Cloudflare’s adjusted operating margin reported significant expansion and the company is nearing GAAP profitability. In addition, its free cash flow grew 92% YoY and there was noticeable customer acceleration in the key metrics.
Cloudflare is going through a transition in customer contracts, transitioning from annual recurring contracts to offering more platform deals that are on monthly, pay-as-you-go terms with 3+ year duration. This is causing DBNRR and RPO to look lumpy, yet the company’s beat/raise is helping to shrug off any concerns from this transition.
Ultimately, Cloudflare is well positioned for AI inference at the edge and it’s operating leverage is a near-term bonus. We look at this and more below!
Revenue and EPS:
Q2 revenue topped estimates by nearly 2%, with Cloudflare’s revenue growth rate decelerating 50 bp to 30% in the quarter. Management increased full year revenue guide. Most importantly, Cloudflare reported significant progress toward becoming GAAP profitable.
- Revenue of $401 million beat estimates by $6.5 million, representing YoY growth of 30.0%.
- For Q3, management guided revenue between $423 million and $424 million, slightly ahead of the analyst consensus for $423.34 million. This represents YoY growth of 26.2%, a 380 bp deceleration.
- GAAP EPS of ($0.04) beat by $0.06, marking significant improvement from ($0.28) in the year ago quarter.
- Adjusted EPS of $0.20 beat estimates by $0.06, for YoY growth of 100% from $0.10 adjusted EPS last year and QoQ growth of 25% from $0.16 EPS last quarter.
- Management guided adjusted EPS of $0.18, ahead of estimates for $0.15.
For FY24, Cloudflare now sees revenue between $1.657 billion and $1.659 billion, for YoY growth of 27.8%. This also represented an $8 million increase from the guidance given in Q1. Management also boosted the adjusted EPS outlook to $0.70-$0.71, up from the prior view for $0.60-$0.61.
Margins:
Cloudflare showed strong improvement in operating margin and net margin, and significantly boosted its full-year operating margin outlook.
Based on management’s guidance for adjusted operating income of $50-$51 million in Q3, adjusted operating margin is expected to be 12%. For the full year, management boosted its adjusted operating income guide to $196-198 million, a nearly 22% increase from the prior view for $160-164 million. This pulls full-year adjusted operating margin up to 11.9%, a 210 bp increase from Q1’s view for a 9.8% margin and is suggesting that Cloudflare expects to witness strong operating leverage in the back half of the year.
- GAAP gross margin was 77.8%, up from 75.6% last year and 30 bp QoQ expansion. Adjusted gross margin was 79.0%, up from 77.7% last year but a 50 bp QoQ contraction.
- GAAP operating margin was (8.7%), a significant improvement from (-18.2%) last year and up from (-14.4%) last quarter.
- Adjusted operating margin was 14.2%, a significant improvement from 6.6% last year and up from 11.2% last quarter, reaching its highest quarterly level.
- GAAP net margin was (3.8%), a significant improvement from (9.4%) last quarter. Adjusted net margin was 17.3%, up from 10.9% last year, and up 190 bp QoQ.
Cash and Debt:
Cash flow continued to expand as well, certainly a plus in this environment for a cloud stock. Free cash flow expanded significantly by 92% YoY.
- Operating cash flow was $74.8 million, for a margin of 19%, flat QoQ but up 6 percentage points YoY. OCF increased 16% YoY.
- Free cash flow was $38.3 million, for a 10% margin, up from 9% in Q1 and 6% last year. Free cash flow increased nearly 92% YoY.
- Cash and available-for-sale securities totaled $1.76 billion.
- Debt (convertible senior notes) totaled $1.28 billion.
Network capex was 6% of revenue compared to 8% in the previous quarter. Management reiterated to expect network capex in the range of 10% to 12% in the second half of the year.
Key Metrics:
DBNRR was 112% in Q2, a 3 percentage point deceleration from 115% in Q1. Per the CFO’s opening remarks: “The decline in [DBNRR] was driven by slower net expansion in our larger customer cohorts, increased platform deals in the form of pool of funds contracts, which reduced friction to adoption across our product portfolio but can impact the shape of revenue recognition as well as deferred revenue and current RPO, especially for existing customers that transition into this structure and anniversarying the price increase to our Pro and business pay-as-you-go plans last year. For the next several quarters, we expect new customers to contribute a higher percentage of our overall year-over-year revenue growth. similar to the second quarter.”
There were questions about the pool of funds contracts in the Q&A, detailed below.
Billings increased 23% YoY and 9% QoQ to $421.7 million. This represents a 9% QoQ growth from $387.6 million last quarter. With that said, Billings growth has been decelerating for a few quarters and is down 9 points from 32% growth YoY in the year ago quarter.
Deferred revenue totaled $394.5 million, a 5.5% QoQ increase.
RPO of $1.421 billion represented an increase of 6% QoQ and 37% YoY. This is lower growth than last quarter, when RPO grew 8% QoQ and 40% YoY. See below discussions around Pool of Funds accounts.
Paying Customers & Workers Platform Accelerated
Cloudflare Worker Applications grew from 2M developers to 2.4M developers in four months, per the CEO’s opening remarks. The Workers AI Platform developer accounts grew 67% QoQ and inference requests grew 700% QoQ. Of course, this is large growth on small numbers, but take notice that Cloudflare is one of the only best-of-breed software companies able to quantify their AI impact right now.
Paying customers totaled 210,166 in Q2, a 21% YoY increase. This represented a 400 bp acceleration from 17% YoY growth reported in each of the last three quarters. On a QoQ basis, Cloudflare added more than 13,000 customers, compared to sequential additions of less than 10,000 in each quarter in the last two years.
For customers with ARR of >$100K, Cloudflare reported 30% YoY growth to 3,046. This customer cohort contributed 67% of revenue, flat with Q1 yet up from 64% in the year ago quarter.
Earnings Call:
Pool of Funds Accounts
The CFO explained that Cloudflare is seeing a transition in their billing from annual contracts to pool of funds accounts that are on a monthly basis for three or more years. The pool of funds accounts are unique to the largest customers (for example, 4 of the top 10 customers are this account type) that use many products across the entire Cloudflare platform. These are considered larger platform deals that are paid on a monthly basis in a multi-year contract rather than an annual contract on one product. This is shifting how DBNRR and RPO are reported since revenue is recognized as the customer consumes the service.
This is how the CFO explained it: “So as it relates to revenue, the revenue is now recognized as the customer consumes the service, and as a result, the record revenue recognition might be nonlinear and might ramp over time with respect to deferred revenue because those deals have monthly billing terms, we do not report upfront deferred revenue, and this can result then in lower deferred revenue growth. And then current RPO is also impacted because the contract duration is longer. So you recognize upfront less in current RPO. So while there the deals are very beneficial and healthy to the business. They generate some noise in this transition in our DNR and in the other metrics.”
There was a question about this from an analyst where the CFO pointed toward this creating lumpy, yet “significantly higher total contract values.”
Question
Fatima Boolani (Analysts)
Matthew and Thomas, this is for you both. I had a bare picture question around the pricing strategy across the portfolio. So at a tactical level, you had some meaningful price increases that you're first ones ever. Thomas wondering if you could just opine on how far deep those have pervaded the installed base. And if you can kind of talk to where we are in terms of the innings in terms of how that inferred in the base?
And then Matthew, the bigger picture question for you is, if I piece together a lot of what you shared in the prepared remarks as it relates pool of fund deals, more pay as you go, more consumption, payment modalities especially as the Workers' portfolio scales, how should we generally think about the business impact and sort of revenue elasticity, if you will.
Answer
Thomas Seifert (Executives)
There's not much to add to what Matthew just said. Some of the impacts of this transition, you have seen, we talked about how pool of funds deal impact the lumpiness or make our numbers a little bit more lumpy. We will also have an increasingly higher share of variable revenue in our numbers, while this number is still small today, and it will grow meaningful over time.
But this is less driven by price increases, as Matthew said, but it's more driven by the structural changes that this transition implies. And with all the overall benefits of more stickiness, longer-duration deals, platform fills with better expansion capability and significantly higher total contract values.
Cloudflare’s View on the Inference Market
We’ve discussed in the past how Cloudflare is uniquely positioned to capture inference at the edge. Per the opening remarks, Cloudflare signed a $500,000 contract for Workers AI for inference tasks across their edge network. The key metrics around 2.4M developers on the Workers platform and 67% QoQ growth on Workers AI are also important to pay attention to as we go along.
The CEO explained that his view on inference is that half of it will be run on devices and the other half will be run on networks like Cloudflare: “That also has the benefit of making it as performant as possible. And it also means that you can have the AI that's responding have regional differences more easily so that if you're responding in the U.K., the — an AI can spell color with a U, whereas if it's in the U.S., it can spell it with no U. I think all of those things then drive a lot of the other 50% of inference tasks to be running at a network like Cloudflare.
And so we are trying to build that network out ahead, make sure that we can answer any inference tasks that can't get determined on your own device as close as possible to that device and then make it very easy to get that inference task from us are from the device to us in a standard-based API-driven way, so that it's seamless to that end user […] But I really think that inference is going to be between the end devices themselves and a network that is like Cloudflare that spans the globe and is incredibly close and in every jurisdiction where end users might be.”
Conclusion:
The operating leverage is helping Cloudflare’s stock price today while its AI inference positioning is more of a medium-term story. We are encouraged by the initial ramp of the Workers platform and believe key AI winners are being decided today, evidenced by this early traction. Cloudflare is physically positioned at the edge to where there is no way around Cloudflare when it comes to inference (literally) as hyperscalers are positioned too far away from devices for the low latency that AI inference will require. Management being able to improve margins and cash flow help make it an easy choice to keep Cloudflare in the portfolio as we wait for the medium-term story to solidify.
Damien Robbins, I/O Fund Equity Analyst, contributed to this analysis.
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