Cloudflare (NET) Q3 2022 Earnings Review

Expectations for Cloudflare’s Q3 2022 report were high, particularly following their strong Q2 earnings. As macro headwinds weighed on the quarter’s performance, NET sold off following the report. While I don’t see anything troubling in the results within the context of the flagging IT demand environment, the market’s reaction is understandable given uncertainties going forward. Downward pressure on NET was exacerbated by a general sell-off in software companies, following underperformance from SaaS mainstays like Atlassian.

In this post, I will cover the highlights from Cloudflare’s Q3 results, focusing on growth drivers, profitability measures, customer activity and product highlights. I will tie this commentary back to the general thesis for investment in Cloudflare, concluding that the broader story hasn’t changed. Additionally, our partners over at Cestrian Capital Research recently published a review of the earnings report, including financials and technical analysis. Interested readers can check out that coverage for another point of view, as they consider an investment in NET.

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As investors will recall, Cloudflare’s Q2 earnings report was well-received, driving the stock up 27% the next day. Expectations were low for the Q2 report, as the CEO had warned investors about the general macro environment at an analyst event in June. These comments led investors to expect the worst and had pressured the stock for the period leading up to the earnings report. When Cloudflare outperformed along several measures, the reaction was strong.

Coming into the Q3 report, investors felt Cloudflare might maintain their reliable trajectory of 50% y/y growth. The view that Cloudflare can sustain its high revenue growth rate for a long period of time is a big part of the investment thesis (shared by me). This consistency has supported the stock price over time, generating a greater valuation multiple than comparable software companies with higher revenue growth and more FCF. Because Cloudflare’s valuation is so high, any change in this trajectory would have an outsized impact on the stock price, even factoring in macro.

While I thought the report was fine, analysts were looking for more. The fundamental contributors to Cloudflare’s potential are intact and don’t reflect a change in trajectory. Cloudflare is arguably a story stock, requiring investors to believe that its rapid product development, broad serviceable market and competitive advantages from its network will drive outsized revenue growth and cash flow over the long term. In this investment environment, investors are less inclined to provide NET with as much leeway as in the past. Hence, the market’s reaction.

With that set-up, let’s take a look at some of the highlights from the quarter.

Growth Metrics

In my Q2 earnings review, I highlighted Cloudflare’s consistent revenue growth along a compounded rate of 50%. This has underscored Cloudflare’s investment narrative for several years. Coming into the Q3 report, Cloudflare was positioned to maintain that trajectory, with a preliminary revenue growth estimate for $250M – $251M, representing 45.4% annual and 6.8% sequential growth. Applying the same $7.5M beat from Q2 to the Q3 estimate would have resulted in $258M in revenue or 49.7% annual growth.

The actual beat was less than this, coming in at $3.4M for total revenue of $253.9M. This represented annual growth of 47.4% and sequential growth of 8.3%, compared to annual revenue growth of 53.8% and 10.5% sequentially in Q2. In the prior year, Cloudflare delivered 50.9% annual and 13.1% sequential growth. Across a few prior time segments, Q3 2022 performance represented a slowdown.

The leadership team attributed this softness to a couple of factors, similar to those observed in Q2, but with more impact. The explanations were all macro related, and are likely to persist until the economic backdrop improves.

• Longer sales cycles as customers exercise more caution before signing deals (“measure twice, cut once”).
• Smaller pay-as-you-go customers transitioning to the free user tier.
• Concessions in new customer deals to account for currency impact. Cloudflare charges in U.S. dollars, making their services more expensive in local currency due to the strong dollar.

Of these, I thought the currency impact is important to acknowledge. Other software infrastructure companies (like NOW, MSFT Azure) include a constant currency adjustment to revenue because they charge in local currency. This tactic can normalize revenue growth rates when the U.S. dollar has surged in value. For ServiceNow, the currency adjustment to revenue was 6.5% in Q3. For MS Azure, it was about 7%.

While Cloudflare cannot calculate a direct constant currency adjustment, we should consider its impact on Cloudflare’s sales revenue. On the earnings call, the CFO mentioned having to provide concessions to some customers to account for the currency difference, as Cloudflare’s relative costs for international customers increased in the quarter due to the U.S. dollar’s strength. As it appears that the U.S. dollar’s value may have peaked, it’s worth considering that this headwind could become a tailwind going into 2023.

For Q4, Cloudflare projected revenue of $273.5M to $274.5M, representing annual growth of 41.5%. This beat the analyst estimate of $273.7M slightly at the midpoint of guidance. On the surface, the low raise could be considered disappointing. However, when viewed on a sequential basis from the Q3 actual, it is actually quite strong. Revenue in the middle of the range for Q4 would represent a sequential growth rate of 7.9% or about $20M over the actual revenue amount delivered in Q3. This represents the highest sequential percentage guide over the past year and the largest increase ever in dollar terms.

For Q3, the preliminary guide issued in the Q2 report was for 6.8% sequential growth. A year ago, the Q4 2021 guide was for 7.1% growth over the Q3 2021 actual. The achieved Q4 2021 sequential growth rate was 12.4%, surpassing the guide by 5.3%. This could imply a strong sequential revenue growth acceleration for Q4 2022, if the same 5.3% absolute increase is applied to the 7.9% guide (13.2% actual). On the other hand, if Cloudflare matches the sequential beat from Q3’s actual report of 1.5%, Q4 sequential growth would be more like 9.4%.

There could be a couple of interpretations of the high sequential guide. First, the Cloudflare leadership team may have extended the guide to get past the analyst estimate, avoiding a “miss”, but anticipating a small beat. Or, Q3 softness was a one off and Q4 is shaping up as a stronger quarter. It’s possible that some deal slippage occurred in Q3 and is expected to close in Q4. Or, new products like R2 will be generating measurable incremental revenue.

For the full year, Cloudflare estimates revenue of $974M – $975M, up 48.5% year/year. This represented a raise of about $4.5M at the midpoint of annual guidance from the Q2 report. This amount captures the beat from Q3 and the raise to Q4, as would be expected for the final annual guide in Q3 of the fiscal year (if larger, then the Q4 estimate would have to be larger). To get to 50% annual growth would require a beat of about $10M in Q4.

Shifting to other growth metrics reported in Q3, RPO was $831M, up 9.3% sequentially and 52% y/y. Current RPO was 75% of total RPO. In the prior quarter, RPO was $760M, up 10.4% sequentially from Q1 and 57% annually. In Q1, it was up 57% annually as well and 10% sequentially. With Q3’s result, RPO growth remains above revenue growth and still in the 50% range.

Growth by geography illustrates some of the areas where currency is having an impact.

• U.S. was 53% of revenue and grew 49% y/y (Q2 was 55% growth)
• EU was 27% of revenue and grew 51% y/y (Q2 was 54% growth)
• APAC was 13% of revenue and grew 28% y/y (Q2 was 43% growth)

Management called out the growth in APAC as being impacted the most by currency differences. They mentioned customers in that region exhibiting price sensitivity and introducing purchasing delays. This was one of the areas where the sales team had to provide concessions on contract pricing.

A Path to $5B in Revenue

As part of the earnings release, Cloudflare introduced a new long term revenue target. This coincided with their achievement of crossing the $1B annualized revenue run rate in Q3. The target is to increase annualized revenue to $5B within 5 years, representing a 5x increase or a CAGR of 38%. This target is based on organic revenue (not dependent on acquisitions) from existing products in market (no reliance on finding and developing another product extension).

While this growth rate is below Cloudflare’s historical CAGR of roughly 50% up to $1B in revenue, it does reflect a higher growth rate than most other software companies can maintain as they pass $1B in revenue. Additionally, there is likely some decay built into the projection, with 2023 revenue growth returning to the upper 40% range and then slowing into the 30% range. Even past the $5B mark, revenue growth could stay above 30%. This would be similar to other large software companies that span multiple product categories like the hyperscalers, ServiceNow or Salesforce.

With Cloudflare’s market cap currently at $17B, this 5 year target implies a forward P/S ratio of 3-4. Additionally, I think we can assume a FCF margin of 15-20% by that point, given Cloudflare’s long term operating margin target of 20%. With a 20% FCF margin for $5B in revenue, Cloudflare’s forward Price/FCF value would be about 17. ServiceNow’s Price/FCF multiple is 44 as is that for Atlassian. This implies almost a 2-3x return in 5 years at today’s valuation.

While the 5 year plan is ambitious, other software companies have set long term goals like these. Snowflake’s $10B in revenue by FY2029 provides an example. I think this target for Cloudflare is timely, as it sets a floor on revenue growth going forward. Following the growth rate slowdown in the Q3 report, investors would naturally be left to guess how low revenue growth could drop. To offset this concern, Cloudflare management feels confident that they can deliver a 38% CAGR for the next 5 years.

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Profitability Measures

While revenue growth slowed down as a consequence of the macro environment, Cloudflare outperformed on the profitability side. For Q3, they had projected Non-GAAP operating income of $0M – $1M as part of the Q2 earnings report. They actually delivered record Non-GAAP income from operations of $14.8M for an operating margin of 5.8%. This drove Non-GAAP EPS of $0.06, well above their estimate for $0.00 to $0.01. Operating margin was 1.3% in the year ago quarter, representing a 450 bps improvement. While they have signaled an intent to keep operating margins closer to break-even in the years ahead, they have set a long term target of 20%. Given the improvement this quarter, that threshold appears achievable.

If we look forward to Q4, the potential improvement to operating margin could be even larger. Preliminary guidance for Q4 is to deliver Non-GAAP income from operations of $12M-$13M for an operating margin of 4.6%. If we apply a similar beat to Q4 as was delivered in Q3, these numbers would double, potentially bringing Cloudflare’s non-GAAP operating margin close to 10%. While they may not push that far, the possibility demonstrates Cloudflare’s transition into the category of consistently profitable software companies on a Non-GAAP basis.

For the full year, Cloudflare significantly raised their guidance for operating income as well. Considering how much the market has been focusing on profitability, I am surprised this didn’t generate much attention. In Q2’s earning’s report, Cloudflare actually lowered their full year guidance for Non-GAAP operating income from a range of $10M – $14M set in Q1 to $7M – $11M in Q2. They maintained an EPS target of $0.03 – $0.04 for both quarters.

In Q3’s report, they increased the full year operating income guide to a range of $31M – $32M, representing an increase of about $22M at the midpoint. On an absolute basis, they tripled the operating income target from Q2 to Q3. Further, they more than tripled the Non-GAAP EPS target to a range of $0.11 – $0.12.

However, a lot of investor focus in this market for a measure of profitability from software companies is solely on free cash flow. The reasoning is that in a tough macro environment, free cash flow positive companies will not need to raise new funds in a down market. Additionally, valuation analysis has shifted back to a focus on discounted cash flows, which of course favors companies with a history of FCF generation. Cloudflare leadership has committed to achieving positive FCF for 2H2022.

For Q3, Cloudflare delivered negative FCF of $4.6M for a FCF margin of -1.8%. To reach their FCF target for 2H2022, FCF will need to be greater than $4.6M in Q4. Management reiterated that target on the earnings call.

If we step down a level to operating cash flows, Cloudflare’s trajectory looks promising. For Q3, Cloudflare delivered $42.7M of operating cash flow, representing an OCF margin of 16.8%. In the year ago quarter, this value was -$6.9M or -4.0% margin. That represents a margin improvement of about 21%. Additionally, this follows a similar outperformance in Q2, demonstrating the first occurrence of back-to-back quarters of positive operating cash flow.

Of course, from operating cash we subtract capital expenditures, like Cloudflare’s network investments, capitalized software and physical plant expenses (office space), to get to free cash flow. In Q3, these adjustments were $41.9M for property and equipment (network expense and office space) and $5.4M for capitalized software. The network CapEx component represented about 13% of revenue for Q3, according to the CFO.

As investors know, Cloudflare has traditionally invested 12-14% of revenue into this network CapEx. This money has been spent building out data centers and then adding network, storage and compute capacity to them. It is this investment in building their own network that has capped Cloudflare’s FCF growth in the past.

Comparing Cloudflare’s FCF margins to other software infrastructure companies like Datadog, Snowflake, Crowdstrike and even competitor Zscaler makes Cloudflare look inefficient on a free cash flow basis. However, those companies don’t invest in building out their data center and network infrastructure, because they run on top of the infrastructure provided by the hyperscalers.

That topology has provided advantages in terms of FCF generation early in the growth cycle for these companies. They very quickly scaled up cash flow margins, capturing the value add they deliver on top of hyperscaler infrastructure. However, now that these companies are operating at scale, future leverage in FCF margin is unlikely. That is because as they continue to grow, so too will the cost paid to the hyperscalers in a roughly linear fashion.

Cloudflare, on the other hand, owns its infrastructure. While building up their global coverage with data centers in 275+ cities has required a significant investment to this point, they are likely inflecting into a new mode of CapEx investment. As the planet isn’t getting bigger, they probably have enough data centers and can shift new incremental investment to adding capacity to them. I think this will result in higher efficiency for incremental CapEx investment, perhaps even allowing them to dial back the 12-14% of revenue target.

Additionally, as Cloudflare owns their data centers and network, coupled with their highly efficient utilization model of running every service in every data center only on demand (serverless), they should be able to pack many more monetized services onto their infrastructure. This could result in a much higher FCF margin over time, approaching and maybe even passing other software companies built on the hyperscalers.

An analogy that might help is to think of an auto manufacturer. To build cars, that company needs to invest in factories. Initially, they may run one manufacturing line for one 8 hour shift a day in their factories. Over time, though, they might set up multiple lines in the same factory and add two more 8 hour shifts. This would effectively multiply their revenue generation from the same initial capital investment.

I think Cloudflare is setting up for something similar, as they build out different product offerings all served from the same data center and network footprint. By launching products that stress different parts of the infrastructure stack, they can also multiply revenue steams from the same capital investment. As some simple examples, video streams delivery is network bandwidth heavy, R2 consumes primarily storage and security services use a lot of compute. Because all data centers run all services, this multiplier effect is easy to achieve.

If anything, it provides the optionality to dial up FCF margin when needed. This is because Cloudflare could just limit CapEx spend for a period and FCF margin would approach operating cash flow margin. Cloudflare’s operating cash flow margin was 16.8% in Q3, comparable to Datadog at 19.2% OCF margin. Snowflake, Crowdstrike and Zscaler haven’t reported yet, but achieved OCF margins of 13.0%, 39.2% and 32.4% respectively in their prior quarter.

As another comparison, we can look to Akamai, which represents a more mature company in the same market. Like Cloudflare, Akamai has a heavy CapEx spend as they own and operate the majority of their data centers. In the most recent quarter, Akamai’s OCF margin was 42% with a FCF margin of 31%. Further, their Non-GAAP operating margin was 28%. I don’t see a reason why Cloudflare couldn’t deliver the same over the long term.

I just mention this as I think investors have a perception that Cloudflare’s CapEx heavy business precludes it from ever delivering meaningful cash flow. This is often contrasted with other software infrastructure providers that have already reached 20-30% FCF margin. I think Cloudflare can achieve the same – they just required a much heavier investment period up front. Going forward, I think ownership of their delivery infrastructure will provide more leverage over time and make higher FCF margins achievable at scale.

Cloudflare is already dialing back CapEx spend slightly for Q4. On the earnings call, the CFO said that they will “hit the lower end of the 12-14% guidance range for the fiscal year, due to the timing of purchases and efficiencies in the network.” The latter part of that statement implies that there may be more efficiencies in the future, reflecting the fact that much of the heavy investment to build out a global footprint of data centers is behind them. It’s less expensive to add compute and storage to existing data centers, than to build brand new ones.

Going back to operating margin, Cloudflare has been able to increase it by lowering operating expense as a percentage of revenue. In Q3, they kept gross margin roughly linear at 78%, but were able to reduce operating expense by 6% y/y to 72% of revenue, down from 78% a year ago. This is reflected in relative spend by department.

• S&M: 41% of revenue, down from 45% a year ago and 44% in Q2
• R&D: 18% of revenue, down from 19% a year ago and 20% in Q2
• G&A: 13% of revenue, down from 14% a year ago and 15% in Q2

These decreases in operating expenses in Q3 have been partially enabled by a slower rate of hiring for the quarter. In Q3, Cloudflare added 120 employees for a sequential growth rate of 3.9%, which was its lowest rate in the last 2 years. However, this followed two quarters of the highest sequential rates of hiring. The annual growth rate for Q3 is still above the historical average.

Qtr	Headcount	Seq Growth	Ann Growth
Q3 2022	3,180	3.9%	42%
Q2 2022	3,060	11.3%	49%
Q1 2022	2,750	12.7%	42%
Q4 2021	2,440	8.9%	36%
Q3 2021	2,240	9.3%	32%
Q2 2021	2,050	6.1%	34%
Q1 2021	1,931	8.0%	41%
Q4 2020	1,788	5.4%	41%

In Q2, management said they planned to slow the velocity of hiring in the second half of 2022 to account for “macroeconomic uncertainty”. Given the surge in hiring over the prior two quarters, I am not concerned about the impact on operational continuity that the Q3 or Q4 decreases would have. Cloudflare still has a large number of open positions across sales and engineering and is actively promoting these on social media channels like Twitter.

Customer Activity

Cloudflare’s enterprise customer growth continues to be on track. They closed Q3 with 1,908 large customers (defined as having annualized revenue over $100K). This was up 159 sequentially, or 9.1%, from Q2. A year ago, there were 1,260 customers of this size, representing 51.4% annual growth. In Q2, Cloudflare delivered a surge in large customer additions, growing by 212 total and up 13.8% sequentially. Going back to Q1, Cloudflare added 121 large customers for 8.5% sequential growth. So, while Q3 additions dipped from Q2’s surge, it is above the rate from Q1. Going back further, they added 156 of these customers in Q4 2021 and 172 in Q3 2021. Overall, I think 159 additions for Q3 2022 maintains the trend, if we also take macro and currency pressure into account.

Large customers now make up 61% of total revenue, increasing a tick from 60% in Q2. Cloudflare management is committed to continue generating more share of revenue from enterprise customers. As they add more product categories, cross-sell opportunities emerge. In the customer highlights portion of the earnings call, the CEO provided a number of customer examples that started with one product/team and expanded to multiple product additions and broader usage over time.

Total paying customers grew slowly in Q3, increasing by 4,197 from Q2, bringing the total to about 156k. This represents 3.3% sequential growth and 24% y/y. Management mentioned that some smaller paying customers downgraded to Cloudflare’s free tier in the quarter, reflecting an effort to reduce costs given the macro environment. As Cloudflare’s focus shifts to extracting more revenue from large customers, the impact of changes in the total paying customer count will be diminished.

This customer tier, along with the millions of free users, are important as a branding function, by providing technologists with exposure to Cloudflare products. Management has discussed how technology decision makers at enterprises often learn about Cloudflare through side projects and personal use. When the opportunity arises, they introduce Cloudflare into their corporate environment. While the downgrade of smaller paying customers to the free tier would have some impact on revenue generation, it would maintain its lead generation function. As the macro situation stabilizes, these free customers (formerly paid) may upgrade again, providing a tailwind to paying customer growth.

In addition to the large customer ($100K in annualized revenue) metric, Cloudflare leadership periodically shares counts of customers exceeding the $500K and $1M spend levels. Customers spending more than $500K were up 88% year/year, compared to 58% when the metric was last shared in Q1. Customers spending more than $1M were up 63% y/y in Q3, as compared to 72% in Q1. Cloudflare also reached 75 customers spending more than $1M in Q3. Management pointed out that these growth rates in high spending customers were higher than the growth rate of revenue.

As further evidence of large customer penetration, management shared that 32% of the Fortune 500 are currently customers of Cloudflare. The CEO thinks this could grow to 100% as they continue improving their enterprise sales motion and adding more products to the portfolio. Once landed, customers of this size provide a lot of room for spend expansion.

At this point, it’s worth highlighting Cloudflare’s announcement within the Q3 earnings release of hiring a new President of Revenue, Marc Boroditsky. Boroditsky has 30+ years of experience scaling high performance revenue organizations at global software companies including Twilio, Authy, and Oracle. In addition, he has experience in selling Zero Trust and other security services. While we might grimace a little at Twilio’s performance, Boroditsky did achieve 50% organic revenue growth there at a high revenue run rate. Twilio’s execution issues have been primarily with product strategy and profitability, not sales.

I like the fact that Boroditsky has enterprise sales experience. He brings a rolodex of connections and a network of salespeople to tap. Cloudflare would benefit from a more mature enterprise sales go-to-market. This isn’t a knock on the prior head of revenue, Chris Merritt, who took Cloudflare to $1B in sales. He was the first sales hire 10 years ago and grew from there. As Cloudflare sets its sights on the next target for $5B in sales, this transition of the sales organization is appropriate. The good news is that it has been planned for the past year, and initiated by Merritt, so disruption to the sales team should be limited.

Enterprise customer spend expansion is reflected in Cloudflare’s Dollar-Based Net Retention Rate (DBNRR). This dipped to 124% in Q3, after increasing to 127% in Q1. This is inline with the level from a year ago. The decrease is understandable within the context of two factors. First, while large customer counts are increasing, many have slowed down spending growth due to the macro impact. Second, DBNRR spans all paying customers, including those that transitioned from a paid service to the free tier. Because the DBNRR calculation is based on annualized spend in the quarter, these transitions would have a magnified effect on the overall expansion rate. While a small contributor to overall revenue, negative movement in smaller accounts would drag DBNRR downward, even if enterprise spend remained linear.

On the earnings call, management reiterated their target to increase DBNRR to surpass 130%. This would be achieved by selling more product to larger customers. The fact that Cloudflare is targeting an increase in DBNRR as they grow revenue is a positive signal, as most software companies over $1B in revenue start telegraphing expectations for decreasing net expansion rates as they grow.

On the earnings call, Cloudflare’s CEO provided the typical highlights of customer additions and expansions for the quarter. These were the primary themes:

• The vast majority of customer wins and expansions called out this quarter were with Fortune 500 companies. The CEO made a point of the fact that the first 8 of the 10 customer highlights are members of the Fortune 500. He further predicted that nearly every Fortune 500 company will be using Cloudflare for something in the next five years.
• Workers was part of several deals, including a Fortune 500 retailer, a Fortune 500 apparel company and a large software monitoring company (likely New Relic). The software company is using Workers heavily, migrating parts of their application from AWS to Workers. With the $3.6M expansion deal in Q3, their total annual spend is more than $5M.
• Two of the deals were for Cloudflare’s Data Localization service, which is powered by Workers. Having the ability to localize data processing within a country’s boundaries is becoming a requirement for many companies in the EU and Asia. Data Localization is fairly unique to Cloudflare in providing this capability. The CEO thinks this service will be included in more deals in the future.
• Cloudflare has been pushing the narrative on Zero Trust hard over the past couple of quarters. They highlighted Zero Trust product wins for two companies out of the 10 customer addition examples. These were a Fortune 500 consumer products provider and a large building materials manufacturer in the EU. They also mentioned that a Fortune 500 technology financial services company signed a $2.8M deal for security products and is evaluating Zero Trust now. I would like to continue to see Zero Trust traction. The CEO did discuss how Cloudflare’s win rate is strong for Zero Trust deals, but awareness could be improved to be included in more evaluations. The new President of Revenue should help build out the marketing aspect of Cloudflare’s Zero Trust strategy with enterprise customers. In addition, their new relationships with channel sales partners should be ramping up.

If you’ve been counting, that’s a lot of Fortune 500 companies. And we’re actually up to 32% of the Fortune 500 now using us. I see a clear path to nearly every Fortune 500 company using us for something in the next five years. And a big part of Marc and the team’s job there is to expand those relationships and then get them to use us for everything.

Cloudflare CEO, Q3 2022 earnings call

Product Updates and Strategy

Throughout the earnings report and subsequent commentary, the Cloudflare leadership team shared a number of product updates and reinforced their product strategy.

Capping off the trend of Innovation Weeks, the CEO mentioned that their final one for the year will be a developer innovation week. In preparation for that, the CEO provided a couple of stats around adoption of Cloudflare’s developer products. At the end of Q3, Cloudflare hosted 2.2M unique applications running on Workers. While many are small or free customers, that does reflect fairly broad adoption. Additionally, Cloudflare Pages is experiencing strong uptake. There are now 367K Pages projects, a count which has doubled since May.

Pages is Cloudflare’s solution for front-end developers to create a full-featured application using the JAMstack web development pattern. With this pattern, the application logic usually resides within the client, with data served by APIs (which can be hosted on Workers). The client application is normally served as a single payload from a CDN. Cloudflare’s Pages product has both free and paid pricing plans, so the rapid uptake of Pages is likely contributing to revenue.

R2 Update

In his remarks, the CEO also provided an update on R2, Cloudflare’s object store. As investors will recall, R2 was brought to GA in late September. As part of the press release, the team hinted at strong customer adoption for R2 as it came out of beta, claiming over 12,000 developers with an active account on R2. They also cited one customer (Vecteezy) who was spending “six figures” on egress fees with an alternate solution.

In the Q3 earnings report, Cloudflare’s CEO mentioned that R2 is now storing over a petabyte of customer data. As the service is in GA, this would be revenue generating. While R2 doesn’t charge for egress as part of its value proposition, it does generate fees from storage and read/write operations.

• Storage is priced at $0.015 / GB, per month
• Class A operations cost $4.50 / million (write)
• Class B operations cost $0.36 / million (read)

Before we get too excited, they do provide a free tier with low usage limits. I imagine that a large number of the 12, 000 developers are on this tier (but not all).

• 10 GB-months of stored data
• 1,000,000 Class A operations, per month (write)
• 10,000,000 Class B operations, per month (read)

A petabyte is one million gigabytes. If we were to assume that all of the petabyte of customer storage is paid, that would generate $15k a month in storage. We could increase that by a third to account for read/writes, corresponding to about $60k a quarter in revenue per petabyte of data.

What I think that we’ll see now that it is out of beta as of the very end of the quarter is that you’ll see much more large companies who are looking to figure out how they can reduce their cloud spend and make sure that they can have a multi-cloud presence adopt R2 services.

And so, we’re talking to very large companies about moving more and more of their stored objects to where we can store that with R2. 

Cloudflare Q3 2022 Earnings call

While one petabyte of storage would have a negligible revenue impact, during the Q4 earnings call, the CEO referenced some “incredible logos” with “hundreds of petabytes” of data that were participating in the beta. A hundred petabytes would represent $6M in revenue a quarter. That would start to have a material impact. It will take some time for this to ramp up, as large customers would want to test the service and slowly load it. However, if successful, the potential to drive future revenue generation is clear. And this revenue is incremental to Cloudflare’s existing product lines.

Gartner Magic Quadrant for WAAP

During the quarter, Gartner released their updated Magic Quadrant for Web Application and API Protection (WAAP) for 2022. Readers can access the full report though a light registration on the Cloudflare site. In the report, Cloudflare ascended to the Leaders quadrant. Cloudflare was the only company to be promoted into a higher quadrant this year.

As you can see in the digram below, most competitive solutions experienced a negative trajectory in the rankings from 2021 to 2022 (red lines). Only Cloudflare, AWS and Microsoft improved their relative positions from 2021 to 2022 (green lines).

While Akamai remains the provider furthest up and to the right, Cloudflare is closing the gap. This provides another example of Cloudflare’s commitment to continually improve their products until they are considered “best-of-breed”. This posture was emphasized in the opening blog post of GA Week in September.

But it’s not just about making products work and be available, it’s about making the best-of-breed. We ship early and iterate rapidly. We’ve done this over the years for WAF, DDoS mitigation, bot management, API protection, CDN and our developer platform. Today analyst firms such as Gartner, Forrester and IDC recognize us as leaders in all those areas.

Over the years we’ve heard criticism that we’re the new kid on the block. The latest iteration of that is Zero Trust vendors seeing us as novices. It sounds all too familiar. It’s what the DDoS, WAF, bot management, DNS, API protection, and serverless vendors used to say before we blew past them.

CLOUDFLARE GA WEEK BLOG POST, SEPTEMBER 2022

The implication of course is that Cloudflare is doing the same in Zero Trust. As investors will recall, in Gartner’s last magic quadrant for SSE (Zero Trust category) from February 2022, Cloudflare was named an Honorable Mention. They were not included because their CASB solution didn’t support an API interface before the cut-off for evaluation. At this point, it does. We should get the next Magic Quadrant for Zero Trust in early 2023 and I suspect that Cloudflare will be included.

FedRAMP Certification

Related to security solutions, we have been waiting for Cloudflare’s announcement of FedRamp certification. This was not discussed during the Q3 earnings report or analyst call. The last update from Q2 was that Cloudflare is in line for the Moderate Impact certification. There is no further action Cloudflare can take to complete its certification – the federal government simply needs to process their application. As of this writing, Cloudflare’s official status for Moderate Impact on the FedRAMP Marketplace is “In Process”.

FedRAMP certification is useful because it streamlines the process of vendor approval for working with a federal government agency. This allows any new agency customer to simply leverage their blanket approval. It doesn’t prevent an agency from working with Cloudflare. Without FedRAMP approval, each agency has to conduct their review independently, which creates additional friction. So, FedRAMP is important and we expect an update on Cloudflare’s status soon.

As an example, Cloudflare is used by the Department of the Interior, even though their application is In Process. However, there is clearly an advantage to having full authorization. Competitor Zscaler in Zero Trust is well ahead on their certifications, with High impact FedRamp approval already in place. Their listing on the FedRamp Marketplace shows 30 federal agencies that are using a Zscaler product for Zero Trust.

Take-aways and Investment Plan

NET sold off heavily following their Q3 report, yet I saw a number of positives in the results. While Q3 annual revenue growth slowed below 50%, Cloudflare set their Q4 revenue guidance significantly higher sequentially than they normally do, at 7.9% above the Q3 actual. This is the largest increase in over a year. Further supporting forward revenue, growth in RPO has been consistent and remained above the revenue growth rate. Finally, lest we think Cloudflare’s revenue growth rate past the $1B mark will decelerate substantially, they set a floor for a 38% CAGR for the next 5 years with their ambitious $5B target.

On the profitability side, Cloudflare delivered record Non-GAAP operating margin and operating cash flow in Q3. Further, they tripled the full year operating income target and set the preliminary target for Q4 operating income at the same amount that they just delivered in Q3. With a similar beat in Q4, operating margin would approach 10%. Additionally, they re-iterated positive FCF for 2H2022, implying that Q4 FCF margin would be above 2%.

New product introductions continue at a rapid pace. These are contributing to revenue with several customer wins in Q3 referencing Workers and Zero Trust. The doubling of Pages uptake in 6 months is a strong indicator, along with the potential adoption of R2 by large customers. These will help Cloudflare achieve its target to increase DBNRR past 130% and its goal to sell into 100% of the Fortune 500 over the next 5 years.

Of course, there are risks with an investment in Cloudflare, relative to other players in software infrastructure and security. The valuation will require strong performance going forward and any revenue growth deceleration after accounting for macro normalization would trigger a re-rating. While Cloudflare is entering new product categories to drive growth, each has entrenched competitors. Cloudflare will have to continue investing to reach feature parity. Additionally, FedRAMP authorization will provide a tailwind to growth, but is unresolved at this point.

For me, I like Cloudflare’s product optionality, rapid development cadence, architectural advantages and overall strategy. As I discussed, I think they can start to achieve leverage in operating margin and free cash flow generation, as they have front-loaded a lot of infrastructure investment. By owning and operating their data centers, they can now layer multiple revenue producing services over the same infrastructure without proportional cost. This will yield some interesting competitive dynamics and magnify cash flow.

In spite of the sell-off following the Q3 report, I plan to maintain an outsized allocation to NET in my personal portfolio. As long as I see a clear path to the $5B revenue target over 5 years, combined with improving operating leverage, Cloudflare will remain a core holding.

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

• Muji at Hhhypergrowth provided his take on Cloudflare’s results as well. Our interpretation of the results were similar and he always provides additional valuable perspective for investors considering a position. Also, check out his prior coverage of Cloudflare.