Cloudflare beat on the top and bottom lines in Q3, although net retention rate softened again. The company missed on revenue expectations for Q4 with management guiding for a midpoint of $451.5 million, for growth of 24.6% compared to analyst expectations of $455.08 for growth of 25.8%. Management spoke at length about being at an inflection point for a sales organization shift, yet this felt like a speculative discussion as evidence of an inflection was not visible in the Q4 guide.
Key metrics were mixed and revenue growth is getting further away from the coveted 30% mark with a 4-point deceleration in Q4. Yet RPO and customer growth remains persistently strong.
Revenue
Cloudflare reported revenue of $430.1 million in Q3, increasing 28.2% YoY, slowing from the 30.0% YoY increase reported in Q2. Revenue growth had been expected to be steady at ~26% YoY for the next few quarters, which is quite strong for best-of-breed cloud as many >40% revenue growth cloud companies have dipped <20%.
However, Cloudflare guided to just 24.6% YoY growth in Q4, seeing revenue between $451 million and $452 million, shy of the estimate for $455.8 million. This implies a sequential deceleration of ~3.6 points.
For FY24, management slightly raised its guidance, though it seems as if the raise stemmed solely from Q3’s outperformance relative to its initial guide. Cloudflare now sees FY24 revenue of $1.661 to $1.662 billion, a raise of just $3.5 million at the midpoint from its prior view for $1.657 to $1.659 billion. Q3’s $430.1 million sum beat management’s internal guidance by ~$6.5 million, implying that it is the primary factor behind the raised guide given Q4 was a miss.
Margins
Cloudflare reported strong adjusted operating margin of 14.8%, which led to raising its adjusted operating margin guide for FY24 to 13.3%, up from last quarter’s FY24 guide of 11.9%. GAAP operating and net margins continue to make slow progress towards positive territory due to high stock-based compensation of 20.5%.
- GAAP gross margin was 77.7%, down slightly from 77.8% in Q2 but up 1 point from 76.7% in the year ago quarter. Adjusted gross margin was 78.8%, down from 79.0% in Q2 but up slightly from 78.7% in the year ago quarter.
- GAAP operating margin was (7.2%), improving from (8.7%) in Q2 and (11.7%) in the year ago quarter. Adjusted operating margin was 14.8% in Q3, well above the 11.9% guided and improving from 14.2% in Q2 and 12.7% in the year ago quarter.
- For Q4, management guided adjusted operating margin of 11.9%.
- For FY24, management guided for adjusted operating margin of 13.3%, a strong increase from 9.8% at the beginning of FY24 and its previous guide for 11.9% given in Q2. The increased guide is driven by Q2 and Q3’s outperformance, with both quarters seeing adjusted operating margin >14%.
- GAAP net margin was (3.6%), improving slightly from (3.8%) in Q2 and (7%) in the year ago quarter. Adjusted net margin was 16.9%, falling from 17.3% in Q2 but up slightly from 16.5% in the year ago quarter.
EPS
For fiscal year 2024, Cloudflare is expected to report EPS growth of 51% YoY to $0.74. Cloudflare beat slightly on EPS in Q3, while guiding for flat QoQ growth for adjusted EPS for Q4.
Cloudflare is close to GAAP profitability yet it’s not clear given stock-based compensation when the company will tip over the edge. The stated in the investor’s presentation the long-term goal is a 20% adjusted operating margin, which implies GAAP profitability would be narrow, yet achievable. Notably, there is no firm date being provided.
- GAAP EPS was ($0.04), flat QoQ and up from ($0.07) last year.
- Adjusted EPS was $0.20, beating estimates and Cloudflare’s guide for $0.18. This was also flat QoQ and up 25% YoY.
- For Q4, management guided for adjusted EPS of $0.18. For FY24, based on the slight beat in Q3, management raised its adjusted EPS guide to $0.74, up from its previous view for $0.70 to $0.71. This represents YoY growth of 51%.
Cash and Balance Sheet
Cash flow generation remained steady in the quarter as cash flow margins expanded sequentially.
- Operating cash flow was $104.7 million in Q3, for a 20% margin. This improved from a 19% margin in both Q1 and Q2.
- Free cash flow was $43.7 million, for an 11% margin, an improvement from 10% in Q2 and 9% in Q1. The company stated its goal is a 25% FCF margin.
- Cash and available-for-sale securities totaled $1.824 billion while convertible notes totaled $1.286 billion.
Cloudflare’s free cash flow is especially impressive given the company has to build a bigger network and invest in GPUs for edge AI.
“Network CapEx represented 10% of revenue in the third quarter. During the quarter, we saw a notable shift in customer conversations and buying behavior from AI training to AI inference, including our first multimillion dollar workers AI contract.
This gives us confidence to continue to increase our investment in higher-end GPUs as well as the breadth of our GPU rollout as we provision greater capacity to support demand in 2025. As. A result, we continue to expect network CapEx to increase again in the fourth quarter to reach 10% to 12% of revenue for the full year 2024.”
Key Metrics:
RPO
RPO came in at $1.53 billion for growth of 39% year-over-year and up 6% sequentially. This is higher than the year ago quarter when RPO was at 30% YoY and up 5% sequentially.
Compared to last quarter, RPO reported growth of 37% year-over-year and 6% QoQ, for 69% of total RPO, which means this was technically a stronger quarter on this key metric.
DBNRR
Cloudflare’s DBNRR dropped again in Q3, falling to 110%, compared to 112% in Q2 and 115% in Q1. Throughout 2023, DBNRR hovered around 115% and higher, so the decline over the past two quarters is important to watch. This quarter, management reiterated the decline is being driven by slower net expansion in the larger customer cohorts as they move to “pool of funds” contracts, which shifts billings from annual contracts to pool of funds accounts that are on a monthly basis for three or more years (for larger customers).
Per management again this quarter:
“Our dollar-based net retention was 110%, down 2 percentage points quarter-over-quarter. While customer churn remains consistently low, our shift to more pool of funds deals with our largest customers, which represented nearly 10% of new ACV booked in the quarter, up from 1% a year ago has put downward pressure on dollar-based net retention and change the shape of revenue recognition in the short term.
Over the long term, however, we believe pool of fund deals are very positive for the business as they represent our largest customers making a broad commitment to Cloudflare's overall platform.”
Customers
Paying customers increased 22% YoY to 221,540, accelerating from 21% in Q2 and 17% in Q1. Management stated on the call they count 35% of the Fortune 500 as customers.
For customers with >$100K ARR, growth decelerated 2 points sequentially to 28% YoY to 3,265 customers. This cohort accounted for 67% of revenue in Q3, flat with Q2 but up from 65% last year. Management pointed out that the 28% resulted in a record addition 219 large customers, referring to the growth remaining high even on a larger base of customers.
Billings
Despite other metrics such as >$100K ARR customers and DBNRR decelerating, Billings accelerated sequentially in Q3. Billings increased 24% YoY to $447.3 million, a 1-point acceleration from 23% growth last quarter.
Earnings Call:
Net Retention Rate; New Sales Org
The tone on the earnings call was more of a “wait and see” tone about the new sales organization reaching an inflection point. On one hand, we are seeing strong total customer growth and billings inflect. Yet, on the other hand, Cloudflare is asking investors to place their trust in the company on the “pool of funds” deals that are causing a rapidly decelerating net retention rate.
What investors should keep in mind is that management is foreshadowing the mixed key metrics could last for a few quarters as current customers shift to the new billing terms: “As we mentioned last quarter, we expect new customers to contribute a higher percentage of our overall year-over-year revenue growth for the next several quarters.”
There was also a note that larger deals were pushed back, yet the miss in Q4 doesn’t inspire confidence they were pushed back only by a quarter: “However, some larger deals slipped out of the quarter in the U.S. in particular, during what was a transitional period under new sales leadership in that region. These deals are still active in our pipeline with many having already closed this quarter.”
The company discussed being at an inflection point, yet as an investor, I prefer more evidence of this with revenue growth inflecting, as well (which did not happen): “All the changes in our sales force may have impacted the short-term cadence of some larger deal cycles. What stood out to me is that the third quarter felt like we hit the inflection point in the rebuild of our go-to-market team.”
However, when pressed, management remained confident it was truly an inflection point. My best guess is the inflection will catch up to revenue perhaps by Q2 given the note it’s a few quarters out.
Timothy Horan Oppenheimer & Co. Inc.
There's a lot of moving parts, obviously, with the sales productivity and limited capacity there in the pooling. Can you maybe talk about the timing of when revenue growth can accelerate again. Do you think the fourth quarter around 25% guide, is that the bottom? Or do you think it's still a few more quarters out? And related to this, can you update us on what you think the timing of for the $5 billion revenue target that you have? And I had a quick product follow-up.
Thomas Seifert CFO
Yes. Thank you for the question. As we said before, for us, in our subscription business model, revenue is very much a lagging metric. Sales capacities is a product of the amount of headcount we have and the productivity progress they are making, this translates into pipeline and sales prospects, turns into ACV and then ACV is recognized ratably over the lifetime of the contract as revenue. So it's very much a lagging indicator. And as we said before, models like this, there are slow on their way down, but they're also slowing their way up.
But the important part is, as you heard in Matthew's prepared remarks that we think we have reached this key inflection point with net sales capacity now, which is the leading growth indicator have been patent. So from there on, we expect sales activity translating the ACV moving forward and going up. And you see this already in those parts of the world where this conversion and transition has happened successfully. Revenue was up 38% already in APAC, and it was up 1% in Europe, which is our highest productivity region has been over the last several quarters. So we think we have bottomed out from a net sales capacity perspective, and move forward from there.”
Capex Spending and Edge AI
Cloudflare has offered visibility in capex spending plans as it builds out GPU-powered edge servers for AI inferencing purposes. This involves large orders of GPUs, to which Cloudflare made it quite clear they are able to work with any hardware on the market and at a high utilization rate.
Given Cloudflare may one day become a leading AI stock, discussions around the AI market are provided for future reference as we along, especially given there is no official AI revenue number being reported by Cloudflare today.
Per the company, there has been progress: “During the quarter, we saw a notable shift in customer conversations and buying behavior from AI training to AI inference, including our first multimillion dollar workers AI contract.”
Notably, there was not an update to the Workers key metric of 2.4 million developers this quarter.
The discussions around one of Cloudflare’s key value propositions was the following:
“And in order to support that, we have made the investments to increase not only just the number, but also the power of the GPUs that we're deploying around the world. What I think is unique about Cloudflare is 2 things. One, we are actually able to deliver inference incredibly close to where anyone is on earth because we've deployed the inference capabilities across at this point, nearly all of our network.
But in addition to that, we've actually done the work to get higher utilization out of those same GPU resources where what we see when we survey customers that are trying to manage this themselves, through hyperscale public cloud is that they're getting utilization rates that are sort of in the 5% to 10% range of the resources that they're buying.
We're able to deliver much higher utilization. And in the process of that, that means that we can actually pass on the effective savings to our customers. So they not only save in not having to maintain their own team to manage these virtual machines and containers, but they also save because we can just do more with the same GPU resources that are being deployed.”
Conclusion:
Cloudflare is among the highest in terms of valuations for best-of-breed stocks at a 19.7 forward PS. Although this was a decent report with no major red flags, this valuation is not where I’d be buying the stock given the report was not a knockout. The question being considered is if we should close the position since odds are quite high we will get the stock lower.
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