Cloudflare beat on both revenue and EPS figures in what management dubbed an “exceptionally strong” Q4. Revenue growth held steady at the 32% range in the quarter, and while cash flow generation was superb, GAAP profitability remains elusive with little change to the bottom line.
Under the hood, the key metrics shined by accelerating where it matters most – RPO, Paying Customers, Annual Contract Value and Customers Paying over $100K.
Revenue and EPS:
Cloudflare has been able to slightly accelerate revenue in the last two quarters, yet the guide implies that management is not confident revenue will sustain in the >30% growth range. Cloudflare’s price action tends to be strong because although the cloud stock has decelerated on a YoY basis from 42% growth, its peers have decelerated much further. As a general rule, the further away a cloud stock is from the 20% growth mark, the better. Cloudflare is comfortably above this.
Revenue:
- Revenue in Q4 was $362.5 million, beating estimates of $353 million and representing YoY growth of 32%.
- Cloudflare accelerated in the September quarter to 32.2% from the June quarter at 31.54%. Although minimal, it’s one of the few best of breeds that has done so.
- Next quarter management is guiding for revenue to be $373 million at midpoint, implying YoY growth of 28.5%. Therefore, the thin acceleration we saw in the previous two quarters may not hold.
- For FY23, revenue totaled $1.297 billion, increasing 33% YoY from $975.2 million. For FY24, management guided revenues to be $1.65 billion at midpoint, implying YoY growth of 27.3%.
EPS:
- Adjusted EPS was $0.15, beating estimates of $0.12 and representing YoY growth of 150%. GAAP EPS was ($0.08), beating estimates of ($0.11).
- For FY23, non-GAAP EPS was $0.49, increasing 277% YoY. GAAP EPS was ($0.55), a minor improvement from ($0.59) in FY22.
Margins:
While Cloudflare was able to demonstrate strong improvement in adjusted (non-GAAP) margins in Q4 and for FY23, GAAP margins were little changed down the line, highlighting the headwinds created by elevated levels of SBC on a path to GAAP profitability. Stock based compensation is 21.3% of revenue, or $77.3 million in the most recent quarter, which is in line with previous quarters.
Adjusted operating profit increased to $39.8 million, up 2.5X from $16.9 million in the year ago quarter. However, next quarter adjusted operating profit is expected to be between $34 to $35 million, so this is something to watch.
- GAAP gross margin for Q4 expanded 30 bp QoQ and 170 bp YoY to 77%. Non-GAAP gross margin expanded 20 bp QoQ and 150 bp YoY to 78.9%.
- GAAP operating margin in Q4 was (-11.8%) compared to (-11.7%) last quarter and compared to (-18.5%) in the year ago quarter. Non-GAAP operating margin was 11.0% compared to 12.7% last quarter and compared to 6.1% in the year ago quarter. The lack of margin expansion QoQ is a weakness to this report and something to watch.
- GAAP net margin was (7.7%), down 70 bp QoQ but up 900 bp YoY.
On an annual basis, the adjusted operating margins have expanded nicely with Cloudflare having a flat adjusted operating margin in mid-2022 to having mid-single digit adjusted operating margins to now having high-single digit adjusted operating margins. The market has reacted favorably to Cloudflare becoming profitable on an adjusted basis.
- For FY23, GAAP gross margin was 76.3%, a 20 bp YoY improvement. Non-GAAP gross margin improved 10 bp YoY to 78.3%
- GAAP operating margin was (14.3%), a 630 bp YoY improvement. Non-GAAP operating margin was 9.4%, a 670 bp YoY improvement, up from 3.7% in FY2022. The company had $122M in adjusted operating profit.
- GAAP net margin was (14.2%), a 560 bp YoY improvement. Non-GAAP net margin was 13.1%, a 950 bp YoY improvement.
For FY2024, management stated that both cash flow and operating profit will be lower in the first half and higher in the second half. Management guided for operating profit of $154 to $158 million.
Though operating and free cash flow margins improved quite dramatically YoY, GAAP operating and net margins barely budged, with SBC weighing down on strong growth in gross profit.
Cloudflare reported nearly 35% YoY growth in gross profit to $279.2 million in Q4, though operating income improved less than 16% YoY to ($42.8 million). This partly stemmed from high SBC, at $77.3 million, or 21.3% of revenue, in Q4.
Total operating expenses were 115% of gross profit in Q4, down from over 124% in the year ago quarter. For the full year, that ratio was nearly 119%, compared to 127% in FY22. While Cloudflare is making progress in reducing spend, it will struggle to become GAAP profitable without cost cuts so long as it maintains SBC at or above 20% of revenue. Operating expenses are growing nearly 8 points slower than revenue, at around 25% in Q4, but again, this growth rate must moderate significantly should revenue growth decelerate to below 30%, as guided for FY24.
Cash and Debt:
Cloudflare’s cash flow generation was remarkably strong, with operating cash flow more than doubling YoY with free cash flow turning sharply positive. The consistent and strong cash flow is key to Cloudflare’s positive price action. The company reported record FCF in Q4 of $50.7 million.
- Operating cash flow was $85.4 million in Q4, or 23.6% of revenue up from 20% in the September quarter yet down from 28% of revenue in the year ago quarter.
- For FY23, operating cash flow increased 106% YoY to $254.4 million, or 19.6% of revenue.
- Free cash flow was $50.7 million in Q4, or 14% of revenue and is up from 12% of revenue in the year ago quarter. For FY23, free cash flow was $119.5 million, up from negative free cash flow of (-$39.8 million) in FY22.
- One of the differences between operating cash flow and free cash flow is network capex. This is a primary reason why FCF can be minimal at times. Network capex was 8% in the most recent quarter and was lower than 10% in the same quarter last year due to greater efficiency from its infrastructure. Network CapEx is expected to be 10% to 12% of revenue in 2024, including the additional investment due to the AI opportunity.
- Cash, equivalents and short-term investments totaled $1.673 billion.
- Convertible debt totaled $1.283 billion.
Key Metrics Accelerate:
Per management: “We blew away our previous record for new ACV [annual contract value] booked in the quarter. In Q4, new ACV booked grew nearly 40% year-over-year, making it not only our record in absolute ACV but also the fastest percentage growth we've seen since 2021.”
Paying customers increased 17% YoY to 189.8K, a third-straight quarter with customer growth accelerating after slowing to just 13% growth in Q1.increased 17% YoY to 189.8K, a third-straight quarter with customer growth accelerating after slowing to just 13% growth in Q1. Growth in customers with >$100K ARR accelerated 1 point to 35% in Q4, reaching 2,756, and accounting for 66% of revenue, up from 63% in the year ago quarter.
Per management on the call: “We saw particular strength in our largest customers with a record number of net new customers spending more than both $0.5 million a year and $1 million a year on an annualized basis. We signed our largest new logo with an expected total contract value over $30 million and our largest customer renewal with a total contract value of $60 million.”
- Customers paying over $500,000 totaled 346, up 56% YoY.
- Customers paying over $1 million totaled 118 customers, up 39% YoY.
- Revenue from large customers increased to 66% of revenue, up from 63% in the year ago quarter.
- For FY2023, revenue from large customers represented 64% of total revenue compared to 61% in 2022 and 54% in 2021.
Deferred revenue of $347.6 million is up 11% QoQ from $311.5 million in the previous quarter and is up 50.8% YoY from $230.4 million in the year ago quarter.
RPO accelerated to $1.245B, up 37% YoY compared to 30% YoY growth last quarter. The QoQ RPO growth of 15% is the highest for at least two years (we began tracking Cloudflare closely in Q4 2021).
DBNRR was 115% in Q4, a 1 point sequential decline. This needs to be watched as we move along. Management stated last quarter when DBNRR was 116%: “We continue to believe the recent decelerating trend in DNR stabilizing near these levels.”
Geographically, revenue growth surged in EMEA, while revenue growth in the US remained steady QoQ at 29.8% to $188.1 million. EMEA revenue increased 38.2% YoY to $101.2 million, an acceleration from the 36% growth rate recorded in the region in Q3.
Additional Earnings Call Commentary
Mark Anderson, the former CEO of Alteryx and former President of Palo Alto Networks, is joining Cloudflare as President of Revenue. In the opening comments, there was also mention of a 3-year contract with the U.S. Department of Commerce worth $33 million. Plus, a leading technology company signed a 3-year $66 million contract for Cloudflare’s Zero Trust products.
In 2023, Cloudflare deployed GPUs in 120 cities and has plans deploy inference-specific GPUs in nearly every city of their global network to be within milliseconds of every device connected to the internet. As stated in a previous write-up, this will be important for the edge network. Per management: “from our launch in September to the month of December, the average number of daily workers' AI request increased 9x.”
Notably, the outperformance this quarter was driven by Cloudflare’s Zero Trust and SASE security products with AI not yet materially impacting revenue. When an analyst asked why Cloudflare is showing so much strength in Zero Trust, the CEO replied: “And what we find is when we're in the consideration set, we're just a next-generation platform, and we're faster, we're more secure, we're more reliable, and we're a better solution for a lot of vendors. And so not only are we winning the greenfield opportunities, but we're increasingly winning opportunities from first-generation Zero Trust vendors where their customers aren't satisfied with the solutions they have and they're moving fully to us.”
More on AI Inference at the Edge:
Although AI is not materially impacting revenue right now, it inevitably will in the next couple of years. This company is well positioned for AI inference at the edge, which we’ve covered in a deep dive here. Part of this is building out GPU capacity which is why capex will increase to 10%-12%.
Here was a good question to help timing for Cloudflare’s AI potential.
Question
Timothy Horan (Analysts)
Related to the previous question. Can you maybe update us on your best guess on timing when the Workers platform, starts to drive some material revenue when it starts to move the needle? And maybe the same thing for AI. I know you said kind of not this year. And what do you think for both these platforms, what does this mean for overall growth rates for the company?
Answer
Matthew Prince (Executives)
Yes. I think what has been interesting has been that Workers is a big piece of a lot of the deals that we see. So it's still in somewhere around 20% of the large deals that we closed, have some workers component to it. And that's held actually fairly steady, but those deals are continued to go up and up. So it depends on how — we don't break out the various pieces of Cloudflare because we think that the platform functions very well as one unified platform.
And we close more deals because we have workers involved. But a lot of times, that includes our reverse proxy security services oftentimes includes our Zero Trust security services. And what we really want to be is not a one-trick pony for any one of our customers. We want to actually have multiple different things that they rely on and be that strategic vendor that provides a broad set of solutions to them. So I think it's already materially driving new business and large deals.
But as the Workers platform, I think the AI space, I think a lot of the money, which is being spent on AI right now, especially with some of the hyperscale public cloud, a lot of that is for training of models that is not — we are not the right place to actually do model training. But as that transitions over time and people start to figure out how can you take those — the models that you've built and turn them into real products. I think that's where you'll start to see a much more significant share of — you'll start to see revenue that is showing up that is meaningful to us. In terms of delivering the value in the AI space.
But I think it's — we're still so early. And I think that the thing to track is less about us. It's more about how long does it take product managers and engineers to really figure out how to harness these new tools into — and providing customer value. I think we've seen a ton of — I mean, the challenging thing with AI is, it is really easy to make a demo, but it's very hard to make a product. There's a ton of value that will be created here, but I think it's going to still take some time. And I think it's going to be up to some things that are somewhat out of our control. But I can't imagine being better positioned than we are.
Macro Remains a Headwind:
Given the strong price action, I want to highlight that management is still not fully confident in the macro environment:
Matthew Hedberg
Great color. If I can ask one follow-up to Thomas. Your guide for '24 revenue, I think calls for about 600 basis points of deceleration. Obviously, you talked about a lot of positive sequentially, but also some of the caution that you still have about the macro. Just wondering if you could unpack a little bit more some of the assumptions there. I think you noted maybe NRR might be nearing a bottom. But just what's built into that in terms of like logo adds, maybe an improvement in NRR, but just sort of unpack that a little bit more.
Answer
Thomas Seifert
Yes. Obviously, we had a very good fourth quarter with a lot of good data points, pointing in the right direction. The improvement that Matthew was talking about on the go-to-market side. Not only in terms of productivity, but pipeline improved, the deal size has improved and linearity went better. We also saw their best quarter-over-quarter improvement from an RPO perspective. This is all pointing in the right direction.
But we still have to cope with the fact that one data point alone is hard to change your prediction and your trajectory. So we are still cautious that everything else that is going on. Matthew mentioned in his part that the big scenes that we saw last year from a macroeconomic perspective, skittishness of buyers and budget releases is continuing. And I think this informed our view for the year. And obviously, we'll adjust our strategy and approach to the year as we have — unless we collect more data points. But it served us well over the last 4 years as a public company, to look really hard at the data we have and draw the right conclusions from it. And I hope that '24 will get us to the same outcome
FY2024 Revenue Growth Helped by Government Deals:
Following a question about the U.S. Dept of Commerce deal, the CEO stated the following about the public sector:
“I think that our federal business as well as our SLED business, state local education, and our global government business has all been real signs of strength. And I think that, that, in part, is because of the fact that the world is getting scarier and we're seeing more attacks […] More than half of the world's population will vote in 2023 in elections. And so I think the fact that we've been leaders in protecting elections and making sure that elections are run without cybersecurity being part of the story has gotten us in the conversation in a lot of places around the world. […] So I would expect that, that business continues to be strong throughout 2024.
Your second question is kind of the flip side of that, which is I think that the macro continues to be challenging. There are two hot wars going on right now. I think we are not out of the woods economically in terms of getting totally ahead of inflation. Again, I think in the U.S., that looks better than some of the other places in the world. There's a lot of ways that you can imagine the world continues to get more complicated. And I think IT buyers need to be skittish. Q4 definitely felt like people were starting to make decisions, and they were starting to say that there are certain things that are must-have versus nice-to-have. And I think we continue to be sorted into the must-have bucket.”
Conclusion:
Cloudflare’s price action today was certainly welcomed, and not all that surprising given the Big 3 is accelerating on cloud. There’s bound to be some cloud stocks that beat this quarter if the bellwethers are showing a rebound of sorts. Cloudflare provided hints in the last earnings report that it was a solid choice compared to its peers.
We are especially excited for Cloudflare’s potential in the future (next 1-2 years), as the CEO pointed out that most AI spend is on training, yet they are well positioned for when the focus is on inference and the edge. We see this stock as a winner in the next phase for AI, which we detailed in our most recent webinar and in our deep-dive here.
This 20%-ish move will put Cloudflare at or just above that resistance level of 20 Fwd P/S for cloud valuations. What cloud investors need to see in the (very) near term (next 1-3 months) is if cloud can push past the 20 Forward P/S resistance it’s been hitting since the FED lowered rates OR will cloud resume a more blow-off top valuation of 40 Forward P/S which we saw for about 1-2 years in 2020-2021. There is risk in both scenarios so each investor will need to decide for themselves how to handle cloud positions now that cloud stocks are reaching that resistance. There is no easy answer – yes, these are great stocks, quality companies, that will do well long-term — but they are also pricey right now. We will keep you up to date on our real-time decisions via text alerts.
Damien Robbins, Equity Analyst at the I/O Fund, contributed to this article.
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