

An assumption that these architectural advantages will allow Cloudflare to disrupt existing providers in each product category underscores the investment thesis. Business performance may cycle through periods of strength and weakness as they traverse various product adoption curves, but Cloudflare’s architectural design will allow their offering to eventually surpass competitors on price, performance and feature set. The team selectively chooses product categories where they can capitalize on these advantages. As with any technology disruption, however, change will often take longer than expected and will be faced with counteractive measures from incumbents.

Product Development Waves

Cloudflare has organized their product strategy into Acts. Each of these represents a product segment with a target buyer. Capabilities in later Acts often leverage technology developed as part of an earlier Act, reflecting the strong composability of the Cloudflare developer platform. As expected, the order of the Acts also correlates to maturity of the product and relative penetration in the market.

• Act 1 – Application Services
• Act 2 – Zero Trust Services and Network Services
• Act 3 – Developer Services

During Investor Day in May 2023, Cloudflare leadership provided another update on their addressable market. The primary change was the addition of Cloudflare Developer Services as a discrete market segment (Act 3). This encompasses both the serverless application platform (Workers) and object storage (R2). In the previous TAM diagram, the Workers product was parked in future growth and R2 solely contributed the revenue projection for the top market segment. Additionally, the estimated size of the market for 2023 was raised by $21B to $146B and now includes estimates out to 2026.

While these types of TAM slides for software providers can feel a little outlandish, they do serve to clarify the target market and set expectations for the size of the opportunity. One priority that has become clear coming into 2023 and highlighted during the Investor Day in May has been Cloudflare’s effort to grow enterprise spend through product subscription expansion. This is a tactic employed by other software and security infrastructure providers, with examples like Datadog and Crowdstrike regularly reporting growth in multi-product subscriptions.

Cloudflare has historically employed a product-led, bottoms-up sales model for Act 1 services, but has shifted to a more enterprise focused motion to sell Act 2 services like Zero Trust. With the GTM restructuring initiated in Q1 and led by Cloudflare’s new CRO, I think we will see deeper penetration of these large customer cohorts. The other benefit for Cloudflare is their foothold with the Fortune 1000 (31% are customers), mostly through Act 1 products. Often representing a visible component of a company’s security strategy, these application services provide an entry point to promote other Act 1 offerings and introduce Acts 2 and 3.

The growth of large customer spend is being driven by an increasing number of product purchases. As part of his Investor Day presentation, Cloudflare’s CFO shared the percentages of contracted customers that subscribe to 8+, 9+ and 10+ products. These percentages have been increasing over the last 4 years. This is similar to the multi-module attach rates exhibited by software and security infrastructure peers, like Datadog and Crowdstrike. Multiple product attachments are also driving a larger share of total revenue. Customers with 6 or more product subscriptions contribute the majority of Cloudflare’s total revenue.

Related to the opportunity for Act 2 and 3 product offerings, the CFO provided updates on attach rates for each Act and the overall contribution to total revenue for 2022 (likely higher now in 2023). Adoption of newer products is growing quickly, with Act 2-3 products reaching 15-20% of paying customers. While this doesn’t sound like a lot, these numbers were much lower a year prior, when reported for end of 2021:

• Application Services: 75%
• Zero Trust: 10%
• Network Services: 10%
• Developer Services: 15%

It’s notable that Zero Trust penetration doubled in just a year. Accounting for total customer growth over that period, the number of customers with a Zero Trust subscription increased by 131%. Network services (74% growth) and Developer services (54% growth) experienced high annual growth in customer penetration as well (applying adoption percentage to total customer count at end of each period).

Shifting to large customers, Cloudflare currently enjoys penetration into 31% of the Fortune 1000 and has 6 of the Top 10 global companies as paying customers. As Cloudflare’s product offering expands and the GTM motion improves, a major contributor to the growth story will be increased spend from their largest customers. As an example from one shared data set, customers that reached the $5M threshold in Q4 2022 had increased their spend on average by 18x over the four year period since Q4 2018.

The CFO also showed the minimum spend needed to land in different segments of the largest customer cohorts. By the end of 2022, the smallest Top 10 customer was spending $6.2M annually. This is up almost 5x since 2018. It also implies that Cloudflare’s very largest customers have pushed past the $10M mark. Similarly, Cloudflare has 25 customers over $2.6M in spend and 100 customers over $888k. In Q4 2022, they reported 85 $1M customers, up 52% y/y.

As Cloudflare drives towards their $5B revenue goal, a large contributor will be from $10M+ ACV customers. At a recent analyst conference, the CFO even referenced a few $20M+ customers. The growth rate of these largest customers has been higher than Cloudflare’s overall revenue growth. As Cloudflare continues to build out the product offering, leveraging their inherent advantages in cost and performance, these large customers have more products to adopt. This broader product footprint provides more opportunities for consolidation of vendor spend and the ability to enhance the combined product subscription through customization via Workers.

As we would expect, this rapid growth in Act 2 and 3 attach rates is showing up in revenue contribution. While the percent of revenue for Act 2 and 3 products was negligible in 2016 and 2018, it became material in 2020. By 2022, Act 2 and 3 products contributed more than 20% of total ACV. This is based on the annual contract value of customers over the full year of 2022. The percentage contribution may be even higher in the most recent quarters of 2023.

Product Releases

In the period since the Investor Day session in early May, Cloudflare has continued their rapid product innovation. Most of the major product development announcements since then were associated with two innovation weeks and a couple of new product offerings. These brought incremental capabilities in AI and Zero Trust, as well as continuing to underscore Cloudflare’s enablement of data staging and distribution through R2.

Developer Week (May 15-19)

Developer Week included a number of releases to facilitate AI processing on the Cloudflare development stack. The highlight was the introduction of Constellation, which allows developers to run fast, low-latency inference tasks using pre-trained machine learning models natively with Cloudflare Workers scripts. Some example application functions that run at the edge might be image classification, object detection, anomaly capture in data streams, sentiment analysis and text summarization.

As the facilitator of AI processing through data distribution, R2 received a few enhancements. The S3 to R2 Super Slurper was made generally available. The tool supports a one-time migration that allows customers to easily copy objects from Amazon S3 to an R2 bucket. Incremental migration is being added as well, with a private beta program introduced for interested customers. Cloudflare integrated R2 with Snowflake as well, so that customers could pull data from R2 into their Data Cloud instance. The Cloudflare team has been focusing on the performance of R2, making many improvements and claiming that R2 is faster than S3 when serving media content via public access.

Finally, the developer experience received a few incremental capabilities. The team consolidated Workers and Pages scripts to provide a unified environment for developers. They improved the usability of Workers with a new CLI capability, a Quick Edit feature and a better development environment for testing prior to release to production. In addition to these improvements to the developer experience, they added a few new capabilities including a Secrets Store, consumer concurrency, explicit acknowledgement in Queues and the open beta of the Workers Browser Rendering API.

All of these releases contribute to the usability of the Workers platform as a full-featured development environment for high-throughput, distributed applications running on Cloudlfare’s global network. The addition of support for AI inferencing is particularly interesting as that allows Cloudflare to address some new AI-driven distributed use cases, where close proximity to the end user device for low latency is a requirement. R2 provides some advantages for data-heavy AI companies, allowing them to stage training data at low cost near available processing capacity.

Speed Week (June 19-23)

Speed Week focused on just that – measuring and improving performance across Cloudflare’s suite of products. A number of the announcements associated with Speed Week were informative and educational. These revolved around demonstrating how Cloudflare products are optimized for speed and providing customers with best practices. Examples included tuning of machine learning inference, Zero Trust performance comparisons across providers, an update on the performance and size of Cloudflare’s network, a review of the Time To First Byte (TTFB) measure, how they made Cloudflare Pages 10x faster, how to use Cloudflare to speed up a WordPress web site and much more.

There were a number of new products and capabilities released, keeping with the underlying theme of performance. The team launched a new Digital Experience Monitoring tool to beta, allowing administrators to monitor the connectivity experience of their users. To allow customers to measure the performance of their web sites and API’s, they introduced new analytics tools to help users understand what is contributing to any delays between Cloudflare’s network and the customer’s origin. 

A popular feature among observability providers is Real User Monitoring (RUM). As part of Speed Week, Cloudflare announced the general availability of Observatory, which allows users to monitor their web site performance using RUM. It runs scheduled tests from multiple geographic regions and publishes all the results in a single view. If performance is slow, the tool will identify any issues and highlight customized recommendations to resolve them.

To speed up customer API responses, Cloudflare released Richochet for API Gateway. Richochet allows customers to automatically reduce average latency through intelligent caching of API requests that would otherwise go to origin. They also announced full support for HTTP/3 Extensible Priorities and extended Argo Smart Routing to improve the performance of UDP traffic (games, voice calls, video transmission).

Data Sharing

On June 20th, Cloudflare announced a partnership with Databricks to facilitate data sharing across clouds. This was accomplished through a native integration between Databricks’ open data sharing protocol called Delta Sharing and R2. This allows enterprise data teams to securely share data sets from R2 with partners, suppliers and across lines of business. Because R2 has zero egress fees, data sharing doesn’t incur additional cost as enterprises scale up distribution within their business ecosystems. This partnership with Databricks follows a similar relationship with Snowflake, announced as part of Developer Week.

Unified Data Protection

On September 7th, the company announced the Cloudflare One Data Protection Suite. This provides a set of security solutions for protecting enterprise data across multiple touchpoints, including their web presence, interfaces with other SaaS tools and private applications. These protections are made available through Cloudflare’s Zero Trust product powered by their Security Service Edge (SSE).

Customers can secure their code and internal data from inadvertent exposure by employees making use of AI tools or other third party services. It provides administrators with easy management tools and risk scores by user, based on prior activity.

This release brings Cloudflare’s DLP capabilities another step closer to more mature competitive products. The Data Protection Suite is now available to customers through their Cloudflare One subscription. In the year since launching their DLP solution in September 2022, Cloudflare has made significant progress adding new capabilities to the tool. The product team outlined the full list and discussed future plans in a comprehensive blog post.

Birthday Week

For those who follow Cloudflare closely, you will know that Birthday Week is coming up at the end of September. Historically, this has represented the period during which Cloudflare has made some of the most exciting product announcements, often with the theme of looking a little further forward in the company’s product evolution.

And increasingly, they’re using the edge of our network to perform inference. We are continuing to invest in this area and believe that we are uniquely positioned to win the inference market, which we believe will be substantially larger than the AI training market. In Q2, we hosted our Developer Week, highlighting 10 major announcements and features to extend Cloudflare Workers as the preeminent developer platform for the leading AI company. Q3 will feature our annual Birthday Week, and we have a lot more in store to provide picks and shovels to enable AI companies to build the future.

Cloudflare Q2 2023 Earnings call

For this year, the focus appears that it will center on AI service enablement. The CEO teased this during his Q2 remarks as delivering more of the “picks and shovels” for AI companies. Strategically, the opportunity for Cloudflare will be to leverage their global, fully distributed network of data centers to enable inference as close to the end user as possible. This makes sense in theory, as training will gravitate towards central locations and endpoint devices may lack the capacity to handle larger inferencing jobs. Cloudflare’s strategy to capture this middle tier distributed globally represents a unique capability they can harness.

Q2 Earnings Highlights

Cloudflare announced Q2 earnings results on August 3rd. For the two months prior to the release, NET stock traded around the $60 range. This followed a disappointing Q1 report, in which the company lowered their full year sales guidance. This triggered a rapid drop to touch $40 in early May, followed by a quick recovery to $70 over the following month, keeping investors on their toes.

Following the Q2 report, NET stock briefly spiked to $75 before settling around $70. Since then, it has once again returned to the $60 range. For the full year of 2023, NET is up about 39%. While this would be a nice return for 2023, zooming out to the full one year chart, the stock hasn’t really moved, up just 3% y/y. Valuation has largely kept a lid on appreciation, at least until the company can show re-acceleration of revenue growth on top of its improving profitability. For now, the stock sits at a EV/S ratio of about 18.5, on the high end for a 30% revenue grower.

Cloudflare has benefited from the perception of having a large TAM, which sets a foundational assumption for long-term durable revenue growth. Over the last year, while its growth rates have decelerated along with other software infrastructure providers, the amount of deceleration has been less pronounced. Analysts have set forward revenue growth projections in anticipation of this durable growth. For 2023, they have modeled 32% revenue growth for the full year. For 2024, that decreases slightly to 30% and then remains at 30% projected for 2025.

Comparatively, Crowdstrike declines from 36% annual revenue growth this year, to 28% and 25% for the next two fiscal years. Zscaler is projected to slow growth from 48% in the just completed fiscal year to 28% and 25% as well for the next two years. Snowflake beats Cloudflare slightly with projections for 31% and 31% growth in the forward years, after finishing this year at 33% annual growth. I point this out to help understand why the market maintains such a high valuation premium for NET, relative to these other companies that have posted faster growth in recent quarters. It also means that Cloudflare needs to hit these estimates in the forward years to maintain its multiple.

The other factor likely providing some support for the high valuation is Cloudflare’s improving profitability measures. Both operating and FCF margins were negative by 5% or more two years back. A year ago in 2022, these reached break-even. In the most recent report, Cloudflare passed 6% on both operating margin (6.6%) and FCF margin (6.5%). On a Non-GAAP basis, EPS hit $0.10, with more improvement forecast going forward. This even brings the forward PE ratio to 165. While still high, it is now non-zero and decreasing rapidly.

Looking forward to 2024, I think stabilization of the revenue growth rate and a little acceleration would provide a catalyst for the stock. Combined with continued progress on EPS and FCF margins, investors could see the stock begin to appreciate consistently once again. I am not expecting NET to return to the peak of $200 a share anytime soon, but upward growth towards $100 a share over the next couple of years would represent a reasonable return. The stock dropped below $100 in April 2022 and hasn’t broken $80 since then.

Revenue

As part of their Q1 earnings report, Cloudflare leadership had lowered the revenue target for Q2 to a range of $305M-$306M for 30.2% annual growth. This was far below the analyst estimate of $320M for 36.5% annual growth. To reach the revised target in the actual Q2 report, Cloudflare needed to increase revenue by 5.3% sequentially over Q1 or by $15.3M.

The actual result for Q2 was $308.5M, up 6.3% sequentially and increasing by $18.3M over Q1. This sequential growth rate was slightly higher than the 5.6% delivered in Q1. This also beat the analyst target for $305.8M. On an annual basis, Q2 revenue was up 31.6%, down from 37.0% growth in Q1. Like other software infrastructure companies, Cloudflare’s annual growth rate has been declining each quarter since Q2 2022.

Looking forward to Q3, Cloudflare projected revenue in a range of $330M – $331M. This beat the analyst estimate for $329.8M. While a slight beat isn’t impressive, Cloudflare’s revenue projection would result in a 30.2% growth at the midpoint annually and 7.1% sequentially. The sequential growth rate represents an acceleration over what was just delivered in Q2. The annual growth rate is roughly inline with prior quarter. With a similar sized beat to Q2, annual growth would match the prior quarter and sequential growth would pass 8% (which annualized represents 36% growth).

Q3 may mark the bottom of the deceleration in revenue growth rates over the past year. The pressure will remain on, as the current Q4 revenue estimate calls for $356.4M, which would require another $26M or 7.9% increase above Q3. This is achievable with a similar performance to Q2, though. Notably, the Q4 estimate represents 29.7% annual growth, which is roughly inline with Q3 (and has room to beat). For the full year, Cloudflare management raised the revenue target to a range of $1.283B – $1.287B, representing just $3M, which was about the magnitude of the Q2 beat.

Looking at other growth indicators, RPO was $1.0B, for growth of 8% sequentially and 36% y/y. Current RPO was 75% of total, or $750M. This represents customer commitments expected to be realized over the next 12 months. In Q1, RPO was up 6% sequentially and 39% annually, so we are seeing some stabilization here as well.

While our customers and prospects continue to be very careful around their IT spend, our improved execution led to a record quarter in new ACV bookings. My sense, talking to customers, is that while the macro environment is still challenging, it is stabilized.

Q2 was another record for new pipeline generation. As we discussed last quarter, we made significant changes in our sales team to proactively address underperformance. That went very well, both qualitatively and quantitatively. Our top performers are invigorated.

Cloudflare, Q2 2023 EARnings call

The CEO also reported record new ACV bookings and sales pipeline generation. This follows some challenges with the GTM team discussed on the Q1 call. With a new head of sales executing a plan to restructure the sales organization and processes, these issues appear to be getting addressed. It’s possible the changes may be having an impact sooner than expected. Assuming these types of restructuring exercises require a few quarters to complete, there may be further upside remaining.

The performance in Q2 represents a big improvement from the reduction in revenue targets coming out of Q1. During the Q1 earnings call and subsequent Investor Day presentation in May, management attributed the shortfall to elongated sales cycles, exacerbated by the general underperformance of a segment of the sales organization.

In Q1, the average number of days required to close a deal increased by 27% overall and by 49% for expansion deals with existing customers. This change had a magnified impact on Cloudflare because deal cycles are typically short, normally closing within the same quarter. Slower closes push deals out into subsequent quarters.

In Q2, management stated that sales cycles returned to timeframes experienced in 2022. The CEO attributed this to better sales process management and discipline around assessing all the customer inputs required to close. Additionally, he thinks the IT spending environment has stabilized. It’s not markedly better, but isn’t getting substantially worse, as has been the case over the last year.

Our focus on go-to-market improvements is already paying off. After we saw sales cycles increase 20% in Q1, discipline around deals had them return to levels closer to what we saw last year. While our customers and prospects continue to be very careful around their IT spend, our improved execution led to a record quarter in new ACV bookings. My sense, talking to customers, is that while the macro environment is still challenging, it is stabilized.

Cloudflare Q2 2023 Earnings call

While existing large customers are still careful making commitments, new customer demand has been increasing, as evidenced by record sales pipeline and growth in new ACV bookings. This increase in sales pipeline has been reported for the past 3 quarters, which may fuel revenue acceleration going into 2024.

We’re making good progress, both in terms of restructuring our team, in terms of adapting our tactics and strategies, how we move upmarket. But you have to remember that, bringing on new people takes ramp time, a little bit shorter in the mid-market, a little bit longer in the enterprise segment. We have not seen most of those improvements yet, and we do not expect to see them over the — over the course of the remainder of this year. So, we are making really good progress, but we’ve been cautious in terms of what we’ve factored in the guidance that we’ve given for the second half.

Cloudflare Q2 2023 Earnings Call

Additionally, while Cloudflare management is pleased with the improvement in sales cycles observed in Q2, they acknowledge that there is still much work to do in the GTM organization and that the full impact will take more time to realize. In response to an analyst question about whether management could quantify the impact of the new CRO and sales improvements thus far, the CFO shared that he expected those changes to require the rest of 2023 to implement, implying that the full benefit would be felt in 2024. Given that Q2 seemed to already reflect some positive momentum, this commentary might imply that the best is yet to come.

Profitability

Cloudflare continues to make progress on profitability. While it lagged software infrastructure peers in 2020-2021 by registering negative Non-GAAP operating margin, the company inflected to positive margin in 2022. For the current year, management has estimated 6% operating margin for the full year. Given that they already hit this level in Q1 and Q2, and set 6.2% as the baseline estimate for Q3, the company might exit the year with operating margin approaching 10% in Q4. As I mentioned previously, the forward PE ratio (Non-GAAP) is now under 200 and dropping quickly.

For Q2, Cloudflare had estimated operating income in a range of $14M-$15M for an operating margin of 4.7% at the midpoint. They actually delivered $20.3M for a 6.6% operating margin. This beat their estimate by almost 200 bps. On a per share basis, they had projected Non-GAAP EPS of $0.07 – $0.08, and actually delivered $0.10.

Even on a GAAP basis, Cloudflare showed marked improvement. GAAP loss from operations improved to -$56.2M, up from -$64.5M in Q2 2022. Compared to revenue, the GAAP operating margin decreased from -27.5% to -18.2% over the prior year. Stock based compensation expense increased by 24.5% year/year, which is less than the 32% revenue growth rate.

Looking forward to Q3, Cloudflare leadership estimates operating income of $20M – $21M for an operating margin of 6.2%, against the revenue estimate for $330M – $331M. This projection is $6M higher than the $14M – $15M range estimated for Q2 and about equal to the operating margin just delivered. Applying the Q2 beat to the Q3 estimate implies that Cloudflare could reach 8% Non-GAAP operating margin for Q3 actuals.

For the full year 2023, they raised the operating income target to a range of $81M – $85M, up from the $73M – $77M estimate issued in Q1 and $54M – $58M set in Q4 2022. The new estimate would deliver 6.5% operating margin for the year. Similarly, Cloudflare leadership raised the full year estimate for EPS to $0.37 in Q2, up from a prior range of $0.34 – $0.35 in Q1 and $0.15 to $0.16 in Q4 2022.

Cash flow showed a similar trend. In Q2, Cloudflare delivered operating cash flow of $64.5M, representing 20.9% of revenue. Of this about 11% or $34M was allocated to network CapEx, which is the term Cloudflare uses to describe investments in their global network of data centers. They also spent about $10M in cash on facilities and capitalized software. This left almost $20.0M as free cash flow, delivering a FCF margin of 6.5%. This is up from -1.9% a year ago.

When comparing Cloudflare’s FCF margin to software infrastructure peers, it is important to account for network CapEx. If we add back in 11% of network CapEx, Cloudflare’s comparable FCF margin would be 17.5%. Most peers in software infrastructure and security, like SNOW, DDOG, MDB, CFLT, CRWD, rent their network and server infrastructure from the hyperscalers. Cloudflare owns theirs, providing certain advantages in terms of customization, utilization and performance tuning.

Eventually, Cloudflare will reach a similar margin profile. Their long-term operating model projects free cash flow margins of 25%+, which is similar to peers. More mature companies that own their infrastructure, like Akamai, deliver a free cash flow margin in this range.

At this point, gross margins have reached their peak, hitting 78% on a Non-GAAP basis in Q2. This is in the middle of the range of 77% – 79% for the prior four quarters. The long term model actually has this coming down some, to account for more cost expected in data ingress/egress. This is likely in anticipation of the rapid growth of data storage and distribution services, like R2. In spite of this, the long-term operating margin target is still set at 20%+.

Other cost reductions have been generated from efficiencies in S&M and G&A. As a percentage of revenue, these allocations have been decreasing annually. Management expects further efficiency gains from improved sales productivity, economies of scale and automation. R&D is already in the target range of 18% – 20% of revenue. Given Cloudflare’s heavy emphasis on product development, it is important that they can keep scaling R&D spend proportionally to revenue growth going forward.

After steadily expanding the employee base each quarter, Cloudflare’s reported headcount actually decreased by 5 employees sequentially in Q2. This is most likely a consequence of the restructuring of the sales team highlighted in the Q1 report and discussed at length during the Investor Day session on May 4th. As investors will recall, the CEO had pointed out that about 100 sales reps were consistently underperforming the rest of the organization. In response to questions at Investor Day, the CFO implied that org changes to address this were rolled out in May.

Those org changes would have created a 100 headcount deficit within Q2. That was then likely offset by some hiring of new sales reps and limited additions to other departments. Even with a reduction in headcount, Cloudflare management issued a Q3 revenue target above consensus and slightly raised the full year revenue projection as part of the Q2 earnings report.

How could this be? During Investor Day, management shared some statistics around sales rep productivity. The top performers make up 15% of the sales organization and consistently achieve 129% of quota. Of this segment, productivity only declined by 1.7% from 2022 to Q1 2023. On the flip side, the 100 sales reps that have consistently missed quota only contributed 4% of ACV. Further, their productivity is about 20% of even the average sales rep.

This meant that a significant gain could be achieved by just replacing the low performing reps with average performers, versus having to recruit all top sales people. By reaching a more normalized distribution of quota attainment, the new Head of Sales estimated that AE productivity would increase by about 20%. This is without increasing the overall headcount of the sales organization. Additionally, he is introducing a number of initiatives that would streamline the sales process, including simplifying the number of tools, organizing the team around specializations, improving sales materials and providing more rep training.

As underperforming sales reps are replaced and the overall sales process is streamlined, it seems reasonable to expect that Cloudflare can achieve the same revenue growth rates with a smaller sales organization than previously. There might even be some upside after all underperforming reps are replaced with at least average performers, given that the underperformers were delivering about 20% the ACV of an average rep.

During the second quarter, we addressed consistently low-performing sales capacity with a focus on upgrading our customer-facing talent to improve growth, increase productivity and drive long-term success.

We will continue to pace hiring for the year based on market conditions and remain committed to raising the bar on new high additions given talent opportunities available in the market.

Cloudflare Q2 2023 Earnings Call

In addressing this on the earnings call, the CFO confirmed that they had been making changes to the sales team during the quarter. He also highlighted the opportunity to upgrade the level of talent, given that other companies have been conducting layoffs over the course of the year.

While I wish the management had identified this issue with the sales team sooner, I can appreciate that the Covid demand surge probably kept the priority low. Looking forward, this restructuring should provide upside opportunity and allow Cloudflare’s growth to match or eventually exceed peers in software infrastructure that already have achieved sales organization excellence.

Customer Activity

After subdued performance in Q1, customer activity metrics outperformed in Q2. Cloudflare delivered record additions of $100k and $500k customers, as well as one of the highest number of $1M customer adds. They also landed their largest Zero Trust deal to date. At the bottom of the funnel, even total customer additions remained on track, with over 174k paying customers, increasing by the same 6k for the past 3 quarters.

Of large customers, which Cloudflare defines as those with more than $100k in annualized revenue, the company added a record 196 in Q2 for 9.1% sequential growth. This represented a nice uptick from the 114 added in Q1. Additionally, these large customers contributed 64% of total revenue in the quarter, which hit a new high. After this contribution decreased in Q1 by 1%, the share increased by 2% again in Q2.

If we apply these percentages to total revenue for each quarter, we can calculate the amount of revenue attributed to large customers. This allocation grew by almost 10% sequentially from $179.9M in Q1 to $197.4M in Q2. When asked about the source of this strong growth during the earnings call, the CFO explained that Q2 had a greater than normal share of new customers closing deals that put them past the large customer threshold immediately. In the past, the split was closer to 50-50 between contribution from existing and new customers. In fact, some new customers vaulted to the $1M annualized spend category on their first engagement.

The reason this is possible is the method of calculating the annualized spend for a customer. To allow the inclusion of both existing and new customers, Cloudflare takes the sum of revenue for each customer in the quarter and multiplies that amount by four. This magnifies the effect of new customer signings, but in a reasonable way. Given the nature of Cloudflare’s products and contracts, this is generally not consumption revenue and can be expected to recur at similar levels.

While large existing customers may not be expanding their spend as quickly as in the past, new customer sign-ups with significant commitments can bolster the $100k, $500k and $1M counts immediately. This is a leading indicator, in that these deals would continue to pay over the following quarters.

This mix explains the ongoing trend with the dollar-based net retention rate (DBNRR), which continued its decent from a high of 127% in Q1 2022 to 115% in Q2. Given the strength in large customer additions and ongoing improvements to the sales organization, management expects this decline to bottom shortly and begin inflecting upwards. DBNRR is calculated by comparing the annualized spend of all paying customers four quarters ago to the current quarter for the same set of customers. It takes contraction into account, as well as attrition (spend is $0). It does not include any activity from new customers.

It’s also one of the reasons for my previous answer that the large customer growth was pretty much coming more biased toward new logos than it was coming from expansion. Expansion, as I said in my prepared remarks, as far as the lagging indicator because it’s pretty much a look back to the four prior quarters. That is what you compare to a sign-on. So, any movement we see in an existing quarter will take time to show up in DNR.

We think we are seeing bottoming of the DNR development. So, we are quite sure we’ll move that upwards to beyond where we came from. But because we are so conservative in how we measure DNR, it’s an all-in across all customer cohorts. It’s very much a lagging indicator.

So, it will take a while before all the improvement that we are initiating in getting expansion going again will show up in DNR.

Cloudflare Q2 2023 Earnings Call

Additionally, because Cloudflare calculates DBNRR by annualizing spend in only the two quarters being compared (prior and one year ago), the impact of a decrease is magnified. This is different from some peers that include all four quarters of each annual period in their calculation. As the broader optimization of IT spend by enterprises moderates, we should see expansion resume. For Cloudflare, improvements to the sales organization, streamlined processes and better packaging should provide another tailwind to enterprise growth. With easier comparables, we might see DBNRR inflect upwards and even accelerate (because of the calculation method) over the next four quarters.

In Q2, Cloudflare added 5,970 paying customers, growing by 3.6% sequentially and 14.7% annually. This count is roughly inline with the 6,073 and 6,086 added in the prior two quarters. It is also well above the 3,619 added in Q2 2022. With 174k total paying customers, I think the big opportunity for Cloudflare is to focus on increasing the spend from existing customers rather than trying to accelerate this total customer growth. Put another way, Cloudflare doesn’t have a problem with customer reach.

Rather, the opportunity is with cross-sell and expansion of share with existing customers. Large customers only make up 1.4% total customers. This effort will be helped by Cloudflare’s growing product offering, the benefits of platform consolidation and an upgraded sales team with the tools to capitalize on landing larger enterprise deals.

Cloudflare also isn’t limited by the size of spend. This has been an area that they have emphasized recently. Cloudflare currently has 31% of the Fortune 1,000 as customers (up from 30% last quarter). While they don’t report $1M and $500k customer counts quarterly, commentary indicated strong growth in these cohorts. At the end of 2022, they reported 85 customers spending $1M+ and 222 over $500k. These counts were up significantly y/y.

It is this rapid growth in the average spend of the largest customers that should continue to fuel Cloudflare’s durable revenue growth over time. The average Top 10 customer spent $6.2M in 2022, which had almost tripled over 2020. During the recent Goldman Sachs Communacopia conference, Cloudflare’s CFO mentioned that they have a few customers spending over $20M annually, which I wouldn’t have imagined a few years ago. These largest customers aren’t even subscribing to all Cloudflare products, implying there could be further upside.

Customer and Product Highlights

During the Q2 earnings call, the CEO ran through his typical update on significant customer wins. This elicited a few notable trends, which bode well for the opportunity to capture more spend from large enterprise customers, as well as the new breed of well-funded AI start-ups. I will summarize a few of the trends here.

Traction with AI companies. As an example, the CEO said that one of the fastest growing generative AI company (we assume OpenAI) expanded their relationship with Cloudflare, by signing a new one-year contract for $1.7M. They are using R2 to stage data near available GPU’s for model training and continuing with security services to control access to their applications. The CEO also mentioned that the company is using Cloudflare’s edge to perform inferencing.

With a fully distributed network of data centers across the globe running in parallel, Cloudflare has some architectural advantages in delivering inference with close proximity to users. Cloudflare plans to continue building out their product capabilities to support inferencing, with some new announcements expected at Birthday Week, usually held during the last week of September.

Another benefit of the continued success in penetrating AI companies is that I consider these a proxy for all start-ups. The reality is that companies with an AI angle are receiving the majority of new funding currently, as VC’s have dialed back investments generally in 2023. As new companies plan their software infrastructure from a blank slate, they appear to be increasingly choosing Cloudflare for significant portions of it. These include application security, distributed serverless compute and object storage.

This doesn’t imply that Cloudflare is the primary platform in all cases, and these companies likely have a significant presence on a hyperscaler as well. Rather, it demonstrates that Cloudflare can claim a meaningful share of spend from newer companies, as opposed to trying to break into established enterprises (which they are doing too).

Further adoption in Zero Trust. This is important as it has the potential to become a significant source of revenue and anchors what Cloudflare leadership calls their “Act 2” products. Zero Trust, delivered through a SASE configuration, is a popular security initiative currently for many enterprises. Besides Zscaler’s continued momentum in the space, Palo Alto Networks cites Zero Trust as one of their fastest growing business lines. While Cloudflare entered the category far later than other providers, their existing network architecture and topology enables them to deliver a competitive offering.

This has already been popular for the SMB segment, as evidenced by Cloudflare’s 32,400 Zero Trust customers (based on 20% attach rate at end of 2022). The opportunity for Cloudflare is to move upmarket and capture large enterprise Zero Trust spend, where deals can generate well over $1M in ACV. Most enterprise C-level decision makers will hesitate to bet on a newcomer. The challenge is being able to reference successful implementations of a similar size. It’s a bit of a “chicken or egg” problem. To win large enterprise business to serve as references, Cloudflare needs existing references from large enterprise customers.

Fortunately, it appears the tide is turning here. Cloudflare landed its largest Zero Trust customer to date in Q2. The CEO provided several examples of customer wins in Zero Trust:

• A Fortune 500 technology services company expanded their relationship by signing a three-year $7.2M contract ($2.4M a year) for 25k Zero Trust seats. That brought their annual spend to over $5M. The company first became a customer in Q3 2022 with application security products. Cloudflare won the Zero Trust business over competitive offerings due to the opportunity to consolidate security spend.
• One of the largest online recruiting platforms signed an expansion contract for $2.4M, spread over 2 years. This brings their annual spend to over $5M. With a heavy remote-work organization, the company was seeking out a comprehensive Zero Trust solution and evaluated Cloudflare against every leading vendor in the market. Cloudflare won the business, providing 15k seats for Zero Trust Network Access (ZTNA), Secure Web Gateway, Cloud Access Security Broker (CASB), Data Loss Prevention (DLP), Remote Browser Isolation (RBI) and Cloud Email Security (through Area 1).
• An Australian technology company expanded their relationship with Cloudflare by signing a one-year $2.2M contract, bringing their total spend with to over $5M. This customer started out on the pay-as-you-go plan in 2016. In Q2, they signed a Zero Trust deal to protect their expanding workforce. They’re also broadening their use of Cloudflare’s developer platform with both R2 and Durable Objects.
• A leading Australian healthcare provider signed a new three-year $2.8M contract. Cloudflare is consolidating a set of first-generation Zero Trust vendors onto their platform, with 12k seats of ZTNA, SWB, RBI, CASB, DLP and email security.
• Another generative AI company expanded their relationship with Cloudflare, signing a three-year $1.3M contract. This customer started with the developer platform, signing up as a pay-as-you-go customer. Because this company is developer led, they approached Cloudflare for their security needs, signing a deal for application security and Zero Trust products. The company only has 100 seats now, but is growing quickly and building Cloudflare deep into their whole stack.

I like these examples for four reasons. First, the number of seats for enterprise customer examples range from 12k to 25k. These become reference customers for other enterprises of a similar size. It is much easier to win new Fortune 500 business in Zero Trust when Cloudflare can point to existing Fortune 500 customers using Zero Trust at scale.

Second, these customers are racking up significant total spend, with the examples exceeding $5M of ACV or more a year. As Cloudflare builds out its product offerings, they are seeing customers adopt an increasing number of them. More product subscriptions drives larger annual spend. To have an existing Fortune 500 customer add a $2.4M a year Zero Trust commitment to their existing application security spend and now exceed $5M in ACV represents a significant opportunity.

Third, the ramp of some of these large customers is steep. The Fortune 500 company cited has been a customer for less than a year. Yet, they have increased their spend twice at least and are now over $5M. Looping back on DBNRR, this customer’s spend would not be included in the calculation until next quarter. Then, it would have a significant impact.

Fourth, the generative AI company echoes the comment I made made earlier about adoption by start-ups that implement their software and security stack from a clean slate. As these types of companies have a strong developer mindshare, Cloudflare gets introduced through the development organization. Later, the company learns about Cloudflare’s security offerings. Competitors in Zero Trust and application security don’t have the ability to start the customer relationship with the application delivery stack.

Additionally, the CEO provided some highlights on adoption of new products. These primarily revolved around the developer platform (Act 3).

• Cloudflare Workers continued rapid growth. In Q2, it reached 10M active Workers applications. Per the earnings call, this count is up 250% since December and 490% year/year. Investors will recall that on the Q1 earnings report, the CEO cited a figure of 4.9M applications running on the Workers platform. That count has surpassed 10M, representing a doubling over one quarter. Per the Q3 earnings script, there were 2.2M applications at end of September 2022. Before we get too excited, revenue from Workers doesn’t grow proportionally to the number of applications. There are free plans with limits and paid plans generally scale by usage. With that said, these counts provide powerful signals regarding the uptake of Cloudflare’s developer platform. Creating an application requires work and an active application would be consuming resources. Therefore, this activity growth should impact revenue eventually. As noted above, Workers was bundled as part of several large deals in Q2 (as well as past quarters).
• R2, Cloudflare’s object store, is growing quickly as well. The CEO shared that R2 stores more than 13PB of customer data, which is up 85% over the 7PB reported for Q1. More importantly, R2 storage growth rates appear to be accelerating, as Q1’s usage was up 25% sequentially. In a prior post, I had calculated that that 1PB of R2 storage with normal read/write activity would generate about $60k in revenue per quarter, or $240k a year. Therefore, 13PB of R2 storage would represent about $3M in annual revenue. Given that Cloudflare will generate over $1.2B in revenue this year, that is a small run rate currently. If the quarterly growth continues at the latest rate, however, then it will represent a material contributor to 2024 revenue.

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 an R2 subscription, and brand-name customers are beginning to adopt it as their primary object storage solution.

And by our estimates, Cloudflare is the most commonly used cloud provider across the leading AI start-ups. They’re using R2 to help arbitrage the lowest GPU cost to train their models. 

Cloudflare Q2 2023 Earnings Call

At the end of September, investors will get further insight into the product roadmap for R2 and AI-related services. Cloudflare will be holding their annual Birthday Week. This tends to include the most ambitious new product announcements of the year. This may provide more signals for Cloudflare’s growth path in the Act 3 product category.

Investment Plan

After a disappointing Q1 earnings report, Cloudflare snapped back with a relatively clean Q2. Revenue beat their guidance for the prior quarter and nudged past estimates for the next quarter and full year. On a sequential basis, revenue growth appears to be accelerating and supports an annualized growth rate above 30%. Profitability measures are scaling nicely, with both operating margin and FCF margin pushing past 6%. Looking forward, these margins should continue to expand, driving EPS upwards.

Customer activity was particularly strong, with record additions of large customers (spending over $100k, $500k and $1M ACV). While DBNRR continued its downward trajectory, it is likely to bottom and increase again. This is based on the 9.7% sequential increase in large customer revenue in Q2 and the lagging nature of the calculation. Total customer additions remained on a steady growth path as well, hitting 174k paying customers. Given that large customers (with more than $100k ACV) only make up 1.4% of total customers, the big opportunity for Cloudflare is to increase their share of large customer spend.

To accomplish this, Cloudflare has been rapidly expanding their product touchpoints within the enterprise. They already have a firm foundation in their still necessary “Act 1” products in application security and delivery. These increased their attach rate within total customers from 75% in 2021 and to 90% in 2022. The bigger opportunity is in the adoption of “Act 2” projects around network services and Zero Trust.

Deals in this category tend to exceed $1M ACV for the largest enterprises. Cloudflare highlighted several wins with large enterprise companies in Q2 for Zero Trust. These deals ranged from 12k-25k seats, demonstrating that Cloudflare’s Zero Trust product can handle scale. More importantly, they provide reference customers for other enterprises to consider in their purchase decision. This represents a critical inflection point, in my opinion, addressing the common “chicken or egg” problem with moving upmarket into the enterprise.

Workers and R2 comprise Cloudflare’s Act 3 solutions. These are experiencing rapid growth as well, with the attach rate for Workers doubling between 2021 and 2022. R2 usage is even accelerating, growing by 85% from Q1 to Q2, versus the 25% increase from Q4 to Q1. While still small, the amount of data stored on R2 currently would generate $3M of annualized revenue at list price. If that growth rate continues, this will soon become a meaningful contributor to overall revenue.

Besides their break-through in Zero Trust, AI represents a future opportunity for Cloudflare. They claim to have most advanced AI focused companies as customers. When these technology teams consider their desired software stack from a clean slate, Cloudflare is increasingly chosen as part of the mix. Many of these companies are growing rapidly (or at least getting a lot of funding). Assuming some may eventually reach the Global 2000 size, they would provide another source of large customer spend expansion.

Given these tailwinds, I am still optimistic about Cloudflare’s potential to realize meaningful penetration into the $164B TAM they have targeted for 2024. The restructuring of both sales and marketing should provide additional positive benefit, as Cloudflare establishes a more healthy balance between world-class product development and their GTM motion.

For my personal portfolio, I maintained my allocation to NET stock following Q2 earnings. If it appears that performance stays on track as 2023 progresses and even accelerates going into 2024, I may take advantage of price dips to add to the position.

NOTE: This article does not represent investment advice and is solely the author’s opinion for managing his own investment portfolio. Readers are expected to perform their own due diligence before making investment decisions. Please see the Disclaimer for more detail.

Additional Reading:

• Muju over at Hhhypergrowth has published a review of Cloudflare’s Q2 results on his premium site. He also plans to cover the upcoming Birthday Week announcements. Well worth the cost for broader perspective and deep product analysis.
• I have been using Koyfin for stock charting and research. Readers can click on this link for a healthy discount off of the list price.