Cloudflare (NET) Q4 2022 Earnings Review

Cloudflare’s Q4 FY2022 earnings report was much anticipated by the market. Like other software infrastructure companies with their fiscal Q4 aligned to the calendar year, investors received their first firm view of guidance for not just the current quarter, but also the full year of 2023. Given trends that I discussed in a prior post, results from the hyperscalers pointed to further deceleration in cloud utilization as a consequence of workload “optimization” by customers. As the hyperscalers generally only project results a quarter forward, investors lack a clear signal as to when optimization headwinds might abate. A few software companies reported in the interim, providing some support for a view that software infrastructure demand might level out over the full year.

Additionally, as part of their Q3 2022 earnings report, Cloudflare leadership recognized the milestone of a $1B revenue run rate with a new ambitious growth target. They expect to reach a $5B revenue run rate within 5 years – specifically meaning that revenue in Q3 2027 would be $1.25B. This implies a revenue CAGR of 38% for the next 5 years. With the demand environment deteriorating further since the Q3 report in early November, investors were left to wonder if Cloudflare would have to revise this target coming into 2023. Close followers of the company would have noticed that they quietly reiterated the goal in a press release announcing a leadership hire in January.

Nonetheless, coming into the Q4 report analysts were looking for $1.312B in revenue for FY2023, representing growth of 34.6% over their FY2022 estimate. Surprisingly, Cloudflare issued guidance for revenue of $1.330B – $1.342B, representing growth of 37.0% at the midpoint above the actual FY2022 revenue. In this environment, where most software companies are just meeting or even lowering the forward year revenue estimate, Cloudflare’s initial guide a couple points above expectations seemed detached from reality. Assuming they follow a standard, but subdued beat/raise cadence as the year progresses, they might even end 2023 with revenue growth around 40%. This would outpace most peers in the software and security space.

This full year guide left analysts perplexed. Some just don’t believe it, assuming Cloudflare management is setting themselves up for failure. Guggenheim even reiterated their Sell rating, after having downgraded the stock in January. They raised their price target slightly from $36 to $43, and expressed that “2023 revenue guidance implies an unlikely material increase in new business signings from that seen in 2022.” In their view, Cloudflare’s execution risk is much higher with this guide.

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Perhaps. Even with the high starting point, Cloudflare management described the guidance as “prudent” with no expectations for macro or sales productivity improvement. This leaves expansion of sales from existing product offerings along the same trajectory to drive revenue growth to the full year target. But with a declining DBNRR, that seems implausible. If we isolate revenue growth in the large and small customer segments, however, the source of growth becomes clear. Spend expansion by the large customer segment significantly outpaced overall revenue growth during 2022. Extrapolation of the same sequential growth rates from Q4 2022 to each customer segment’s revenue contribution over 2023 provides a path to the revenue target.

Over the last 2 years, Cloudflare has been innovating at an extreme rate, leveraging their unique architecture to roll out a variety of new product offerings for customers. Several of these are beginning to scale their revenue contribution. The additional contribution from new offerings is stacking on top of the existing security and delivery products that are still in high demand. Further, a number of Cloudflare products can be sold for lower cost than competitive offerings and positioned as a mechanism for enterprises to lower their IT bill. Like other platform plays with multiple adjacent products under one umbrella (PANW comes to mind), the consolidation argument is resonating.

When Cloudflare’s CEO describes their product/market strategy as one of “Stacking S Curves”, the market’s reaction often ranges from skepticism to indifference. Yet, that appears to be exactly what the company is doing. If we recognize that several different product vectors are ramping up their individual S-Curves of revenue growth, then it’s possible to see the path to $5B in revenue over 5 years.

In this post, I’ll step back and review the product strategy from Cloudflare that provides the foundation for this growth target. Then, I’ll dig into the Q4 results to further investigate how the strategy seems to be aligning with the financial execution. Our partners over at Cestrian Capital Research posted a useful review of Cloudflare’s results as well, with detailed financials and technical analysis.

For frequent followers of SSI, I apologize for the delay in getting this review out. I spent several days preparing for my annual guest lecture for the London Business School. If you are interested, you can download the presentation deck. It provides perspective on my investment approach around finding companies with durable revenue growth driven by competitive advantage. I will include a few slides in this post, where they help elucidate the deep competitive moat that Cloudflare has established.

Cloudflare’s Product Strategy

To appreciate what makes Cloudflare’s product strategy unique, investors have to consider a couple of important architectural decisions that the team made early on. These provide the foundation for their competitive advantage and underscore the growth thesis. These principles appear simple in practice, but applied in a disciplined manner over 10 years have created quite a competitive moat.

What is powerful is because we have done the hard work on the networking and software side to make it so that any server, anywhere can handle any request, that means that as we continue to expand our network out that we’re able to directly interconnect with the various ISPs and networks around the world and drive our cost down for things like bandwidth, co-location and other variable costs that are part of our business.

Cloudflare Q1 FY2022 Earnings Call

These principles represented a divergence from common practices at the time and even recent trends with the emergence of the hyperscalers over the last 5 years as a foundation for many SaaS businesses.

• Owned and Operated. Cloudflare owns and operates its 275+ data centers across the globe. It coordinated and established 11,500 network interconnects with regional ISPs, cloud service providers and large enterprises. Many of these connections with country ISPs were by “invite”, as an outcome of Cloudflare’s free services to individual users and small businesses.
• Run Everywhere. All services run on every host in every data center. Every service deployment is fully global and distributed as a first principle. The serverless runtime (Workers) upon which new features are built provides critical isolation, allowing all Cloudflare products to be supported on one common backplane without creating a mess of code conflicts. While complex, this has enormous benefits. A new capability like R2 can be pushed to the whole network at once, versus having to plan for an additional “R2 server tier” upon which to host the service. This greatly increases the roll-out velocity and also allows the team to share hardware resources across all services. Part of the genesis for R2 was an observation that the global data center footprint included a fair amount of unused disk space on individual servers.
• Composability. The Cloudflare technology team created a highly distributed development platform (Workers) upon which all products are built. This platform is exposed as a product for external developers to use as well. Because of this approach, Cloudflare incurs the overhead of maintaining a development platform, versus just writing the code, compiling and deploying it directly onto their servers. The latter approach would be much easier, but the former has the added benefit of composability. As the Cloudflare engineering team builds new services within the Cloudflare development platform, these then provide building blocks for future product offerings (both internally and externally). This composability accelerates product development, as new offerings can be bootstrapped with the building blocks from prior releases. Many of Cloudflare’s newer products make use of other services as primitives. As an example, R2 leverages Durable Objects under the hood. It also has the side benefit of customization, allowing customers to personalize, enhance or supplement any aspect of a product.

These architectural tenets embraced by Cloudflare differ from the conventional approach taken by most software infrastructure providers. It’s understandable why these conventions are the common path – they generally result in faster time to market for the first couple of services, require little upfront CapEx investment and minimize cross-service conflicts. These Cloudflare anti-patterns are:

• Outsource Infrastructure. Leverage hyperscaler compute, storage and network resources. While this allows a new entrant to rapidly spin up an infrastructure service, it creates an ongoing tax as the service scales. Costs paid to the hyperscalers will increase proportionally to usage. Exposure to raw hardware and network resources is limited, curtailing the ability to fine tune performance or leverage underutilized capacity without additional payment (like extra disk space for R2).
• Isolate Service Tiers. As each new infrastructure service is built, it should be deployed onto a separate tier of servers, isolated from the others. This reduces conflicts between teams and allows for separate scaling of capacity requirements. However, each new service requires the activation of another service tier. This can slow down new releases (as additional capacity is provisioned globally) and result in redundancy of resources (underutilized resources on each server tier like compute or storage can’t be shared across services).
  • Deploy Machine Code. This pattern is a little harder to grok technically, but the idea is that the standard approach is for a development team to write their code for a service using their preferred language, tooling and build process. That runtime artifact is then pushed onto the isolated service tier to run independent of other services. Code can be shared and even organized into microservices, but it isn’t being built into a common development platform that is also available to external developers. The net result is some re-use of code and services, but not the overarching composability available to the Cloudflare product team. Additionally, having a distributed development environment available packaged with all monetized product offerings allows customer development teams to customize any aspect of the service. Want to integrate a Zero Trust feature with some component of application delivery or data storage? It’s just a Worker script away. Competitive products without a development environment require that the provider perform all customization.

Why can’t hyperscalers or new entrants just duplicate this approach? For new entrants, it would require building a network of 275+ data centers similar to Cloudflare’s scale, incurring substantial CapEx cost. For hyperscalers, it would require a significant re-architecting of their systems and likely conflict with existing revenue streams (like charging for data egress).

Added to Cloudflare’s competitive advantage is a culture of innovation led by a passionate founder/CEO who highlights product releases and accomplishments on social media channels popular with developers. Combined with the most active and informative company blog I have seen in the software space, it projects an environment that attracts top engineering and sales talent. Leadership has shared metrics around hiring before and recently revealed that 400k candidates applied for 1,300 positions in 2022. Considering that much of 2022 included a tight labor market, this is an impressive stat.

In a world in which a great engineer is 10x more productive than a mediocre one (believe me, the rule is true), then concentrating product development in a low cost country isn’t necessarily the most efficient approach. This contrasts with casting a wide recruiting net by creating an environment that attracts the best engineers globally.

Additionally, while engineers (like anyone) expect reasonable compensation, they are also motivated by the opportunity to solve complex, Internet-scale problems. With a broad mission to “help build a better Internet”, many engineers can find a home that aligns with their passion for technology.

Stacking S-Curves

Upon the architectural foundation and culture of innovation described above, Cloudflare is selectively pursuing new market opportunities where they feel they can apply leverage. To be clear, their vision is not to compete directly with the hyperscalers across all services. Rather, they are surgically identifying segments of the software infrastructure and security markets where their global network can deliver competitive advantage. These advantages may be realized in cost, performance or synergy.

Cost and performance advantages over competitive offerings are a consequence of Cloudflare’s architectural choices highlighted above. By owning their infrastructure, they can undercut competitors who build services on top of the hyperscalers. Performance is better because Cloudflare has full control over the infrastructure stack down to the machine and network level. By running all services in all data centers, applications are delivered at the closest point possible to the user and can be packed onto available hardware with a high utilization rate.

While cost and performance are important base drivers of competitive advantage, interesting synergies across products are starting to emerge as Cloudflare’s product platform expands. These synergies provide new product efficacy benefits that can be promoted to secure new customer wins. Those wins then feed back to create incremental benefit.

Cloudflare’s free tier of services drives these synergistic advantages. While Cloudflare has over 162k paying customers, they provide a free service tier to millions of additional users. These services span hosting, secure network access and application protection. Although this offering might be construed as a waste of cash on the surface, Cloudflare’s architectural choice to own and operate their network makes this possible. Utilization from the free tier is relatively low and capped, making the incremental cost to serve these users negligible.

However, the benefit is immense. These users are often the first recipients of new product releases, providing a lost cost way to safely battle test capabilities and gain feedback before promoting to paid tiers. This usage tier also feeds security efficacy. More users doing more things on the Internet provides more signals to identify threats and malicious behavior. Regional ISPs provide Cloudflare with an interconnect after they notice a critical mass of their citizens using Cloudflare’s free services.

Finally, free users often represent small businesses that can eventually grow into paid customers or represent IT leaders at enterprises who use the free tier for their pet projects. As we learned in the Q4 earnings report, ChatGPT started on a free product. Most of Cloudflare’s competitors cannot support such an extensive free tier, due to their operating model and architecture choices.

Regarding synergies, competitive advantages are emerging in somewhat unexpected ways. Cloudflare provides paid and free hosting, application protection and delivery services for millions of web sites globally. With the proliferation of DDOS attacks, application protection is a basic requirement to run any web site at scale. Because of Cloudflare’s powerful and generous offerings for application protection, they are now the entry point for over 20% of the world’s million busiest web sites, based on the January 2023 Web Server Survey from Netcraft.

According to the survey, Cloudflare jumped from 3rd place to 1st place among the top million busiest sites in January, overtaking both Apache and nginx in a single month. Its market share increased by 0.56% and is now 21.6%. This means that almost 22% of the most popular web sites on the Internet have Cloudflare’s reverse proxy in front of them. No other commercial competitor is even close. Additionally, Cloudflare’s share continues to increase the fastest.

This situation yields a number of advantages for Cloudflare. First, as the entry point, they occupy a critical role in the web site’s infrastructure. If Cloudflare goes down, the web site is inaccessible. This isn’t meant to point out a risk to Cloudflare, but rather highlight their importance in the services value chain. That relationship and dependency provides an opportunity for Cloudflare to cross-sell and upsell the web site’s IT team on additional services.

Secondly, this relationship with over 21% of the Internet provides an advantage to their Zero Trust offering. It means that enterprise customers using Cloudflare for Zero Trust network access can reach a large portion of Internet services without leaving the Cloudflare network.

But it’s more than that. The fact that we are today somewhere in front of 20% to 25% of the web means that for customers that use our Zero Trust products, if they are going forward to that 20%, 25% of the web that uses us, then they never have to leave Cloudflare’s network.

And we can deliver a much more significant product. So, as we are on in front of more content and as we are in front of more eyeballs, that just makes the experience for both sides of that network better and better and that catalyzes the network effect, which again is very difficult
for other competitors to catch up with.

Cloudflare Q4 2022 EArnings Call

No other Zero Trust vendor can refer to this benefit, because none of them also provide application hosting and DDoS mitigation services. This circumstance confers advantages to Cloudflare in both performance and security. It makes for a great product marketing bullet and separates Cloudflare’s Zero Trust product from competitive offerings.

These architectural advantages, combined with a culture biased towards innovation and shipping product, have favorably positioned Cloudflare to expand revenue across a number of new product streams. Most of these have a clear customer target, but are also being adopted in unexpected ways.

On the Q4 earnings call, leadership highlighted their relationship with a major generative AI company (presumably ChatGPT). They started with Cloudflare on the free tier in 2017 and evolved into a $1M deal in Q4, with more opportunity ahead. They are currently using CDN, DDoS, Bot Management and Gateway DNS, with consideration for Workers, API Shield and Image Resizing. This pattern is being repeated with other AI companies. After Nvidia’s results, we know AI represents a rapidly growing segment of IT.

The additional surprise, however, came with the revelation that the largest user of the R2 storage solution is another AI company. AI companies are storing their training data in R2, making it accessible globally for low cost.

What we’re finding with these AI companies is that R2 and other Workers products naturally become the glue at the center of a multi-cloud ecosystem. R2 has become the natural neutral place for these AI companies to store their training data, in order to make sure it can be inexpensively and efficiently accessed from anywhere. It’s obvious in retrospect, but it’s the use case we didn’t anticipate.

Today, our largest R2 customer is another AI company, using us for exactly the purpose of being a neutral place to store their training data. And, of course, being a neutral networks super cloud that stitches together the traditional public cloud isn’t a problem exclusive to AI.

Cloudflare Q4 2022 Earnings call

At the core of this are Cloudflare’s rapid product development cycle, bias to ship and unique architecture. On the earnings call, leadership mentioned another innovation week in March. This too will focus on security, highlighting Cloudflare’s iteration cadence in building out their Zero Trust and network security product set.

While they came to the Zero Trust market later than some competitors, the Cloudflare product offering is catching up quickly. As pointed out earlier, they bring unique competitive advantages in cost, performance and synergy. Once their base offering reaches feature parity (and it’s getting close), then I think we will see adoption of Wave 2 products rapidly climb the S-Curve. Wave 3, 4, 5 and onward will follow as Cloudflare finds new ways to leverage their differentiated architecture and intrinsic competitive advantage.

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Q4 Earnings Highlights

Revenue

While Cloudflare’s full year 2023 guide provides optimism, they are demonstrating revenue growth deceleration like other companies in the software infrastructure space. One of the strong drivers of the valuation multiple for NET in the past has been their consistent revenue growth rate, around 50% for several years in a row (even pre-Covid). As we navigate the impact of an overall pullback in IT spend as a consequence of macro pressure, the question for 2023 is whether growth rates will bottom out and then stabilize (or even re-accelerate somewhat as the year proceeds). This could provide a nice set-up for investors in 2024, as accelerating revenue growth rates usually drive up stock price.

Going back to Q3 of 2022, Cloudflare delivered $253.9M in revenue for 47.4% annual growth and 8.3% sequentially. This represented a slight beat of about 150 bps (1.5% annual growth) over their prior guidance issued in Q2 for $250M-$251M. For Q4, they originally guided for $273.5M – $274.5M, which represented 41.5% annual growth and 7.9% sequentially. The magnitude of the raise for the preliminary Q4 revenue target was substantial. At $20M and 7.9% sequential growth, it represented Cloudflare’s largest sequential raise to date.

The Q4 actual just barely beat this range, coming in at $274.7M for 41.9% annual growth and 8.2% sequentially. The beat over their prior guidance was about 40 bps annually and 30 bps sequentially. The sequential growth rate was roughly linear to Q3’s 8.3%, so at least sequential growth is holding.

As another benchmark, Cloudflare finished full year 2022 with revenue of $975.2M, up 48.6% over the prior year. In 2021, Cloudflare had $656.4M in revenue for 52.0% annual growth. The linearity around 50% annual growth is roughly intact for 2022 as a whole.

For Q1 2023, Cloudflare guided to a range of $290M-$291M, representing annual growth of 36.9%. At the midpoint, this is an increase of $15.8M over the Q4 actual for 5.7% of sequential growth. Interestingly, going back a year, management’s preliminary guide for Q1 2022 revenue issued in the Q4 report was $11.9M above the Q4 actual and 5.9% sequentially. In the actual Q1 2022 report, Cloudflare beat by $6.7M, reaching 9.6% sequential growth. Further, in the Q4 2020 to Q1 2021 transition, the preliminary guide was for even less sequential growth of $4.6M or about 3.7% sequentially.

So, while the Q1 2023 guide just met analyst expectations for $291M at the high end, the sequential raise of 5.7% is actually in line (or slightly above) the historical Q4 to Q1 average. This positive view is tempered by the fact that Cloudflare has delivered smaller beats over its guidance the last two quarters (1.5% and 0.3%), versus beats of 3.7% and 6.0% in sequential growth in those prior periods.

The magnitude of beats will be important going forward, as they will determine if sequential growth can support the FY2023 full year guide. So far, it roughly does. 8.25% sequential growth (average of Q3 and Q4) annualized yields 37.3% growth, which is the current FY2023 guide. For the full year, Cloudflare’s initial 2023 guidance is for a range of $1.330B – $1.342B in revenue, which represents 37.0% annual growth over the FY2022 actual of $975.2M.

If sequential growth holds in the 8-9% range, then the full year guide is realistic. While annual growth rates have decreased the last couple of quarters, the sequential growth rates have remained linear. One of the key data points for the first couple of quarters of 2023 will be whether this sequential growth can hold. Cloudflare would need to beat their preliminary Q1 guide for 5.7% sequential growth by about 2.5% to remain on track. This is above the beats for the past two quarters, but less than quarterly beats historically.

To provide another signal for the forward revenue potential, we can look to RPO. Remaining Performance Obligations (RPO) was $907M at the end of Q4. This is up 45% annually and 9.1% sequentially over $831M in Q3, which was up 9.3% sequentially from Q2. Current RPO in Q4 was 74% of total RPO or $671.2M. This increased 7.7% from Q3’s current RPO of $623.2M (75% of total). RPO represents revenue under contract that hasn’t been realized yet. Its consistent trajectory would support further linearity in revenue growth.

Profitability

After reaching break-even operating income on a Non-GAAP basis in Q3 2021, Cloudflare has been gradually increasing their operating margin since then. At that point in 2021, the leadership team discussed the idea of maintaining break-even in order to continue investing in the business going forward. With greater scrutiny on profitability in 2022, their approach evolved towards the “Rule of 40” model, in which revenue growth and operating margin can be traded off based on the demand environment. As revenue growth has decelerated in 2022, operating margin has increased.

This trade-off is reasonable and the market appears to appreciate the more consistent delivery of positive operating income. For Q4, Cloudflare achieved Non-GAAP operating income of $16.8M for operating margin of 6.1%. This beat their estimate set in the Q3 report for $12.5M by 34%. Compared to a year ago, operating income was $2.2M for an operating margin of 1.2%. This represented a year/year increase of over 5x and nearly 500 bps improvement in operating margin.

Going back further, we can see the incremental annual improvement in operating margin. While the trajectory of improvement was clear, the inflection to positive operating margin represented an important milestone for investors and removed a long-standing gripe. Cloudflare’s operating margin still has room to reach levels enjoyed by some software infrastructure peers, but the path to getting there is becoming clearer. As part of the Q4 investor presentation, Cloudflare leadership reiterated their long-term model of reaching 20%+ operating margin.

The improvement in operating margin has been driven by a methodical reduction in the percent of revenue allocated to S&M, R&D and G&A. Interestingly, Cloudflare has reached their long-term target for R&D spend. G&A is getting close and Sales and Marketing has a way to go. I expect that as Cloudflare’s product portfolio expands, the relative allocation to S&M can decrease. As I will discuss in the Customers section, an increasing share of Cloudflare’s total revenue is being generated by large customers.

These large customers are increasing spend at a faster rate than overall revenue growth, driven by adoption of an increasing number of Cloudflare products. An upsell will generally require less sales effort than landing a brand new customer. The expansion motion with large customers should support higher sales efficiency, supporting less investment in S&M while maintaining the same growth rate.

To achieve higher operating margin in the second half of 2022, Cloudflare tempered the pace of hiring. In Q4, they added 40 incremental employees over Q3, representing the lowest sequential growth in several years. This followed a reduced Q3 as well, but a record number of additions in Q1 and Q2.

The slower level of employee expansion is appropriate in this environment. While hiring in Q4 dropped off, total employee additions for 2022 was 780, which exceeded the total of 652 for all of 2021. So, I don’t think Cloudflare is at risk of the employee pipeline impacting planned expansion. The CFO also reiterated the investment philosophy as it aligns with their $5B in 5 years revenue goal

We will continue to pace hiring for the year based on current market conditions to deliver consistent results, with a keen focus on allocating our talent to key strategic areas of the business to help us achieve our objective of $5 billion on annualized revenue in five years and to do so profitably, predictably, and productively.

Cloudflare Q4 2022 Earnings Call

For Q1 2023, leadership projects Non-GAAP operating income in the range of $11.5M to $12.5 for an operating margin of 4.4% at the midpoint. This is below the $16.8M achieved in Q4, and almost inline with the original estimate of $12.5M for Q4 at the midpoint. For the full year, they set a baseline for $54M – $58M in operating income for an operating margin of 4.2%. This is above the 3.7% operating margin delivered in 2022.

Shifting to cash flow, Cloudflare management intends to continue driving free cash flow generation upwards over time. For Q4, Cloudflare reported record cash flow metrics. Operating cash flow was $78.1M for an OCF margin of 28.4%. This compares to $40.6M for a 21.0% OCF margin a year ago. After backing out capital expenditures, which includes 10% allocated to network CapEx, free cash flow in Q4 was $33.7M for a FCF margin of 12.3%. A year ago, free cash flow was $8.6M for a FCF margin of 4.4%. So, while annual revenue growth decelerated to 42%, FCF almost quadrupled. Delivering positive FCF margin in Q4 was also a firm market expectation.

For the full year of 2022, Cloudflare delivered negative free cash flow margin of -4%. Going forward into 2023, leadership committed to positive free cash margin for the full year and subsequent years. They also set an allocation to network CapEx of 11% to 13% for 2023. This is below the 12% to 14% range that had been set for 2022. The CFO attributed the year/year reduction to the “flexibility, elasticity and scalability that we have achieved in our network.”

One change that will help drive cash flow is the roll-out of new pricing and billing terms for Cloudflare’s pay-as-you-go customers. This segment represents less than 20% of revenue. The change was to shift from monthly payments to annual payments up front. If the customer chooses to remain on a monthly payment, the cost would increase by 25%. For an annual payment made in advance, the effective monthly fee would remain the same. While this represents a smaller segment of customers, the full lump sum up front should have a material impact on cash flow. For the rest of the business under contract, we can assume the Cloudflare sales team is trying to negotiate more front-loaded payment as well, as part of billing terms.

The benefit to Cloudflare from up front payments is that it increases cash flow. Mathematically, Cloudflare will always allocate a percent of their revenue to capital expenditures. But, if they can collect that cash near the beginning of a billing cycle versus the end, then operating cash flow margins will be higher. This shift wouldn’t matter if Cloudflare’s revenue growth rate were 0%, but at 40% a year, it does make a difference.

Looking forward, investors are left wondering where FCF margins could go from here. I think it’s fair to assume that network CapEx slowly trends downward over time. This would be explained by the need to front-load investments in order to achieve a global footprint (mostly done) and then add capacity to accommodate more utilization. I think the full CapEx load (network CapEx, plus physical plant and capitalized software) could trend towards 14%-16%.

That leaves projections for operating cash flow, which reached a record 28% in Q4. A few factors could contribute to further improvement here: 1) collecting more cash up front and 2) packing more services onto the existing footprint. Both efforts are underway, with the second providing significant leverage unique to Cloudflare due to their architecture (tenet of Run Everywhere). Looking at comparables for other companies that make a substantial investment in their own data centers and network, Akamai (AKAM) and Digital Ocean (DOCN) provide a reasonable proxy.

In their most recent quarter, Akamai’s operating cash flow margin was 37%, or about 9% above Cloudflare’s OCF margin of 28%. That implies Cloudflare could reach 20% FCF margin. Digital Ocean provides an even higher target. For all of 2022, they delivered 13.5% FCF margin. Looking forward to 2023, they are enacting several initiatives to increase FCF margin further. They have set a preliminary target for 21% – 22% FCF margin for the full year, with the Q4 exit rate approaching 30%.

While Cloudflare is growing faster than these two companies and is earlier in their cash flow optimization cycle, I provide them as examples to illustrate what might be achievable for Cloudflare. In the past, investors have assumed that Cloudflare could never generate favorable cash flow due to their heavy CapEx investment. They compare Cloudflare to other software infrastructure companies that already enjoy FCF margins approaching 20%.

The difference, however, goes back to the point I made earlier about Cloudflare’s architectural decisions. Software infrastructure and SaaS companies that run their services on top of hyperscaler infrastructure can reach peak FCF margin earlier in their growth cycle. They will always incur an operating expense with the hyperscalers that scales linearly to their growth, however, creating a ceiling for cash flow margin.

Companies that own their infrastructure (like Cloudflare) will incur more CapEx cost up front, creating a drag on their free cash flow generation early in their evolution. However, lacking the overhead of an expense to the hyperscalers, they can drive operating cash flow margins higher over the long term. As incremental CapEx investments slow down with scale, FCF margins can match or even eventually exceed those of their software infrastructure peers that don’t own their infrastructure.

Customer Activity

Cloudflare ended Q4 with 162,086 paying customers. This increased by about 6,000 from the 156k reported in Q3 and was up 16% y/y. Sequential additions picked up a bit in Q4, versus 4k – 5k in the prior two quarters. This increase was attributed to better retention in the pay-as-you-go tier. Due to economic pressure, many of these customers were downgrading to the free tier in Q2 and Q3. That can be done temporarily for smaller customers by reducing usage rates below the threshold for free.

With 162,000 customers total, the big opportunity for Cloudflare is to convert more of these into large customers. Slower growth in the total customer count is acceptable for now, as there are plenty to upsell. Cloudflare defines large customers as those with annualized revenue greater than $100k. Large customers make up just 2.3% of total customers currently, so I am not really watching the rate of total customer growth.

Q4 ended with 2,042 customers spending more than $100k on an annualized basis. This represents an increase of 134 for 44% annual and 7.0% sequential growth. In Q3, they added 159 large customers and 212 in Q2. The rate of these additions has been slowing down. Large customers contributed 63% of total revenue, up from 61% in the prior quarter and 57% a year ago. I’ll discuss the implications of the rapidly growing share of revenue from large customers shortly.

Cloudflare also provides counts of $500k and $1M customers annually. They ended the year with 222 customers spending $500k or more, up 83% from 121 at the end of 2021. The count of $1M+ customers increased 52% from 56 at end of 2021 to 85 in 2022. The fact that these counts are increasing faster than revenue growth and the count of $100k customers demonstrates the high elasticity of spend with large customers. This plays well into Cloudflare’s product strategy to expand their footprint with large accounts and continuously upsell customers on more adjacent services.

While the count of large and extra large customers is trending upwards, Cloudflare’s dollar-based net retention rate (DBNRR) has been decreasing for the past couple of quarters. After reaching 127% early in 2022, it has been steadily declining over the course of 2022. This is alarming on the surface. However, the CFO explained that the company is not experiencing elevated churn. The decrease is attributable to slower expansion with the pay-as-you-go customers and those spending less than $100k. This was the case in Q3 as well, reflecting macro pressure as these smaller customers slow down expansion or transition into the free tier. Reduction in spend from smaller customers would create a negative drag on DBNRR.

Looking at just the large customer segment (those spending $100k or more), net expansion was flat sequentially and consistent with the average quarterly DBNRR for that segment since the end of 2019. Further, while DBNRR has been decreasing this year, management reiterated their expectation that DBNRR will trend upwards over time towards their long-term target of 130% plus.

Our dollar base net retention rate was 122% during the fourth quarter, a decrease of 200 basis points sequentially and a decrease of 300 basis points year-over-year. We’ve not experienced elevated churn. Instead, similar to last quarter, the decline was primarily driven by less net expansion and customer spending less than $100,000 with Cloudflare as well as pay-as-you-go customers.

Conversely, our large customer net expansion was flat quarter-to-quarter and remains consistent with our average quarterly DNR for this customer segment since the end of 2019. We continue to expect DNR to trend upward over time to our long-term target of 130%-plus. Also, we anticipate some variability from time to time, particularly as customers are more cautious in their near-term spending which, as I mentioned before, has impacted sales cycles.

Cloudflare Q4 2022 Earnings call

As he typically does each quarter, Cloudflare’s CEO highlighted a number of customer wins. These examples reinforce a few themes in Cloudflare’s product strategy and expansion potential. They also reflect the idea that Cloudflare has several product S-Curves running in parallel. Finally, they illustrate further examples of customers using the Cloudflare development platform and network in unexpected ways.

• Zero Trust Wins. The CEO described several large Zero Trust security deals, a few of which represented competitive wins or displacements. These included a Fortune 500 energy company (3 year $1.6M deal for Gateway, Access, RBI and DNS), a Fortune 500 telecom (1 year $400k deal for DNS content filtering) and a European financial services company (5 year $1.8M deal for application services, Access, DNS filtering, Magic Transit and Data Localization)
• AI Market Segment. A leading generative AI company (presumably ChatGPT) signed a 1 year deal for $1M for CDN, DDoS, Bot management and Gateway DNS. They see a further expansion opportunity for Workers, API Shield and Image Resizing. Cloudflare is working with other AI companies as well. This segment materialized from near zero spend in the last 12 months.
• New Use Cases. The CEO highlighted two use cases for Cloudflare products that were unexpected, but represent large future potential. First, AI companies have found benefit in storing training data in R2, allowing it to be accessed across cloud providers. Their largest R2 customer is now another AI company (not ChatGPT) and is growing rapidly. Second, a public utility company in Africa signed a $2.8M deal for an IoT use case. They will use Cloudflare’s network (presumably with Workers) to monitor 3,300 sensors tracking material shipments.
• Expanding Set of Products. An existing Fortune 500 financial services customer expanded from application services, adding Access, Gateway, RBI, Magic WAN and Magic Firewall (for 3 year, $1.1M deal). The customer wanted to consolidate security vendors, reduce costs, gain more control over their traffic flow and implement Zero Trust.
• Government Opportunity. Cloudflare is gaining traction in U.S. government deals, aided by their recent FedRamp moderate authorization in December. They landed a major $7.2M five-year deal to operate DNS for the .gov registry. This win is significant for Cloudflare, as it connects their network to every federal agency, offering an entry point for other service upsells. They also won a three-year $3M deal with the State of North Carolina to provide protection for 50 state agencies. This relationship started with the Athenian Project, demonstrating how Cloudflare’s commitment to provide free support for election security has become a lead generator. Public sector business only makes up 3% of revenue currently, which leadership believes can be increased.

Overshadowing the success with customer highlights was feedback on the enterprise sales process and go-to-market effort. As investors will recall, Cloudflare brought on a new head of sales in Q3 (Marc Boroditsky, previously Chief Revenue Officer at Twilio). At the 100 day check-in, Cloudflare’s CEO shared that Boroditsky identified a number of opportunities for improvement in the structure and processes associated with the sales effort to large customers.

As our product becomes more complicated, and we are selling to larger and larger customers, it’s increasingly clear that we need to step up our game in marketing and sales. I introduced Marc Boroditsky, who joined last quarter to lead our sales organization. Last week he briefed me and Michelle on his first 100 days. My initial reaction, if I’m honest, was embarrassment over some of the basic things we should have been doing better. But my second reaction was excitement because there are so many opportunities for us to improve.

In addition to Marc, Brent Remai joined us last quarter to lead our marketing team. Brent was previously CMO at FireEye and CMO of Core Services is AWS. His career perfectly prepared him for Cloudflare’s delivery of cloud security services. We’ve seen early results with Brent’s team generating pipeline in Q4 and January Q1 coming in ahead of our target.

Cloudflare Q4 2022 Earnings Call

Additionally, Cloudflare hired a new head of marketing, Brent Remai, who appears well prepared to drive Cloudflare’s awareness in the Zero Trust security market. The CEO mentioned that the marketing team under Remai’s leadership has already improved lead generation effectiveness with sales pipeline for Q4 and January coming in ahead of target.

Having more effective marketing to fill the customer pipeline and improved sales processes to engage and close prospects should help drive higher revenue generation for Cloudflare, over what was accomplished previously. The new heads of marketing and sales are working to establish “a consistent structure, model, and process that simplifies how we operate and how we interact with prospects, customers, and partners.”

Cloudflare leadership expects these new sales and marketing processes to ultimately improve revenue growth and sales productivity. This is based on the success of these leaders accomplishing the same at other organizations and their early results. The CFO again reinforced that their 2023 guidance makes no assumptions for these improvements and even models sales productivity levels below recent historical lows to be safe.

Additionally, the CFO said that while the customer pipeline improved notably as they exited 2022 (due to improvements in marketing), they are assuming that the elongated sales cycles experienced in second half of 2022 will continue. Finally, he is modeling no improvement in the macro environment in 2023.

Going back to the full year guide, then, how will Cloudflare achieve 37% revenue growth as a baseline? It seems they are handicapping every potential driver of improvement. If we look closely, though, the management team did provide a few key pieces of data that yield insight into why they think 37% or more revenue growth is possible for the full year of 2023.

This has to do with the revenue contribution from large customers. As Cloudflare has evolved, they have aspired to improve their upmarket motion and sell more services to the largest enterprises. This is why they provide examples of customer wins in the Fortune 500. Their penetration of this cohort of enterprises has been steadily increasing, reaching 33% this quarter. The CEO thinks that all Fortune 500 companies could eventually become customers.

As Cloudflare’s product offering has expanded into additional segments (S-Curves), they are able to sell a larger bundle of services to these enterprises. Over the past year, leadership has provided more granular metrics around the revenue contribution of these large customers, specifically reporting not just the increase in count of customers spending more than $100k in annualized revenue, but also their contribution to total revenue by percentage. Applying this percentage progressively to each period, we can calculate the actual revenue generated by the large customer cohort.

Cloudflare leadership provided a new graph in the Q4 2022 slide deck showing this data for the past 4 years. We can see that the growth of revenue annually for the large customer cohort has averaged 71% over 4 years. This is higher than the 49% CAGR for total revenue growth. Additionally, for FY2022, the growth in large customer revenue contribution was 67.4%. This is almost 20% higher than then full year 2022 revenue growth of 48.6%.

Further, if we look at customer segment contribution by quarter for 2022, we can calculate sequential growth rates. For Q4, the contribution of revenue from large customers ticked up 2% to 63% of total. Revenue from the large customer cohort grew 56.7% y/y in Q4, which is also higher than overall Q4 revenue growth of 41.9%. As Cloudflare started providing this percentage mix each quarter during 2022, investors can now track the sequential growth rate.

For Q4, large customer revenue increased by 11.7% sequentially, which was above Q3’s rate of 10.1% sequential growth (14.3% in Q2 and 11.5% in Q1). If we annualize the 11.7% sequential growth, it implies a full year revenue growth rate of 55.7%. This is significantly higher than the preliminary guide for FY2023 for 37.0% of total revenue growth.

This growth in large customer revenue is likely the driver of the optimistic full year revenue guide. If we perform an exercise in which we project the Q4 sequential growth rate for both customer cohorts forward for all 4 quarters in 2023, we get a total of $919.4M for large customers ($173.0M with 11.7% sequential growth over 4 quarters) and $433.4M for small customers ($101.6M with 2.6% sequential growth over 4 quarters). The sum of those two is $1.353B. The midpoint of the full year guide was $1.336B.

It’s the fairly consistent and elevated sequential growth rate of revenue generated from the large customer cohort that provides the support for the full year 2023 guide. This doesn’t require improvement of close rates or the macro environment from the trajectory coming out of Q4. It is possible that demand deteriorates further from here, but there is some buffer in the guide. Further, we would expect some new products to come online in 2023 that might start contributing to revenue.

This exercise also informs the the $5B in 5 years target, as Cloudflare’s expectation is to sell into 100% of the Fortune 500 at some point (3x the current penetration) and expand product adoption of large customers further into the $1M+ range. Large customer spend expansion also illustrates management’s confidence in the path to DBNRR over 130%. It is likely that DBNRR for large customers is already at or above this threshold. As large customers make up a greater portion of overall revenue, it will pull up overall DBNRR with it.

Investment Plan

If we believe Cloudflare’s guidance and assume a few percentage points of raises through the year, then they could end 2023 with $1.365B in revenue and 40% annual growth. This would keep them on the path towards $5B in revenue by 2027 (technically $1.25B in Q3 2027).

When Cloudflare management set this target, it was based on the current product set. As an innovation engine, we can assume that the Cloudflare team will continue introducing new capabilities and monetized products. While those aren’t included in the $5B target, they would provide momentum to continue driving revenue growth past $5B. Given that Cloudflare has defined their TAM as being $135B through 2024, this leaves plenty of room for further expansion. Additionally, new products would expand this TAM further.

Given this, it’s likely their revenue growth rate at the $5B target is still in the 30% range. Additionally, I think FCF margins can reach 20%. This is based on the current trajectory, management’s long term guidance for operating margin above 20% and comparison to peers with a similar CapEx heavy profile. Akamai delivers 37% OCF margin and Digital Ocean just promised nearly 30% FCF margin for Q4 2023. Both Akamai and Digital Ocean make significant investments in building out data centers and network connectivity.

That would imply $5B in revenue and $1B+ in FCF by 2027. Cloudflare’s current Market Cap is $20.4B. That yields a forward P/S ratio of 4 and P/FCF of 20. Cloudflare’s current trailing P/S ratio is 20.6. If we back down the expected P/S ratio for 2027 to 15-16 (for 30% revenue growth and 20% FCF), it implies a rough 4x increase in valuation from here. TEAM and NOW enjoy P/S ratios in the 12-13 range with a lower revenue growth rate, so not out of the ballpark. Further, Cloudflare leadership committed to a 3% cap on SBC dilution impact annually going forward.

Investors can apply their own assumptions for reasonable valuation multiples on the 2027 targets. Personally, I am comfortable with these projections and am planning to maintain my outsized allocation to NET in my portfolio. While the valuation appears steep, I think Cloudflare has established a unique set of competitive advantages that will allow it to maintain elevated durable revenue growth and achieve favorable cash flow margins over the next 5 years.

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 couple of posts on his premium site covering Cloudflare’s Q4 results and their recent CIO innovation week. Well worth the cost for additional perspective and deep product analysis.