First Look at Cloudflare’s Q1 2022 Earnings Report

(Revised May 10th. Added commentary on CapEx at end)

Cloudflare (NET) announced Q1 FY2022 earnings on May 5th. I will share a short summary of my reactions to the report, structured around positives, negatives and additional data points that are of interest. I won’t rehash all of the metrics, as those are readily available online in the earnings report and Investor Presentation. Additionally, Cloudflare has an Investor Day event scheduled for May 12th, which will offer additional insight into product strategy and long term financial targets.

The Good

• Revenue growth continues along its expected trajectory of 50% annually. I don’t see evidence of deceleration in Q1 revenue growth or forward guidance, if we apply similar beats. The market likes consistency and Cloudflare meets that expectation.
  • Q1 revenue growth was 53.6% annually and up 9.6% sequentially. The beat of $6.7M over the initial guide from Q4 was a little lower than we normally see, but the increase from Q4 to Q1 is the same 9.7% sequential increase we saw a year ago.
  • Q2 Revenue guidance was strong, representing annual growth of 48.9% or 7.0% sequentially. The growth target was about the same as the initial Q1 guidance, demonstrating no expectation of a slowdown. The sequential guide implied in the guidance is higher than that between Q1 and Q2 a year ago (which was for 5.8% growth).
  • For the full year, Cloudflare raised their target annual growth rate from 41.5% to 45.8% or 430 bps. If Cloudflare delivers the same pace of raises as last year, the annual growth rate should land in the mid-50% range. The dollar raise was $28M, which far exceeds the $6.7M beat from Q1. In Q1 2021, the full year guide was for 42.4% growth, which ended the year at 52%. We are currently 3.4% above that pace.
• Non-GAAP gross margin remained stable at 78.7% of revenue. This is up 110 bps from a year ago, and down 50 bps from the prior quarter. The key consideration is that usage of Cloudflare’s network increased substantially y/y (up 76%, more metrics below), yet Cloudflare is showing no degradation in gross margin. Leadership points to their high network efficiency as a competitive advantage and intends to use their pricing power to take market share. Competitors who lease their data centers and network infrastructure from other providers, or maintain legacy, hardware-driven network routing, don’t have this advantage.
• Non-GAAP operating margin increased slightly to 2.3%, up from 1.2% last quarter and -5% a year ago. Also, forward guidance implies Cloudflare will remain with a slightly positive operating margin through the year (full year target reiterated at about 1% op margin). This approach was articulated by the CEO as part of Q4 earnings, so I categorize this as a positive for sticking to the plan. Some peer software companies actually lowered operating margin targets. With that said, the market is fairly comparing Cloudflare to some software companies (DDOG, SNOW) who are continually increasing operating income while maintaining high growth. This is likely weighing on Cloudflare shares.
• Dollar-based net retention (DBNR) increased to 127%, up from 125% last quarter and 123% a year ago. For me, this was the highlight of the report. It underscores Cloudflare’s effort to expand sales with large customers, which now make up 58% of revenue. Leadership provided customer examples where Cloudflare is capturing incremental spend, after the initial customer use case within one department or one product line. They believe that Cloudflare’s platform of services will appeal to large companies looking to consolidate their vendor solutions and reduce cost.

• Total paying customers had a record number of additions in Q1. Cloudflare added just over 14k customers, bringing the total to 154,109. This was up 10.0% sequentially from Q4 and 29.3% annually. This represented a nice re-acceleration, after prior quarters of sequential growth in the 4-6% range.
• Leadership highlighted the fact that 12 customers and partners now spend over $5M a year. We hadn’t heard a reference to this level of spend previously, underscoring leadership’s messaging that Cloudflare can attract large enterprise spend for customers interested in consolidating a number of network and security use cases onto a single platform. To further underscore the large spend upside potential, leadership highlighted an expansion deal with an existing Fortune 500 software customer bringing their spend to $15M a year.
• They also updated us on growth in customers spending over $1M a year, up 72% y/y in Q1. This is down slightly from 75% in Q4, but still robust. This growth in very large customers is also indicative of the motion up market to capture large enterprise spend.

Areas for Concern

• While I highlighted strength in total customer additions and $1M+ customers, growth in the mid-sized customers lagged a bit in Q1. Large customers (defined as those with >$100k ARR) increased by the least sequentially in a year. They added 121 of these sized customers in Q1, up 8.5% sequentially and 63% annually. This is down from 156 added in Q4 and a record 172 in Q3. Revenue from these customers now makes up 58% of the total, up from 50% a year ago. This dip could be temporary, but will be a metric to watch over the next few quarters. It is important that new customers progress up the spending brackets to maintain revenue expansion. Recent growth appears concentrated in the $1M+ customers, given that DBNR continues to increase.
• RPO was $688M at end of Q1. This was up 10% sequentially from Q4’s value of $624M, and 57% annually. Current RPO is 76% of total. In Q4, RPO grew 14% sequentially and 63% y/y. Going back to Q2, RPO was up 77% y/y. This growth rate appears to be decelerating. It hasn’t manifested in revenue projections at this point, but should be monitored.
• FCF inverted substantially negative in Q1 to -$64.4M or 30% of revenue, after delivering positive FCF in Q4 of $8.6M or 4% of revenue. Looking at operating cash flow (minus impact of CapEx), Q1 came in at -$35.5M. The decrease in cash flow was primarily related to a unique withholding tax payment of about $30M. This brings Q1 operating cash flow closer to break even, with the remainder of the FCF gap attributed to CapEx spend. The CFO indicated that they expect to return to positive FCF in the second half of the year.

Other Data Points

There were other data points and comments made on the call that I found interesting. Some of these may benefit performance in the future, but the impact can’t be measured at this time.

• Network and CPU utilization increasing faster than revenue. The CEO highlighted a couple of metrics on growth of overall utilization of Cloudflare’s network and compute resources, reflecting that they are increasing faster than revenue.
  • Traffic on Cloudflare’s network increased 75.8% y/y, and was up 15.9% sequentially in Q1. This is noteworthy as peers like Akamai reported a decrease in network traffic and expect that to continue through the year.
  • CPU utilization grew 89.1% y/y, and was up 21.8% sequentially in Q1. This metric reflects use of Cloudflare’s products that consume compute resources, like security products and Workers.
  • Since Cloudflare doesn’t charge customers based on usage and has a free user tier, these increases aren’t monetized and explains why revenue doesn’t grow in the same proportion.
  • At the same time, the increase in usage does signal growing interest in Cloudflare’s products and likely represents an upsell opportunity as contracts renew. It also reflects positively on gross margins, which were stable during the same period. This durability of gross margins provides further proof that Cloudflare should have a pricing advantage over competitors.
• Cloudflare is still hiring aggressively. Headcount increased by 42% y/y in Q1 to 2,750. This is up 12.7% sequentially from Q4 with 2,440 employees. In Q4, annual growth in headcount was 36%. This increase in Q1 may be tied to leadership’s intent to maintain operating margin break-even going forward, meaning that operating leverage improvements previously were applied towards reaching break-even. Going forward, this excess operating income will be re-invested back into business operations.
• Leadership cited receiving 133k job applications in the quarter, far exceeding the 310 employees hired. More importantly, attrition ticked down in the quarter. This is in contrast to general industry commentary about challenges with resignations and hiring talent.
• The email security product gained through the acquisition of Area 1 Security is off to a strong start. Leadership referenced a competitive customer win with a Fortune 1000 trucking company, representing a $385k deal over 2 years for 7,500 seats. This was an existing Cloudflare customer that tacked on email security. Leadership expects more of these types of add-ons for email security.
• Leadership cited a large Indian company in which Cloudflare won a $150k deal for 5,000 seats for their Zero Trust products. This was a competitive win against Zscaler and Palo Alto Networks. The CEO commented that they are competing more often with these providers and that win rates are favorable. What I find interesting is that Cloudflare just entered this space two years ago and is already competing with the best-of-breed providers.
• Cloudflare is close to receiving FedRamp approval and has passed the review with their sponsoring agency. That will clear the way for more federal agency business, for which they claim demand is high. They also highlighted a customer win with a midwest U.S. state government in Q1 for a 3 year $5.1M deal.
• Cloudflare reported that 47% of their revenue is international. US grew 56%, EMEA was up 57% and APAC is the laggard growing at 31%, but improving each quarter. In Q4, US growth was 52%, EMEA was 60% and APAC was 29%.
• Leadership called out a couple of new customer wins just for Workers.
  • A large social network signed a $3M deal over 5 years to use Workers for authentication of their messaging product. This will require massive scale and Workers passed scrutiny by the company’s sophisticated engineering team.
  • A major software company in Australia signed an initial engagement worth $145k to use Workers and Durable Objects for a new collaboration feature. They expect the company to expand to more use cases over time.

Finally, the CEO highlighted that next week with be another Innovation Week, focusing on the development platform (Workers). As part of this, they intend to bring R2 storage from closed beta to open beta. In the Q4 earnings call, the CEO stated that R2 already had 9,000 customers “including some incredible logos, representing hundreds of Petabytes of data.”

I wondered what R2 might be worth in terms of new business, expecting it to be trivial. In the announcement for R2, Cloudflare indicated that pricing would be $0.015 per GB per month, with no egress fees. For high volume data storage, AWS S3 pricing is about $0.021 per GB per month, with high fees for moving data out of the system. A petabyte (PB) = 1,000,000 gigabytes (GB). That means a PB of storage on R2 would cost about $15k a month. If “hundreds” is 200, that translates to $3.0M a month, or about $36M a year of incremental revenue.

These are just metrics from the closed beta. I suspect we will get an update on progress next week. An additional $36M+ of revenue a year would have material impact. Cloudflare plans to bring R2 to GA in Q4, implying this revenue would start accruing in 2023. If Cloudflare ends this year with $1B in revenue, R2 would already drive a roughly 4% lift.

Take-aways and Investment Plan

Overall, I thought the Q1 results were good. Steady as she goes. Cloudflare is still exhibiting the consistent execution that we have become accustomed to. Some areas exceeded expectations, some were lower. Overall, I don’t see cracks in the thesis and am excited about the potential for Cloudflare looking forward. As far as I can tell, durable revenue growth at 50% is sustainable.

This is particularly evidenced by a few items:

• Advantages of their software-driven network architecture. This is allowing them to deliver high performance and more capabilities at a lower price than competitors. This is evidenced by the consistency in gross margins as network utilization scales rapidly and anecdotal commentary provided by management about taking share.
• The net expansion rate continues to improve. DBNR was 117% in Q1 2020, rising 10% over the following two years to 127% now. These increases have been consistent, growing about 1% a quarter. We could cross the coveted 130% point within the next year, which would provide further support for revenue growth durability. If Cloudflare can maintain the same level of new customer additions and increase the DBNR rate, then it’s fair to assume that annual revenue growth rates will accelerate in proportion to DBNR growth.
• Cloudflare continues to roll out new products at a blistering pace. While not all of them stick, most do. We have to remember that Cloudflare’s Zero Trust enterprise security solution was introduced about two years ago. Now, it is referenced as part of major customer wins and can compete with best-of-breed providers. Looking forward, I see similar opportunities with Workers and data storage solutions like R2 and Durable Objects.
• Companies are looking to consolidate their network and security products onto a single platform to simplify support and save money. Cloudflare is well-positioned to provide this, as they keep rounding out the edges and filling in gaps. Email security provides a good example of a thoughtful addition that is driving new deals.

With that said, market sentiment is not favoring growth stocks currently. More challenging for Cloudflare is that its valuation is arguably ahead of peers like Datadog and Snowflake, which are growing faster and show better operating leverage. This makes NET’s current valuation harder to defend, as it is more about the long term compounding of durable revenue growth. This is against the backdrop of a market that is demanding immediate evidence of profitability and cash flow.

While I am confident in the long term trajectory for Cloudflare’s product adoption and revenue growth potential, I can’t predict how the stock price will perform in the near term. The way the market is judging high growth stocks has shifted significantly over the last 6 months. Some say we are returning to how they should be evaluated. In any case, valuation criteria are in a state of flux. However that plays out, at some point, the market will consider NET’s valuation to be fair. From there, Cloudflare’s consistent compounding at 50% revenue growth and increasing cash flow will drive the stock price. In the meantime, investors can decide how they think the market will value its current performance and factor in the future potential.

For my portfolio, I don’t plan to make any changes to my NET allocation. My basis is very low at $45, so even with the recent drop, I have a reasonable return over 1.5 years. With the price changes and some rebalancing before the Cloudflare earnings report, I evened up my allocations to NET, SNOW and DDOG. I think all three represent bets on large industry trends and are leaders (or emerging leaders) in their categories For investors with new money, I think NET is still worth consideration for a 3-5 year horizon, but there will be volatility in the near term. In November 2020, I set a price target of $180 by end of 2024. I think that threshold is still achievable if the current valuation multiples for growth stocks hold and Cloudflare maintains the expected compounding of annual revenue (and cash flow) over that time.

(Addendum – May 10th)

I have been getting a number of questions about Cloudflare’s planned capital allocations. This stems from the observation that Cloudflare’s FCF margin inverted significantly in Q1 to -30% after delivering positive FCF in Q4. Some of this was messaged by leadership during the Q4 earnings call. Also, leadership indicated on the Q1 call that they expect FCF to return to positive in the second half of 2022.

With Cloudflare committing to break-even operating margins going forward and the step back in FCF this quarter, investors are concerned that Cloudflare is no longer a SaaS business and will be continually encumbered by large capital expenditures. They are drawing parallels to capital spend by AWS and the length of time the hyperscalers required to generate meaningful cash flow. In the current investment environment, this makes Cloudflare unappealing relative to other software infrastructure companies, like DDOG, CRWD and SNOW, that don’t have this heavy capital component.

Much of this is true and I won’t dispute the capital expenditure aspect of Cloudflare’s business. This is, of course, a necessary and deliberate outcome of their strategy to own and operate their data centers across the globe. While Cloudflare rents data center space from other companies, they build and rack their own custom servers to power these data center locations. With 270+ locations across the globe and the intention to expand further with Cloudflare for Offices, Cloudflare will keep buying servers. For 2022, they are targeting spending 12-14% of revenue on network CapEx (associated with building out data centers versus other items like office space), so this will represent a drag on FCF margin.

With that said, there are a few points for investors to keep in mind that I think make this situation tolerable. Additionally, there are aspects of their architecture and service delivery model that make Cloudflare different from the hyperscaler models and provide advantages over other software infrastructure companies.

• Because Cloudflare owns and operates their data centers, they have full control over the server and network stack down to the metal. This allows them to customize and tune their gear to meet Cloudflare’s unique requirements. This should result in substantial efficiencies, performance advantages and operating cost savings. Software infrastructure providers that rent server infrastructure and network equipment from the hyperscalers can’t do this (DDOG, SNOW, CRWD, PANW).
  • Additionally, while a tailwind for these companies, it does create a dependency on the hyperscalers for pricing and service availability. I think this works in their favor for now (I own DDOG and SNOW), but limits their flexibility somewhat.
  • While utilizing hyperscaler infrastructure reduces friction and capital costs, it also eliminates this as a competitive moat (fortunately, they have others). Competitors can use the same infrastructure to launch look-alike services.
• Cloudflare isn’t unique in this approach. A few other software infrastructure and services companies own and operate their data centers and network equipment. Zscaler provides the most relevant example, since they also focus on network security services and have a lot of overlap with Cloudflare on Zero Trust products. In the 6 month period ending January 31, 2022, Zscaler delivered 23% FCF margin and 10% operating margin. In the same period, they allocated 6% of revenue to CapEx (and 7% in the recent quarter). I would posit that Zscaler is operating at scale currently, as they are limiting their product scope to the areas of Zero Trust and network security. If Cloudflare chose to focus just on competing in network services and security (their “Act 2” products), I expect they would achieve a similar margin profile to Zscaler. However, Cloudflare is targeting a broader scope that includes compute and storage as part of the next “Act 3” of product offerings. So, it will take more investment to realize efficiencies in those areas. But, their core business would likely already be comparable to Zscaler if they limited product scope.
• Cloudflare’s architectural approach to its data centers is much different than the hyperscalers. They made the decision to run every Cloudflare product on every data center service. Additionally, these are all run in a fully distributed, multi-tenant, “serverless” model. Without getting too technical, it means that Cloudflare will have very little waste in their server and network utilization. While they will always maintain some additional capacity ahead of demand, they can run their server infrastructure at a much higher utilization rate than the hyperscalers or other providers. That is because any service request can be routed to any server in any data center. In a single tenant, centralized data center architecture, this isn’t possible, requiring a lot of extra capacity to be maintained to absorb local spikes in utilization.
  • This architectural advantage probably explains why Cloudflare could absorb the substantial increase in network and compute utilization (mentioned above) without needing to double or triple their network and compute capacity this year. In brief, network traffic was up 76% y/y and 16% q/q. Compute usage grew 89% y/y and 22% sequentially. Yet, gross margins remained roughly the same sequentially. Cloudflare will need to add capacity to accommodate these growth rates in utilization.
  • This increase in utilization is likely the catalyst for Cloudflare to increase its CapEx allocation. In Q1, they reported that 9% of revenue was allocated to network CapEx. Total CapEx for Q1 was 13% of revenue (includes software and office improvements). Network CapEx will increase to a target range of 12-14% for 2022, which probably brings total CapEx to 15%-18% of revenue.
  • For the second half of 2022, the CFO indicated that Cloudflare would return to being FCF positive again. That implies that cash from operating activities reaches at least the 15%-18% range as well.
  • The surge in CapEx for 2022 is likely being allocated to support a few strategic product additions – R2 (storage), new security capabilities and higher utilization of the Workers product suite. All of these are revenue sources. R2 and Workers generate revenue on a consumption basis, which may create incremental revenue growth if they really scale.

All in all, I can appreciate the concern around the surge in CapEx spend and its impact on free cash flow margins. In the near term, the market will likely view this as a negative. For me, I am willing to wait it out, as I see this investment as creating a large future tailwind for growth. Zscaler shows us that Cloudflare could become more profitable and cash generating now if they chose to. More broadly, the competitive moat and operating efficiencies from owning and operating their data centers will allow Cloudflare to preserve market share and revenue growth for a longer period than if they rented hyperscaler infrastructure. The reinvestment of operating margin that was previously applied to close the profitability gap may even drive some revenue upside going forward.

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.