Cloudflare offered a solid earnings report, yet the valuation is extraordinarily high, thus, the company really needed to report a blowout to justify the valuation (which did not happen). It’s good to see Cloudflare report steady growth, however, and its key metrics supporting sustained growth as we patiently wait for Cloudflare to lead in AI inference at the edge.  

There is a quiet strength in Cloudflare’s fundamentals and key metrics. For example, Cloudflare passed a $2B run rate for the first time, signed their first $100M deal, dollar-based net retention (DBNRR) seems to have bottomed along with a slight 1.3% acceleration in revenue. Regarding the bottom line, Cloudflare is certainly stronger than many cloud peers yet tends to walk a razor’s edge due to capex. 

Regarding AI inference, for the Workers Platform known as Act 3, management connected some important dots on the earnings call as to why agentic AI will drive forward the massive inference trend. The I/O Fund team recently dug up a stat inference is expected to account for 60% to 70% of AI workloads by 2030. In particular, Cloudflare emphasizes their position is what will help the company win this market: “The fact that we sit in front of so much of the web and that more than half of our dynamic traffic is already between APIs means that we are strategically positioned to deliver the agentic web of the future.” 

Cloudflare also introduced Act 4 – a new product that will help AI search engines connect with (and potentially) pay publishers for using derivatives of their copyrighted works. Although the amount of demand for this and exactly how Cloudflare will monetize this new product is not clear, it is interesting management feels confident enough to call the new use case its fourth act.  

Given Cloudflare’s valuation, the entry is probably the most important aspect of this stock right now – whereas in the medium to long-term the most important aspect is timing for the broader inference market.  

We’ve covered Cloudflare’s thesis and Acts 1, 2, and 3 in the analysis “Bringing AI Inference to the Edge” and repeated some of the key aspects later in an earnings update, “Cloudflare: Entering Act 3 to Become a Leader in AI inference at the Edge.”Bringing AI Inference to the Edge” and repeated some of the key aspects later in an earnings update, “Cloudflare: Entering Act 3 to Become a Leader in AI inference at the Edge.” 

Cloudflare Raises FY25 Revenue Growth to Nearly 27% After Largest Beat in Six Quarters

Cloudflare reported its largest revenue beat in the last six quarters at 2.1% above consensus, with Q2 revenue up 27.8% YoY to $512.3 million. This also marked a slight 1.3 point acceleration on the top-line from 26.5% growth in Q1.  

For Q3, Cloudflare guided for revenue of $543.5 to $544.5 million, ahead of estimates at the time for $538.9 million. This corresponds to a slight deceleration to the mid-to-high 26% YoY growth range, where Cloudflare is expected to remain through Q4. This provides no clear indication yet that the company is able to drive a sustained revenue acceleration aided by AI.  

However, not even three weeks from the report, the Street is already getting more optimistic and is now expecting a stronger Q3. Consensus estimates are now above the high-end of management’s guidance at $544.9 million, essentially already pricing in stronger momentum fueling a beat for Q3 despite how early it is in the quarter.  

For the full-year, Cloudflare raised its outlook to $2,113.5 million to $2,115.5 million, for YoY growth of 26.7%. This is a $22.5 million increase at midpoint from Cloudflare’s prior outlook for $2,090 million to $2,094 million for growth of 25.3%. 

DBNRR Inflects 3 Points to 114%, Paying Customer and cRPO Growth Remains Strong 

Cloudflare also showed strong key metrics in Q2, maintaining strong growth in paying customers and billings while DBNRR more meaningfully inflected.  

Paying customers increased 27.5% YoY to 267,929 in Q2, the second quarter in a row with 27%+ growth. This is a notable improvement from 17% and 21% growth in Q1 and Q2 2024. Cloudflare stated that it added a record number of customers YoY spending over $1M and over $5M.  

While Cloudflare noted that its largest customers are growing investments at the highest levels since 2022, growth in its large customer cohort ($100K+ ARR) is decelerating. Cloudflare reported 22% YoY growth to 3,712 $100K+ ARR customers in Q2, decelerating slightly from 23% in Q1 and 30% in the year ago quarter. This cohort accounts for 71% of revenue, up from 69% in Q1 and up from 67% in the year-ago quarter. 

Billings increased 33% YoY to $559.2 million, a third straight quarter with growth above 30% YoY.  

RPO increased 39% YoY and 6% QoQ to $1.98 billion.  

Current RPO accounted for 66% of total RPO, or ~$1.30 billion, increasing 33% YoY in Q2, a four point acceleration from 29% growth in Q1.This is also a notable uplift from 26% growth in the year ago quarter.  

Aided by strength in its >$1M customer cohort, which management said served as a tailwind, DBNRR more meaningfully inflected in Q2 to 114%, its highest level in more than a year.   

Quick note on Pool of Funds:  

We previously covered pool of funds here, explaining that 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. For some time, this shifted how DBNRR and RPO were reported since revenue is recognized as the customer consumes the service. 

The current update (albeit a bit vague) is that “pool of funds deals with our largest customers represented low double digit in the second quarter, up from less than 3% a year ago. So significant progress.” 

GAAP Margins Drift Lower 

Gross margins drifted lower in Q2, driven by both an increase in depreciation expenses and in allocated costs from higher network traffic from paying customers. GAAP operating margins followed, moving further away from reaching break-even. 

Cloudflare had an interesting comment on long-term margins, stating that it expects to remain comfortably in its 75% to 77% adjusted gross margin target despite passing on substantial savings to Workers’ customers. This suggests that upside to operating margins will be driven by expenditures, such as moderating higher sales & marketing spending, at 36% of revenue versus its target range of 27-29%, and high SBC at 24% of revenue. 

• GAAP gross margin was 74.9% in Q2, down nearly 3 points YoY and 1 point QoQ. Adjusted gross margin was 76.3%, down 2.7 points YoY and 0.8 points QoQ. 
• GAAP operating margin was (13.1%), down 4.4 points YoY and 2 points QoQ. Adjusted operating margin was 14.1%, approximately flat YoY and up 2.4 points QoQ; this was also ahead of guidance for 12.6%. 
• For Q3, Cloudflare guided for adjusted operating income of $75-76 million, pointing to adjusted operating margin of 13.9%, down nearly 1 point YoY and moderating slightly QoQ. 
• GAAP net margin was (9.8%), down 6 points YoY and 1.8 points QoQ. Adjusted net margin was 14.7%, down 2.6 points YoY but up 2.5 points QoQ. 

FY25 EPS Raised Slightly 

Cloudflare topped estimates in Q2 driven by the revenue beat and stronger adjusted margins, and boosted its FY25 adjusted EPS outlook as a result. 

• GAAP EPS was ($0.15), missing estimates for ($0.08) as GAAP margins drifted lower. 
• Adjusted EPS was $0.21, beating estimates for $0.18, fueled the outperformance in adjusted operating margin in the quarter.  

For Q3, Cloudflare guided for $0.23 in adjusted EPS, a slight uptick sequentially, while for FY25, the company raised its forecast from $0.79-$0.80 to $0.85-$0.86. This corresponds to growth of ~14.5% YoY, up from the mid-6% range previously. Growth is expected to be much stronger in FY26 at ~30% YoY to $1.12. 

Cash Flow Margins Contract, and Cloudflare Raises $2B in Convertible Debt 

Cash flow margins contracted sequentially, while Cloudflare significantly bolstered its cash pile after a large convertible note issuance.  

• Operating cash flow was $99.8 million for a 19% margin, flat YoY but down from a 30% margin in Q1.  
• Free cash flow was $33.3 million for a 6% margin, down 4 points YoY and 5 points QoQ.  
• Network capex was 11% of revenue in Q2, down from 17% of revenue in Q2. Cloudflare stuck to its guidance for network capex to be 12-13% of revenue for the year, suggesting slight moderation in 2H.  
• In June, Cloudflare raised $1.97 billion in new convertible notes due 2030, raising its cash on hand to $3.96 billion while convertible notes outstanding rose to $3.26 billion.  

Earnings Call Q&A: 

Agentic AI & Small Language Models (SLMs) is where Cloudflare’s AI impact will become more apparent 

Today, AI agents are mainly LLM-based copilots and assistants rather than truly autonomous agents. The broader vision is for agents to set goals and act without a human prompting each action. Gartner is a reasonable forecaster and is placing 2027-2028 as the time frame when 33% of enterprise software apps will include agentic AI.  

While large language models will continue to provide the more complex reasoning tasks, small language models will be deployed to execute the day-to-day automation with major benefits over LLMs such as being quicker and cheaper when running thousands or millions of decisions per user. The major difference is that LLMs are massive knowledge engines whereas SLMs are run locally and offer speed.  

That’s a critical distinction to make when listening to Cloudflare’s management talk about why their stock has not performed as well in the LLM phase of AI versus the upcoming SLM phase:  

“We would not be today the right place for one of the really massive LLMs to run because those, in many cases, will require multiple different machines working in coordination. It is a more complicated task. But for smaller models, we're finding that Cloudflare is the best place for anyone who's building that to run that. And over time, we are investing in making our systems able to support larger and larger and larger models.” 

In addition, Cloudflare represents 20% of the internet and that number is in the mid-30% when considering the top 10,000 sites. By managing a leading percentage of internet traffic, agentic AI will route through Cloudflare’s reverse proxy and CDN to fetch data and trigger APIs. The company offers Cloudflare Workers and WebAssembly for a low-latency and distributed hosting environment to run SLMs. Additionally, agentic AI will require enhanced security since autonomous actions can have a larger impact from errors (bad API calls) or security issues that are more malicious.  

This is how management discussed it on the earnings call: 

“I think what we feel confident, though, is that because of the fact that so much of the Internet sits behind us and inherently, those agents are going to be passing through us that we have an opportunity to help define what those rails are that the agents will ride on and take some fee from that — those transactions as we've helped facilitate them and make them faster, more reliable, more secure, give people the access to those rails.” 

Act 4 Seeks to Minimize the Impact AI has on Publishers 

Cloudflare recently launched a product that prevents AI bots from accessing websites without payment. It’s no secret that AI has made a dramatic impact on publishers given AI-driven search tools do not refer traffic to the sources they scrape data from. Whether it’s OpenAI and Microsoft getting sued by The New York Times or stats like this one that publishers are seeing 25% fewer referral clicks, the evidence is mounting that AI is destroying business models for both smaller, independent publishers and larger media conglomerates. 

Cloudflare had some wild statistics on their call, stating “based on the data that Cloudflare has observed, it's nearly 10x harder to get traffic from Google than it was just 10 years ago.” Even more crazy, they stated “every AI company we've tracked is worse than the Google of old with some being as much as 30,000x harder to get traffic from” – likely referring to OpenAI or Anthropic. 

This is one to watch as it could become one of Cloudflare’s fastest growing products given the pain point Act 4 seeks to solve.   

“But we aren't building search engines anymore. We're building answer engines. And the difference between a search engine and an answer engine is a search engine directs you to that content where you can go and the content creator can monetize it. An answer engine answers without you having to leave. And so there has to be some value creation back to content creators that isn't just based on traffic.” 

You can read the official Pay per Crawl announcement here. 

Valuation is high 

Cloudflare trades at a forward PS ratio of 28.5. The exuberant investor will tell you that any contribution from AI demands a higher valuation than what we’ve seen in the past, yet time will tell if that is true. We prefer to see if we can get Cloudflare and really any cloud stock under 20 forward PS. Typically, Cloudflare at a 15 forward PS is a great spot to buy. 

Conclusion: 

As of now, we are patiently waiting to get Cloudflare lower ahead of the inference market taking off. Remember – our thesis is about Cloudflare’s positioning, which is multi-faceted in terms of how Cloudflare can monetize its AI utility at the internet infrastructure level. As agentic AI and SLMs become a leading paradigm, Cloudflare’s network is set to become a critical player. You’re seeing some of this with Cloudflare able to seamlessly pivot toward helping publishers get paid by Big Tech, which is typically a cutthroat group. The company is also effortlessly expanding its use case for AI inference to include agentic AI and SLMs; meaning no matter where AI development takes inference, Cloudflare will be there.  

Since our firm likes to be prudent, margins are not actually bulletproof as Cloudflare is not GAAP profitable and margins contracted this quarter. This line item has a red mark on our checklist, and we will continue to look at this closely in the coming earnings reports.

Damien Robbins, Equity Analyst at I/O Fund contributed to this analysis.

Please note: The I/O Fund conducts research and draws conclusions for the company’s portfolio. We then share that information with our readers and offer real-time trade notifications. This is not a guarantee of a stock’s performance and it is not financial advice. Please consult your personal financial advisor before buying any stock in the companies mentioned in this analysis. Beth Kindig and the I/O Fund do not own shares in NET at the time of writing and may own stocks pictured in the charts.

Recommended Reading:

• AMD Reports in Line while AI Story to Improve from Here
• Astera Labs Q2: Blowout with double digit Beat/Raise; Emphasis on future growth
• Coinbase Underperforms in Q2; Near-term Volatility Likely
• Microsoft FYQ4: One of the Strongest Earnings Reports in Multi-Decade History

ServiceNow’s upcoming earnings report is of high interest to us. There are many key metrics to highlight, including the company’s ability to re-accelerate subscription revenues to 27% YoY in the previous quarter, up from 22% a year ago. RPO also accelerated nicely to 29% YoY growth up from 22% in the year ago quarter. Net New ACV (NNACV) was up 33% YoY compared to 30% in the year ago quarter with the number of transactions over $1M in NNACV more than doubling QoQ from 83 to 168 transactions.

The CFO stated that the company’s generative AI product, Now Assist, contributed to the recent raise for FY2024 guidance of $165 million. However, gen AI’s contribution is very new and not too impactful yet, per management.

ServiceNow is the rare cloud company that is GAAP profitable and has a strong free cash flow margin of 30% for FY2023.

This report dives deeper into the elements that underpin ServiceNow’s optimism, including an examination of its financial health, strategic initiatives, and the anticipated impact of its AI-driven products on the market.

Key Points:

• Q4 2023 Revenue Performance: ServiceNow reported a 25.62% increase in Q4 revenue, reaching $2.44 billion. QoQ growth improved by 6.6%, with expected Q1 revenue of $2.59 billion, marking a 23.5% year-over-year increase.
• Robust Subscription Growth: ServiceNow's subscription revenues reached $2.37 billion, growing 27% YoY and exceeding revenue guidance of $2.32 billion and growth of 24.75% at the mid-point and $2.32 billion, while professional services declined by 10% YoY in Q4 and 18% for the year.
• Expansion and Strategic Alliances: ServiceNow enhanced its OT management capabilities with acquisitions of 4Industry and Smart Daily Management, collaborated with Hugging Face and NVIDIA on the StarCoder2 LLM, expanded its partnership with NVIDIA for telco-specific AI solutions, deepened its alliance with EY for AI compliance, and launched new payment and AI-powered solutions through strategic alliances with Visa and AWS.
• Mixed Margin Performance: ServiceNow experienced mixed margins year-over-year, with improvements in operating and net margins, while gross and subscription margins saw slight declines.
• Operational Efficiency and Investment Strategy: The company is raising its full-year operating margin target from 28% to 29% due to continued operational efficiencies. Investments are focused on innovation in AI, particularly Gen AI, with significant hiring in R&D to drive these initiatives.
• Strong Growth Outlook with GenAI Focus: According to management, the newly launched Gen AI product, Now Assist is contributing to the company’s largest net new ACV. This segment saw 168 deals greater than $1 million, up 33% YoY.
• Strategic Gains Across Segments: Despite challenges in the market environment, ServiceNow closed numerous large deals globally, including a record number of new $1 million+ deals and major wins in the public sector such as with the US Army and Australian Department of Defense.

Revenue and Earnings:

ServiceNow reported fiscal Q4 revenue of $2.44 billion for an increase of 25.62% YoY. This is a 6.6% improvement QoQ from $2.29 billion in revenue. The growth rate was 24.96% in the September quarter, and thus, December marked a slight acceleration. In terms of being seasonal or not, this did not occur last year, rather the December 2022 quarter decelerated by 90 basis points in growth rate.

ServiceNow is expected to see slightly slower growth next quarter at 23.5% for revenue of $2.59 billion. For the full year, analysts are expecting growth of 21.4% for revenue of $10.89 billion.

The performance in Q4 was packed with milestones for ServiceNow, spanning the full breadth of their portfolio. Each of their workflow businesses, technology, customer, and creator, are over $1 billion in annual contract value (ACV). And the company has 11 individual product lines with north of $250 million in ACV.

ServiceNow ended Q4 with 1,897 customers paying over $1 million in ACV adding 108 customers compared to the prior quarter. This is the addition in $1M customers in the past five quarters.  

The company closed 168 deals greater than $1 million in net new ACV (NNACV) in the quarter, a 33% increase year-over-year, that includes five deals over $10 million. Interestingly, this was over 100% growth QoQ.

For the full year 2023, ServiceNow saw an approximate 30% increase in deals greater than $1 million in net new ACV.

Despite this, total ACV only increased 15% in Q4 2023 compared to the prior year period. This is down from 17% growth in the previous quarter and down from 22% in the year ago quarter.

Remaining Performance Obligations (RPO) and current Remaining Performance Obligations (cRPO) are two popular metrics to track for ServiceNow.

RPO ended the quarter at approximately $18 billion representing an acceleration to 29% YoY. This compares to growth of 26% in the previous quarter and compared to growth of 22% in the year ago quarter.

cRPO was $8.6 billion, representing 24% YoY which was down from 27% in the previous quarter although was up from 22% in the year ago quarter.

Gen AI products, via Now Assist, drove the largest net new ACV contribution for the first full quarter of any of ServiceNow’s new product family releases ever, including the original Pro SKU.

ServiceNow topped analyst estimates on both the top line and bottom line. Analysts were expecting GAAP EPS of $1.43, non-GAAP EPS at $2.78 and revenue of $2.4B, while the company reported GAAP EPS at $1.46, non-GAAP EPS at $3.11and revenue at $2.44B. Even though the company’s earnings growth is expected to slow in 2024, management is still anticipating solid double-digit growth for the year.

Revenue Segments:

In Q4, subscription revenues were $2.37 billion, growing 27% YoY, exceeding the high end of the company’s guidance. ServiceNow closed out 2023 with $8.68 billion in subscription revenues, also representing 27% growth compared to fiscal 2022 subscription revenues. The CFO Gina Mastantuono had this to add on subscription revenues, “All organic at a scale that hasn't been accomplished by any other enterprise software company.”

Professional services and other revenues were $72 million for Q4, a (-10%) decrease YoY. For the full year of fiscal 2023, professional services and other revenues amounted to $291 million, representing an (-18%) decline YoY.

With regards to ServiceNow’s total addressable market (TAM), the CFO commented on a major milestone: “For the first time in a decade, IT services will become bigger than communication services in 2024. Gartner estimates that by 2027, nearly all of the growth in worldwide IT spending will come from software and IT services. And when you drill deeper into the Gartner forecast between 2023 and 2027, $3 trillion will be spent on AI.” This speaks to size and growth of the total addressable market for ServiceNow.

Margins:

Margins were mixed YoY as the company's focus on low-margin AI products is evident in its financial outcomes. Operating margin and net margin improved, while gross margin and subscription margin declined slightly YoY.

Non-GAAP subscription gross margin dipped to 84% in Q4 2023, flat QoQ but a decrease from 86% in Q4 2022. The company expects this margin to improve slightly to 84.5% in 2024, reflecting investments in data centers and emerging growth opportunities, partially offset by a change in useful life in data center equipment from four to five years. ServiceNow is also raising its full year non-GAAP operating margin target from 28% to 29% driven by continued operational expenses efficiencies.

Margins were a topic in the conference call with one analyst congratulating the company on the performance in 2023, with the CFO adding the expectation those margins will continue to expand in 2024.

Cash Flow:

Operating cash flow of $1.61 billion in fiscal Q4 represented a margin of 66%. Free cash flow of $1.34 billion represented a FCF margin of 55%.

There is $8.1 billion in cash and investments on the balance sheet and $1.49 billion in debt. Debt has remained constant since Q4 2022 with no amounts due in the next twelve months.

ServiceNow announced that the company repurchased 400,000 shares of its common stock for $256 million as part of its share repurchase program.

Earnings Call:

ServiceNow is expecting strong growth yet again in 2024 with GenAI being a central part of the bullish view for the stock. Analysts had a lot of questions on the topic.

GenAI

ServiceNow’s new Gen AI product, Now Assist, was stated to have “drove the largest net new ACV contribution for our first full quarter of any of our new product family releases ever.” Therefore, it’s not surprising to see it as a key topic during the Q&A.

And despite the very strong performance in Q4 and fiscal year 2023, it brought out a few interesting takes from management, specifically on the environment they face as we head into 2024.

Here is what the CEO stated when asked about the Gen AI product driving the largest net new ACV contribution:

“What's really happening and I can say this after 186 CEO meetings in the last six months, the CEOs are now getting very involved with the Gen AI revolution. They realize there has to be architectural adjustments to their environment and the manner in which they manage their data and the platforms they're beholden to actually take advantage of Gen AI.

 And if you think about the half a century mess that exists out there with legacy systems, in many cases, multiples of the same system, we have one unifying force in these conversations, which is the Now platform because we cooperate with the complexity of this landscape without putting people in a position to rip and replace […]

As I said, that SKU has outsold any other new introduction we put into the marketplace. So, there's a real appetite to invest in Gen AI, and there's no price sensitivity around it because the business cases are so unbelievable. I mean if you're improving productivity, 40%, 50%, it just sells itself.”

Overall, this is an encouraging note on the sales environment along with the potential of the Gen AI segment for ServiceNow. It’s not a huge revenue driver at the moment, but the trajectory means it could become a key driver of growth in 2024 and beyond.

Here’s what Gina had to add about Gen AI during the call.

I get the question often, do we see the adoption curve to be steeper for our Pro Plus than our Pro. Certainly, in the first full quarter of launch, it absolutely has shown that.

That being said, it's very early days. And so from a revenue contribution perspective, it's not going to be huge, but it's certainly helped when I thought about my guide for 2024 and that increase of $165 million at the midpoint, right? So Gen AI, early days, but the adoption curve so far is steeper than the original Pro. We will keep an eye on it.but it's certainly helped when I thought about my guide for 2024 and that increase of $165 million at the midpoint, right? So Gen AI, early days, but the adoption curve so far is steeper than the original Pro. We will keep an eye on it.

Net New ACV

ServiceNow’s new logo count continued to accelerate in Q4, with a record 10 new customers signing deals over $1 million in NNACV, including a $10 million win with a very large global financial services firm, which is their largest new customer logo in history.

Chipotle, Air France, TIAA, NTT, Data Group Corporation, and Busch are some of the brands that are utilizing ServiceNow to enhance their operations.

Additionally, in Q4 ServiceNow built on a record Q3 with the public sector, with key wins including in the United States Army, US Postal Service, and Australian Department of Defense Digital Delivery Group.

During the call, one analyst wanted more details on the drivers of the momentum in ACV.

Bill McDermott:

Just a couple of statistics on the customer workflows, 18 of our top 20 deals, what we're seeing is there's a tremendous opportunity to really take ServiceNow and squarely place it on the Customer Relationship Management category.

When you think about front, mid and back office and the fact that we can align all three of those things, and nobody has to lose for us to win. We could fill in all the blanks for what the current participants don't do, especially with their integration problems. It's just a fantastic opportunity for our customers.

And I think it's important to note, when I gave the Field Service Management example, our net new ACV in Field Service Management, specifically was up over 50% and year-over-year.

So, I think it's important to recognize that we have a whole list of new logos in this space. And employee workflows, nine of our top 20 deals and was kind of interesting. Every single CEO now is looking to make the people packed far more productive than it is and with natural language to have your employees seek the data and the information they want and have it reported back to them in just a very nice paragraph of content and data so they can do their jobs better, is kind of like in the no-brainer category.

RPO and cRPO

RPO and cRPO are key indicators of growth and future projections for ServiceNow. Analysts were zeroing in on what the upside is for the current quarter, Q1 2024, and how much is due to Gen AI adoption.

Gina Mastantuono:

So, we beat our Q4 cRPO growth guidance by 200 basis points as you know. And I would say it's driven probably half and half by net new ACV outperformance and certainly, Gen AI is in there, but it's not all Gen AI.

So, our core business is also doing well. And then we also did see higher early renewals than we had assumed in our guidance. And I would say it's about half and half of the total beat.

Government:

The government is a very strong potential growth area for ServiceNow. A few analysts wanted more details.

They asked about cyclical spending at the public sector and what their AI adoption cadence is going to look like.

Here’s Bill’s take:

Our federal business is really outstanding. And for the benefit of our shareholders, I think that there's a tremendous opportunity to replicate what we're doing in the United States federal and many other governments around the world. That is clearly an ambition that we have, and we have many use cases and many references to back that up.

Recent AI Announcements:

On March 18, 2024, ServiceNow announced it has signed an agreement to acquire 4Industry, a Netherlands‑based partner whose manufacturing technology application is built on the Now Platform, and has completed the acquisition of  Smart Daily Management, a connected digital worker application from EY. Together, the deals augment ServiceNow’s existing operational technology (OT) management capabilities, adding Connected Worker solutions and enhancing expertise across key industrial markets such as manufacturing, energy and transport & logistics.

On February 28, 2024, ServiceNow, Hugging Face, and NVIDIA, announced the release of StarCoder2, a family of open‑access large language models (LLMs) for code generation that sets new standards for performance, transparency, and cost‑effectiveness.

On February 26, 2024, ServiceNow and NVIDIA announced that they are broadening their relationship with the introduction of telco‑specific generative AI solutions to elevate service experiences.

On January 24, 2024, ServiceNow announced a broader strategic alliance with EY to empower responsible AI use for enterprise customers, deliver unified solutions for AI compliance and governance, and bring AI‑enhanced experiences to EY employees and clients with ServiceNow Now Assist.

Additionally, ServiceNow and Visa announced a five‑year strategic alliance to transform payment services experiences. The initial phase includes the launch of ServiceNow Disputes Management, Built with Visa–– a single, connected solution for disputes resolution.

ServiceNow also announced a five‑year Strategic Collaboration Agreement with Amazon Web Services (AWS) to offer the ServiceNow Platform and full suite of solutions in the AWS Marketplace. The two companies will also co‑develop and launch industry‑specific, AI powered applications.

Conclusion:

The key metrics on ServiceNow help to create a picture that something special is going on at this company compared to many cloud peers. As with nearly every stock in the market right now, investors must contend with valuations. This is one thing if you’ve owned a stock for some time and are sitting on gains, but is a bigger risk if you’re wanting to enter now for the initial entry. We’d like to keep ServiceNow in our pipeline to buy at lower levels, while also keeping an eye on the upcoming earnings report to see if any new information changes that decision. As always, each investor must determine their own unique risk profile for themselves. For our purposes, we view ServiceNow as fairly valued at 17 PS ratio compared to a 17 PS ratio 5-year median and 15.5 PS ratio 3-year median. The bottom line is only recently GAAP profitable and trades at a 88.6 PE Ratio compared to 5-year median of 1826 (noisy signal). Price to free cash flow is at 56 compared to a 5-year median of 52.6. Therefore, for our purposes, it makes sense to try and get the stock lower since the probability it can stretch higher (and sustain a higher valuation) is low. 

Chad Shoop, Equity Analyst for the I/O Fund, contributed to this analysis

Recommended Reading:

• Lam Research: Eyeing Strong 2024 Exit Boosted by Memory Rebound
• Netflix Q1: Large Paid Net Adds Beat, Yet Important Key Metrics Dropped Starting in 2025
• Cloud Earnings Review: AI a key driver for growth

Every quarter, we provide an overview of the cloud sector including hyperscalers and best-of-breed companies. We had discussed in our last analysis that the hyperscalers are showing signs of stabilization. In a further positive development, the hyperscalers growth accelerated in the recent quarter, helped by a much-needed boost from AI.

Below, we look at best-of-breed companies that are expected to decline sequentially by 4 points, the same deceleration we noticed in Q3 to Q4. This is an improvement from an 11 point decline in Q1-Q2 of last year. We also discuss various financial metrics that can help determine which cloud companies will continue to lead.

Tracking the Cloud ETFs YTD performance, SKYY beat the QQQ (tracks the Nasdaq-100 Index) by one percentage point and other ETFs are trailing with WCLD with (1.37%) return and CLOU with (4.06%) YTD returns.

Big Tech is the Best Proxy for Cloud

Big Tech Companies are more insulated than Best-of-Breed cloud and offer a 360-degree view of how the cloud industry is faring. The Big 3 cloud providers are the best proxy since they account for 67% of the cloud market. They also represent the layer in the tech stack that tends to be the most resilient in terms of churn. The switching costs are quite high for cloud IaaS services.

Microsoft Azure had the fastest growth of 30% among the Big 3 and all the three companies showed an acceleration that was helped by AI revenue. Microsoft Azure Q4 growth rate and AWS accelerated by 1%, while Google Cloud accelerated by 4%. This is an improvement from the trend in the previous quarter when we noted, “Microsoft Azure’s Q3 growth rate was the outlier among the Big 3 as its growth rate accelerated by 3%, while AWS remained steady albeit at a slower growth rate, and Google Cloud decelerated by 6%. The steep deceleration in Google Cloud was a negative surprise as analysts were expecting it to grow 26% compared to the actual 22%.”

According to Synergy Research Group the combined Q4 YoY growth of the Big 3 cloud providers marked the highest growth compared to the previous three quarters and also the largest sequential increase ever. “The year-on-year growth rate was 20% in Q4, markedly higher than the previous three quarters. Notably, the market grew by $5.6 billion from Q3. That is by far the largest quarter-on-quarter increase ever achieved.”

Microsoft

• Microsoft Azure grew 30% YoY and 28% in constant currency, including a 6% incremental contribution from AI.
• Growth accelerated from 29% in the previous quarter and was slightly down from 31% in the same period last year.
• The company’s CFO, Amy Hood, said Azure growth will remain stable in the next quarter. “In Azure, we expect Q3 revenue growth in constant currency to remain stable to our stronger-than-expected Q2 results. Growth will be driven by our Azure consumption business with continued strong contribution from AI.”Growth will be driven by our Azure consumption business with continued strong contribution from AI.”

AI’s impact on Azure was notable: Microsoft said that Azure’s 30% growth stemmed from “strong demand for our consumption-based services including 6 points from our AI services.” This 6-point contribution is impressive, given that AI services contributed 3 points to growth last quarter and 1 point in fiscal Q4. While that may seem small, it is significant considering the scale that this growth is attached to, with Azure’s revenue at a $74 billion run rate.

Microsoft’s earnings call reflected growing AI optimism, with strong key metrics for its AI offerings across its product suite. Satya Nadella also signaled in the earnings call Q&A that optimization is over for now on traditional workloads, which is positive. “I'll call it, optimization only and no new workloads start, that I think has ended at this point. So what you're seeing is much more of that continuous cycle by customers, both whether it comes to AI or whether it comes to the traditional workloads.”

AWS

• AWS revenue grew by 13% YoY to $24.2 billion and is now approaching a $100 billion annualized run rate.
• Growth accelerated by one percentage point from 12% in the last quarter yet was lower than the 20% in the same period last year.

The company’s CEO, Andy Jassy, sounded very optimistic in the earnings call on the prospects of AI. “Gen AI is and will continue to be an area of pervasive focus and investment across Amazon, primarily because there are a few initiatives, if any, that give us the chance to reinvent so many of our customer experiences and processes, and we believe it will ultimately drive tens of billions of dollars of revenue for Amazon over the next several years.”we believe it will ultimately drive tens of billions of dollars of revenue for Amazon over the next several years.”

The company’s CFO pointed out that optimizations are slowing. “Similar to what we shared last quarter, we continue to see the diminishing impact of cost optimizations. And as these optimization slow down, we're seeing more companies turning their attention to newer initiatives and reaccelerating existing migrations.”

Google Cloud

• Google Cloud revenue grew by 26% YoY to $9.2 billion, helped by the increasing contribution from AI, beating the estimates of $8.94 billion.
• Even though the growth is lower when compared to the 32% growth in the same period last year, it has accelerated from 22% in the previous quarter.
• The strong growth in the quarter also helped the company narrow the gap to 4 percentage points with Microsoft Azure’s leading growth of 30% compared to 7 percentage points in the previous quarter.

In the earnings call, CFO Ruth Porat said, “The Cloud team is intensely focused on bringing the benefits of Gemini, our industry-leading AI technology, to enterprises and governments globally, and we are gratified with the level of engagement. The strong demand we are seeing for our vertically integrated AI portfolio is creating new opportunities for Google Cloud across every product area.” The company launched Gemini in December and offers three versions: Gemini Ultra, Gemini Pro, and Gemini Nano.

The company’s CEO Sundar Pichai also echoed the thoughts of Microsoft and Amazon’s management on cost optimizations reducing, saying “the cost optimizations in many parts are something we have mostly worked through.”

Best of Breed

We took a sample of the top-ranking cloud stocks on revenue growth, free cash flow, adjusted operating margin, and valuations.

Best-of-breed cloud companies are expected to decline sequentially by 4-points; from 5% QoQ growth last year to the expected 1% QoQ this year. This is the same as we noticed in Q3 to Q4, wherein it showed an improvement from a decline of 11 points in Q1 to Q2 of last year.

However, on a percentage basis, the recent QoQ/YoY deceleration is 72% compared to the 47% decline in Q3 to Q4 estimates and slightly better than the 83% decline in the same period last year.

All the best-of-breed cloud companies showed a deceleration similar to the trend seen in our previous analysis. CrowdStrike has the lowest deceleration, from 9% last year to 7% expected this year. Bill Holdings has the highest deceleration, from 5% growth last year to (4%) this year. In our previous analysis, Bill Holdings had the lowest deceleration.

Earnings Beats

Bill Holdings led with a revenue beat of 6.8%. The company’s revenue grew by 22% YoY to $318.5 million. The core revenue, which includes subscription and transaction fees, grew by 19% YoY to $275 million. Management highlighted the better-than-expected standalone total payment volume (TPV) growth of 10%. However, they are still cautious on macro, “It's too early to call a trough in B2B spend, and we expect the current interest rate environment will continue to depress overall spend growth.” The management guide for the next quarter is $299 million to $309 million, representing a YoY growth of 11.5% at the midpoint.

MongoDB’s revenue exceeded analyst expectations by 5.2%. The company’s revenue grew by 27% YoY to $458 million. However, the stock sold off post earnings as the FY guidance missed estimates. Management FY revenue guide was $1.9 billion to $1.93 billion below the estimates of $2.03 billion. The adjusted EPS guide was $2.27 to $2.49, far below the estimates of $3.22.

HashiCorp’s revenue grew by 15% YoY to $155.8 million, beating estimates by 4.3%. Management revenue guide for the next quarter is $152 million to $154 million, representing a YOY growth of 10.9% at the midpoint. The management highlighted in the earnings call that they are targeting 20% growth sometime in FY2026. Per CFO, “And then what follows is basically progressive improvement on the growth rate until it reaches 20% in the fiscal 2026 period, not that fiscal '26 will be 20%, just to be clear. So what we're signaling is that — the fourth quarter was a great quarter, and we feel like the optimization cycle is abating. There are signs of positive activity. We're not out of the woods.”we feel like the optimization cycle is abating. There are signs of positive activity. We're not out of the woods.”

HashiCorp’s adjusted EPS came at $0.05 compared to ($0.07) in the same period last year, beating estimates by 501%. This was the second consecutive non-GAAP profitability for the company. Snowflake’s adjusted EPS grew by 150% YoY to $0.35, beating estimates by 98%. MongoDB ranked third with a beat of 82.6% and its adjusted EPS grew by 50.9% YoY to $0.86.

Bottom Line and Free Cash Flow

GAAP profitability is another crucial metric to monitor closely, especially with macroeconomic uncertainty. Most of the names listed in the chart below are unprofitable on a GAAP basis because they pay high stock-based compensation.

This is one of the more important metrics that separates the winners from the laggards. For example, CrowdStrike recently achieved the feat of four consecutive quarters of GAAP profits and a full year in GAAP profits. The stock has been up 140% in the past year.

Bill Holdings has improved its operating margin to (13%) from (43%) in the same period last year. CrowdStrike has improved to 4% from (10%) in the same period last year. Zscaler reported (9%) compared to (17%) last year.

ServiceNow has the highest free cash flow margin of 55%, up from 52% in the same period last year. Snowflake ranks second with a free cash flow margin of 42% and Datadog ranks third with a free cash flow margin of 34%.

Valuations

CrowdStrike has the highest forward P/S ratio of 19.5 among the best-of-breed cloud stocks. It is followed by Cloudflare at 19.3 and Datadog at 15.5.

Ranking based on revenue estimates change for next quarter.

GitLab’s revenue estimates have been revised by 2.5% and Zscaler ranks second with a positive revision of 1%. MongoDB had a negative revision of (2.1%) after the company’s FY guidance came in below analyst expectations.

Ranking based on adjusted EPS estimates change for the next quarter.

Zscaler had the highest adjusted EPS revision of 10.5% among the best-of-breed cloud stocks. It is followed by CrowdStrike at 8.3% and Snowflake at 0.8%.

Highlights and Lowlights in Q4

CrowdStrike reported the fourth consecutive quarter of GAAP profits and the first full year of GAAP profits. The turnaround in GAAP profitability is most impressive compared to its cloud peers. The company’s key metrics are also accelerating. Notably, the net new ARR accelerated by 14% to 27% growth in the recent quarter from 13% in Q3. The company is in a unique position by combining cybersecurity with AI in a single platform with a data-centric architecture. Our complete post-earnings analysis is here.

Cloudflare beat revenue estimates by 2.7% and adjusted EPS by 26.3%. The company’s adjusted operating margin grew by 500 bps to 11% in the recent quarter. The free cash flow margin improved by 200 bps to 14%. CEO and co-founder Matthew Prince said in the earnings call, “The machine that underlies Cloudflare is firing efficiently on all cylinders, and we've been able to execute even as the macro environment remains choppy.” Key metrics accelerated, RPO accelerated to $1.245 billion, up 37% YoY compared to 30% YoY growth last quarter. We have discussed the company further in our post-earnings analysis here.

Zscaler beat revenue estimates by 3.6% and adjusted EPS estimates by 31%. On the macro, the company’s CFO said in the earnings call, “We believe we are still operating in a challenging macroenvironment and customers continue to scrutinize large deals.” Despite the beat and raise, the stock sold off post-earnings since the company guided for a (7%) sequential decline in calculated billings, suggesting further deceleration in this key metric to the low-20% range. We have discussed the company further in our cybersecurity analysis here.

Conclusion

The hyperscalers growth accelerated with a boost from AI. Cloud optimizations are reducing, which is positive. However, the macro conditions are still challenging. We will continue to look for outliers in the cloud category as we move into next quarter’s earnings season. We added CrowdStrike and Cloudflare to our portfolio partly informed by scans such as these, which revealed bottom line strength coupled with strong growth. We also use these overviews to keep an eye on valuation, of which cloud stocks are particularly sensitive to in this environment with very few successfully trading over 20 Fwd P/S since Q4 of 2021.

Royston Roche, Equity Analyst at the I/O Fund, contributed to this article.

Recommended Reading:

• Micron Q2: Memory Rebound in Full Force with HBM3e
• Arm-Based PCs and AI Edge Devices
• Broadcom: $10B in AI Revenue This Year Plus Software is Rapidly Accelerating
• Marvell Q4: Data Center Strong but AI Slow to Materialize
• CrowdStrike Q4: RPO Surges, Net New ARR Impresses, GAAP Margins Strengthening