Category: Cybersecurity

Cloudflare: Revenue Accelerates to >30%, Key Metrics Strengthen

Posted on by io-fund

Cloudflare’s fundamental profile strengthened in Q3 with the company reporting its fastest revenue growth rate in seven quarters, returning to >30% YoY territory, while a majority of key metrics all accelerated in unison.  

Outside of the financials, Cloudflare remains very well positioned for AI inference, though inference does not yet contribute meaningfully to revenue. Discussion on GPU utilization rates was fruitful and highlighted how Cloudflare can remain in near lock-step with demand while avoiding capacity constraints and with relatively low capex.  

Management also believes that versus the hyperscalers, they have a strong TCO advantage when it comes to inference, and in the future, the network will be one of the best places to run inference requests. Cloudflare also shed more light on Act 4, its Pay Per Crawl feature, which will enable creators to be monetized for AI data scraping, and while it is quite early, it is aiming to solve a quickly emerging pain point. 

Material Evidence of Revenue Reacceleration, Driven by US and Enterprise Clients 

Cloudflare reported its largest beat since Q1 2022, reporting revenue of $562.0 million in Q3, 3.1% ahead of estimates as growth accelerated nearly three points to 30.7%. On a QoQ basis, revenue accelerated to 9.7% from 6.9% last quarter. 

The US is emerging as a primary driver for this reacceleration, with growth rebounding 10 points sequentially, from 21.7% YoY in Q2 to 31.5% YoY in Q3. US revenue jumped 12.2% QoQ versus a 7.2% QoQ increase in Q2. 

Additionally, Cloudflare’s enterprise cohort, or customers contributing >$100K ARR (and likely primarily US-based) are another key factor behind the reacceleration. >$100K ARR customers drove 73% of revenue in Q3, or ~$410 million, rising 42% YoY and 13% QoQ. This was a sharp 12 point acceleration in YoY growth from 30% in Q1, to the fastest growth since Q1 2023, while QoQ growth was the highest since Q2 2022 at 13%.  

Q3 also marked Cloudflare’s first >30% growth quarter in the past five and its fastest revenue growth in the last seven quarters. This is the first step in confirming a sustained revenue acceleration, yet the more important piece is showing that >30% growth can actually be sustained for multiple quarters.  

For Q4, Cloudflare guided for revenue of $588.5 to $589.5 million, a slight deceleration to 28% on the topline. This was ahead of estimates for $580.8 million. Interestingly, consensus estimates, just one day following earnings, moved from $589 million to $617 million, suggesting analysts are increasingly optimistic on the company’s ability to sustain this revenue acceleration, supported by strong key metrics. 

For FY25, Cloudflare boosted its revenue guidance to $2.142 to $2.143 billion, a $28 million increase from its prior guide. This points to YoY growth of 28.3%, a slight deceleration from 28.8% growth in FY24.  

Key Metrics Strengthen, Aided by Enterprise Transition 

Despite a lack of meaningful AI contribution, other key metrics strengthened significantly in Q3 and support this material reacceleration story. Cloudflare cited its shift from a product-led, SMB-focused company to an enterprise sales company as a primary driver behind the improvement in key metrics.  

There are a few reasons that this focus on enterprise clientele is important for Cloudflare’s growth story, with the simplest being that visible acceleration of enterprise customer revenue in Q3 translated to the material topline reacceleration. Enterprise customers are also likely to expand much quicker than SMBs – for example, Cloudflare noted that accelerating QoQ and YoY growth in its >$1M and >$5M customer cohorts acted as a significant tailwind to DBNRR, which rose five points sequentially to 119%, the highest since Q4 2022.  

This DBNRR expansion is also linked to Cloudflare’s Pool of Funds billing approach, which provides a seamless vector for large customers to explore adoption of Cloudflare’s 55 products under a single contract, and allocate funds to different products based on consumption. While management explained that the rollout initially created some downward pressure on DBNRR, consumption of these deals acted as a tailwind to DBNRR this quarter. CFO Thomas Seifert added that POF is “now low double-digits of ACV” and gaining share in the quarter.  

Enterprise traction is also showing up in RPO, which accelerated four points to 43% YoY to $2.14 billion; on the other hand, current RPO decelerated three points to 30% YoY and accounted for 64% of RPO. 

Management explained that this RPO acceleration “points to primarily 2 drivers, the customer quality and the platform expansion. We are seeing exceptional strength with our large customer cohorts, specifically those that spend more than $1 million or $5 million with us, both delivered record growth this quarter. And in addition to that strength is increased consumption of our large Pool of Fund customers, demonstrating I think, the increasing strategic importance of our platform for those large enterprises globally. And in addition to that, our Workers platform, the developer platform, including Workers AI, is just providing to be a significant new vector for long-term commitment and with that growth.” 

Moving forward, it will be important to see consistent strength in both DBNRR and RPO as further evidence that Cloudflare’s large customers can continue to support >30% revenue growth.  

Bringing GPU Utilization up to 70-80% 

GPU utilization can easily be overlooked, but arguably it is one of the most important discussions for Cloudflare, as its value proposition is inherently tied to executing workloads for customers quickly, efficiently, and with a strong TCO advantage.  

Management provided a more extensive discussion on utilization than they have in recent quarters, hinting that they can potentially improve utilization rates further and quickly bring more capacity online to meet demand without becoming capacity constrained.  

From our free newsletter in February 2025 recapping Q4 results, Encouraging Growth in Key Metrics Drives 60% Gain YTD for Cloudflare Stock, we pointed out that Cloudflare was seeing peak GPU utilization around 70% with room to improve through the year. Now, in October, CEO Matthew Prince slightly raised this, saying that they are leaning heavily on their experience of running CPUs at 70-80% utilization and aiming to have GPUs match that level. This ties in to Cloudflare’s architectural differences compared to the hyperscalers, with Cloudflare’s main goal being improving utilization to serve more workload requests and the hyperscalers’ goal of making as much money from renting GPUs: 

“The other thing that I think is unique about us is that certainly versus the hyperscalers, the primary business of the hyperscaler is to essentially rent you a server or a fraction of a server, and they try to effectively get whatever they pay for the server back 5x over the life of the server. That's their business. Whereas we're about, again, getting work done for our customers. We're selling something different, which is a sort of level of abstraction up from that. What that means is that we believe it's our job, not our customers' job to make the utilization rates as high as possible, make our systems as efficient as possible. 

And so it's been remarkable to see over the last 15 years, how our team has been able to squeeze as much as possible out of the CPU capacity that we have, where we can run that CPU capacity at 70% to 80% utilization and get more out of every CapEx dollar we spend. But what's fascinating is we're sort of speed running the last 15 years now with GPUs, where we're figuring out how to make GPUs multi-tenant, how to make them load and unload models more quickly and driving the utilization of GPUs up substantially. And so that is still well below what we have with CPUs, but we see no reason that we can't get GPUs also up to that 70%, 80% utilization.” 

Continuing to bring peak utilization rates higher and improving troughs should theoretically lead to faster processing times and an ability to handle more requests for customers, all while doing so for cheaper and at a higher margin.  

A core advantage Cloudflare has is its serverless architecture spanning >13,000 networks globally with 449 Tbps of network capacity (up from 348 Tbps in January), letting the company shift workloads anywhere in the world where it has excess capacity. Prince says that while it is not always ideal, Cloudflare can move its smaller, free or low-end customers “to places across the network that have that free capacity, still give them a great performance. but then reserve the capacity that we have as close as possible to our largest customers.”  

More importantly, Cloudflare does not believe it is capacity constrained akin to the hyperscalers, as again the company can shift workloads to wherever necessary and minimize or eliminate pain points where excess demand stalls one network point. Management also said that because they use off-the-shelf equipment with no customization, their “reaction time to deploy hardware where we need it is really, really fast,” letting them quickly stand up new networks whenever needed and quickly convert this to revenue.  

Leveraging an Inference Advantage 

Cloudflare’s network architecture and positioning at the edge gives it a strong advantage to offer high-performance, low-cost inference, yet the company continues to harp on the fact that inference remains de minimis to overall revenue – i.e., the growth curve of inference has not yet been felt in results. Cloudflare clarified that no inference customer is larger than 2% of revenue, while leading AI firms primarily tap Cloudflare for security rather than inference products at the moment.  

While competition for inference workloads from the hyperscalers remains high, Cloudflare believes its key advantage lies in its TCO from handling workload optimization:  

“It continues to be the model of do you want to do this work yourself and have to optimize yourself, or do you want to hand it off to Cloudflare. And I think in the cases where we're in the conversation, we're able to show that there's just a much better TCO, total cost of ownership, a much lower cost, much better performance when we manage that for you.” 

CEO Matthew Prince also added that once customers test the platform and witness the TCO and optimization advantages, the platform becomes very sticky and can land those customers for the long-term. To this point, Cloudflare is continuing to bolster its platform for optimization, recently acquiring Replicate to integrate its expertise with containerized model building on a 50,000+ model catalog to facilitate AI deployments. 

While it still may be early for inference, as more use cases pop up, Cloudflare is well positioned to capture inference-driven workloads. Again, this ties back into its network architecture, high utilization and proximity to users with ultra-low latency. 

For example, management explained that “when you have human computer interaction, especially with something that seems almost alive when you're interacting with it, every millisecond counts, because it breaks that illusion if things slow down, especially as you get to things like voice communication and other things that need to have kind of a natural rhythm to them.” Management believes that while a lot of inference will run on handsets or in driverless vehicles, the next best place to run inference that can’t be run in those locations will be in the network, providing a structural tailwind to drive new workload wins.  

Although it may be later in the future before some of these inference vectors and use cases materialize in full swing, and meaningfully contribute to Cloudflare’s revenue, the company can leverage this network advantage to remain a key enabler of the AI inference era.  

Cloudflare to be Natively Available on Oracle Cloud 

In mid-October, Cloudflare announced a partnership with Oracle’s Oracle Cloud Infrastructure (OCI) platform, making Cloudflare’s services natively available to OCI customers in hybrid, multi-cloud and OCI hosted environments.  

Cloudflare says this gives it access to Oracle’s large pool of customers, and more importantly, an outlet to tap into OCI’s rapid growth runway through 2030. For example, Oracle is projecting a rapid 75% CAGR in OCI revenue, from $10 billion in FY25 to $166 billion by FY30, though OpenAI is projected to account for a majority of this, around $120 billion in FY30. Multi-cloud database revenue was a strong point for Oracle in fiscal Q1, rising 1,529% YoY, and Oracle is also projecting 8X growth in AI-powered database and AI platform revenue by 2030 to $20 billion.  

However, the more important piece was management stating that both companies are aligned on a multi-cloud future, which requires ‘one consistent interface where they can apply security rules, have consistent network performance,” with Cloudflare the provider of choice. 

A multi-cloud future could be a game-changer for both companies, with Oracle benefitting from incremental cloud workloads anchored by its extensive database integrations across AWS, Azure and GCP. In turn, Cloudflare benefits from its positioning as a ‘control plane’ offering unified security, performance and reliability across clouds, which will be likely increasingly important as AI proliferates. This positioning is anchored by Cloudflare’s R2 eliminating cross-cloud data sharing costs, thus addressing some of the main drawbacks of adopting a multi-cloud approach.  

More on Act 4: Pay Per Crawl 

Cloudflare discussed its new product, Pay Per Crawl, in more detail this quarter, aiming to solve an emerging pain point arising from growing LLM consumption – AI crawlers freely scraping websites for data. Reddit is a great example of this, as the site is a treasure trove of human-generated content perfect for improving AI models, yet it has seen AI companies scrape its site without consent.  

For example, Cloudflare noted that a global web infrastructure platform signed a $1.2 million, 14-month contract for AI Crawl Control and Bot Management as they experienced a “massive surge in AI scrapers and malicious bots hitting their origin servers, inflating costs without revenue conversion and obscuring visibility into legitimate traffic.” Cloudflare noted it was “already exploring a much larger opportunity with this customer for Pay Per Crawl.” 

Pay Per Crawl aims to put creators and publishers in control of who can access their content utilizing HTTP source codes. The feature will give creators three distinct options on regulating AI crawlers and unlock new monetization abilities: 1) allow full, free access to content, 2) block access entirely, or 3) require payment for crawling at a flat, per-request price.  

Under the new feature, if a publisher decides to charge for crawling, they still retain the choice to let certain crawlers access the site for free, and can still negotiate other content-accessing deals separate from Pay Per Crawl. With the new service, Cloudflare’s relationship with customers strengthens significantly, as it is no longer simply an infrastructure vendor but now a revenue generator. 

It is still extremely early for Act 4, but given the vast amount of data generated daily on the internet and the need for AI models to constantly crawl to retrieve up-to-date information, this holds potential to be quite an impactful product. 

Financials 

$3 Billion Revenue Run Rate by Q4 ’26, $5 Billion by Q4 ‘28 

Cloudflare provided some insights into its near-term and medium-term revenue targets, with management expecting to reach a $3 billion annualized run rate in Q4 2026, and scale to a $5 billion run rate by Q4 2028.  

At first glance, the $3 billion run rate forecast is not especially impressive, as it implies quarterly revenue of $750 million at the end of next year, whereas analyst estimates were $729 million prior to Q3’s report. This is just a 3% raise to consensus, and essentially signals that management is highly confident in maintaining a 27-28% YoY growth rate through the end of 2026.  

To reach the $5 billion annualized target, or quarterly revenue of $1.25 billion by Q4 2028, Cloudflare would need to maintain this 28% YoY trajectory for the next three years, at a minimum. This is slightly higher than consensus through fiscal 2027 for 26% growth, while exceeding this to ~30% could see revenue reach more than $1.3 billion. 

Other Key Metrics Strengthen 

Billings growth accelerated sharply, from 33% in Q2 to 40% in Q3, rising to $624.4 million. Cloudflare said close rates had notably ticked up both YoY and QoQ in Q3 and bookings from partner-initiated opportunities doubled YoY. 

Paying customer growth accelerated six points sequentially to 33% YoY, impressive at this scale considering paying customers now total 295,552. Growth was 10% QoQ, the highest on record since at least 2022. Cloudflare said the growth here was in part driven by customers graduating from free tier to small paid accounts during its AI Week and Birthday Week promotions. 

Making Progress on Margins

Cloudflare made some progress on GAAP margins and nearly broke to positive territory on the bottom line on a GAAP basis; however, gross margins continued to contract.  

GAAP gross margin was 74.0% in Q3, down 3.7 points YoY and 0.9 points QoQ. Adjusted gross margin was 75.3%, down 3.5 points YoY and 1 point QoQ, again impacted by increases in allocated costs from higher network traffic from paying customers.  

GAAP operating margin was (6.7%), up 0.5 points YoY and 6.4 points QoQ. Adjusted operating margin was 15.3%, up 0.5 points YoY and 1.2 points QoQ; for Q4, adjusted operating margin was guided to be 14%. Driving both a YoY and QoQ expansion on operating margin while gross margin contracts shows strong cost management while driving this revenue reacceleration, with opex up 24% YoY.  

GAAP net margin was (0.2%), up 3.4 points YoY and 9.6 points QoQ. Adjusted net margin was 18.3%, up 1.4 points YoY and 3.6 points QoQ.  

Earnings 

Cloudflare reported a solid adjusted EPS beat in Q3, reporting 35% YoY growth to $0.27 versus the $0.23 estimate. GAAP EPS was on the brink of shifting to positive territory at ($0.00), versus the ($0.07) estimate. 

For Q4, Cloudflare guided for adjusted EPS to be flat QoQ at $0.27, up 42% YoY. For fiscal 2025, Cloudflare raised its adjusted EPS forecast to $0.91, up from $0.85 to $0.86 previously. However, GAAP profitability is not expected on an annual basis until 2027. 

Cash Flow Margins Strengthen 

Cash flow margins strengthened in Q3, with operating cash flow margin up 11 points sequentially. 

Operating cash flow was $167.1 million for a 30% margin, up from a 24% margin in the year ago quarter and a 19% margin in Q2. Free cash flow was $75 million for a 13% margin, up from 11% in the year ago quarter and 6% in Q2. Network capex was 14% of revenue. 

Cash, equivalents and available-for-sale securities totaled $4.04 billion, while convertible notes outstanding totaled $3.26 billion.  

Valuation 

Cloudflare is second to only Palantir when it comes to elevated multiples in large-cap AI-exposed software, trading at 30.7x forward sales, more than 50% above its five-year average of 20x. Shares have pulled back quite sharply from nearly 42x forward sales at the end of October, its highest level since early 2022. 

On the bottom line, Cloudflare is not yet GAAP profitable, but on an adjusted basis, it trades at 205x forward EPS, above its 147x average but below its 278x peak.  

Cloudflare’s valuation presents the largest risk as the company is trading at the highest multiples in 3.5 years, with only one strong quarter under its belt to help confirm its AI-aided revenue reacceleration story. While key metrics are strong, the company still must prove that it can sustain >30% revenue growth through FY26 or the valuation may need to come to terms with a return to mid to high-20% growth.  

Conclusion 

There is a quiet strength in Cloudflare’s fundamentals and key metrics, and this became more evident in Q3, with revenue reaccelerating to nearly 31% YoY, its highest growth in seven quarters. Paying customer growth accelerated six points sequentially to 33%, DBNRR increased five points sequentially to 119%, and billings growth accelerated seven points sequentially to 40%. Cloudflare added a record number of >$1M and >$5M customers for a fourth consecutive quarter, with accelerating spending from these cohorts noted as a strong driver of the DBNRR expansion in the third quarter.

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 Fund’s positions. We then share that information with our readers. This is not a guarantee of a stock’s performance. Please consult your personal financial advisor before buying any stock in the companies mentioned in this analysis.

Cloudflare: Revenue Accelerates to >30%, Key Metrics Strengthen

Posted on by io-fund

Cloudflare’s fundamental profile strengthened in Q3 with the company reporting its fastest revenue growth rate in seven quarters, returning to >30% YoY territory, while a majority of key metrics all accelerated in unison.  

Outside of the financials, Cloudflare remains very well positioned for AI inference, though inference does not yet contribute meaningfully to revenue. Discussion on GPU utilization rates was fruitful and highlighted how Cloudflare can remain in near lock-step with demand while avoiding capacity constraints and with relatively low capex.  

Management also believes that versus the hyperscalers, they have a strong TCO advantage when it comes to inference, and in the future, the network will be one of the best places to run inference requests. Cloudflare also shed more light on Act 4, its Pay Per Crawl feature, which will enable creators to be monetized for AI data scraping, and while it is quite early, it is aiming to solve a quickly emerging pain point. 

Material Evidence of Revenue Reacceleration, Driven by US and Enterprise Clients 

Cloudflare reported its largest beat since Q1 2022, reporting revenue of $562.0 million in Q3, 3.1% ahead of estimates as growth accelerated nearly three points to 30.7%. On a QoQ basis, revenue accelerated to 9.7% from 6.9% last quarter. 

The US is emerging as a primary driver for this reacceleration, with growth rebounding 10 points sequentially, from 21.7% YoY in Q2 to 31.5% YoY in Q3. US revenue jumped 12.2% QoQ versus a 7.2% QoQ increase in Q2. 

Additionally, Cloudflare’s enterprise cohort, or customers contributing >$100K ARR (and likely primarily US-based) are another key factor behind the reacceleration. >$100K ARR customers drove 73% of revenue in Q3, or ~$410 million, rising 42% YoY and 13% QoQ. This was a sharp 12 point acceleration in YoY growth from 30% in Q1, to the fastest growth since Q1 2023, while QoQ growth was the highest since Q2 2022 at 13%.  

Q3 also marked Cloudflare’s first >30% growth quarter in the past five and its fastest revenue growth in the last seven quarters. This is the first step in confirming a sustained revenue acceleration, yet the more important piece is showing that >30% growth can actually be sustained for multiple quarters.  

For Q4, Cloudflare guided for revenue of $588.5 to $589.5 million, a slight deceleration to 28% on the topline. This was ahead of estimates for $580.8 million. Interestingly, consensus estimates, just one day following earnings, moved from $589 million to $617 million, suggesting analysts are increasingly optimistic on the company’s ability to sustain this revenue acceleration, supported by strong key metrics. 

For FY25, Cloudflare boosted its revenue guidance to $2.142 to $2.143 billion, a $28 million increase from its prior guide. This points to YoY growth of 28.3%, a slight deceleration from 28.8% growth in FY24.  

Key Metrics Strengthen, Aided by Enterprise Transition 

Despite a lack of meaningful AI contribution, other key metrics strengthened significantly in Q3 and support this material reacceleration story. Cloudflare cited its shift from a product-led, SMB-focused company to an enterprise sales company as a primary driver behind the improvement in key metrics.  

There are a few reasons that this focus on enterprise clientele is important for Cloudflare’s growth story, with the simplest being that visible acceleration of enterprise customer revenue in Q3 translated to the material topline reacceleration. Enterprise customers are also likely to expand much quicker than SMBs – for example, Cloudflare noted that accelerating QoQ and YoY growth in its >$1M and >$5M customer cohorts acted as a significant tailwind to DBNRR, which rose five points sequentially to 119%, the highest since Q4 2022.  

This DBNRR expansion is also linked to Cloudflare’s Pool of Funds billing approach, which provides a seamless vector for large customers to explore adoption of Cloudflare’s 55 products under a single contract, and allocate funds to different products based on consumption. While management explained that the rollout initially created some downward pressure on DBNRR, consumption of these deals acted as a tailwind to DBNRR this quarter. CFO Thomas Seifert added that POF is “now low double-digits of ACV” and gaining share in the quarter.  

Enterprise traction is also showing up in RPO, which accelerated four points to 43% YoY to $2.14 billion; on the other hand, current RPO decelerated three points to 30% YoY and accounted for 64% of RPO. 

Management explained that this RPO acceleration “points to primarily 2 drivers, the customer quality and the platform expansion. We are seeing exceptional strength with our large customer cohorts, specifically those that spend more than $1 million or $5 million with us, both delivered record growth this quarter. And in addition to that strength is increased consumption of our large Pool of Fund customers, demonstrating I think, the increasing strategic importance of our platform for those large enterprises globally. And in addition to that, our Workers platform, the developer platform, including Workers AI, is just providing to be a significant new vector for long-term commitment and with that growth.” 

Moving forward, it will be important to see consistent strength in both DBNRR and RPO as further evidence that Cloudflare’s large customers can continue to support >30% revenue growth.  

Bringing GPU Utilization up to 70-80% 

GPU utilization can easily be overlooked, but arguably it is one of the most important discussions for Cloudflare, as its value proposition is inherently tied to executing workloads for customers quickly, efficiently, and with a strong TCO advantage.  

Management provided a more extensive discussion on utilization than they have in recent quarters, hinting that they can potentially improve utilization rates further and quickly bring more capacity online to meet demand without becoming capacity constrained.  

From our free newsletter in February 2025 recapping Q4 results, Encouraging Growth in Key Metrics Drives 60% Gain YTD for Cloudflare Stock, we pointed out that Cloudflare was seeing peak GPU utilization around 70% with room to improve through the year. Now, in October, CEO Matthew Prince slightly raised this, saying that they are leaning heavily on their experience of running CPUs at 70-80% utilization and aiming to have GPUs match that level. This ties in to Cloudflare’s architectural differences compared to the hyperscalers, with Cloudflare’s main goal being improving utilization to serve more workload requests and the hyperscalers’ goal of making as much money from renting GPUs: 

“The other thing that I think is unique about us is that certainly versus the hyperscalers, the primary business of the hyperscaler is to essentially rent you a server or a fraction of a server, and they try to effectively get whatever they pay for the server back 5x over the life of the server. That's their business. Whereas we're about, again, getting work done for our customers. We're selling something different, which is a sort of level of abstraction up from that. What that means is that we believe it's our job, not our customers' job to make the utilization rates as high as possible, make our systems as efficient as possible. 

And so it's been remarkable to see over the last 15 years, how our team has been able to squeeze as much as possible out of the CPU capacity that we have, where we can run that CPU capacity at 70% to 80% utilization and get more out of every CapEx dollar we spend. But what's fascinating is we're sort of speed running the last 15 years now with GPUs, where we're figuring out how to make GPUs multi-tenant, how to make them load and unload models more quickly and driving the utilization of GPUs up substantially. And so that is still well below what we have with CPUs, but we see no reason that we can't get GPUs also up to that 70%, 80% utilization.” 

Continuing to bring peak utilization rates higher and improving troughs should theoretically lead to faster processing times and an ability to handle more requests for customers, all while doing so for cheaper and at a higher margin.  

A core advantage Cloudflare has is its serverless architecture spanning >13,000 networks globally with 449 Tbps of network capacity (up from 348 Tbps in January), letting the company shift workloads anywhere in the world where it has excess capacity. Prince says that while it is not always ideal, Cloudflare can move its smaller, free or low-end customers “to places across the network that have that free capacity, still give them a great performance. but then reserve the capacity that we have as close as possible to our largest customers.”  

More importantly, Cloudflare does not believe it is capacity constrained akin to the hyperscalers, as again the company can shift workloads to wherever necessary and minimize or eliminate pain points where excess demand stalls one network point. Management also said that because they use off-the-shelf equipment with no customization, their “reaction time to deploy hardware where we need it is really, really fast,” letting them quickly stand up new networks whenever needed and quickly convert this to revenue.  

Leveraging an Inference Advantage 

Cloudflare’s network architecture and positioning at the edge gives it a strong advantage to offer high-performance, low-cost inference, yet the company continues to harp on the fact that inference remains de minimis to overall revenue – i.e., the growth curve of inference has not yet been felt in results. Cloudflare clarified that no inference customer is larger than 2% of revenue, while leading AI firms primarily tap Cloudflare for security rather than inference products at the moment.  

While competition for inference workloads from the hyperscalers remains high, Cloudflare believes its key advantage lies in its TCO from handling workload optimization:  

“It continues to be the model of do you want to do this work yourself and have to optimize yourself, or do you want to hand it off to Cloudflare. And I think in the cases where we're in the conversation, we're able to show that there's just a much better TCO, total cost of ownership, a much lower cost, much better performance when we manage that for you.” 

CEO Matthew Prince also added that once customers test the platform and witness the TCO and optimization advantages, the platform becomes very sticky and can land those customers for the long-term. To this point, Cloudflare is continuing to bolster its platform for optimization, recently acquiring Replicate to integrate its expertise with containerized model building on a 50,000+ model catalog to facilitate AI deployments. 

While it still may be early for inference, as more use cases pop up, Cloudflare is well positioned to capture inference-driven workloads. Again, this ties back into its network architecture, high utilization and proximity to users with ultra-low latency. 

For example, management explained that “when you have human computer interaction, especially with something that seems almost alive when you're interacting with it, every millisecond counts, because it breaks that illusion if things slow down, especially as you get to things like voice communication and other things that need to have kind of a natural rhythm to them.” Management believes that while a lot of inference will run on handsets or in driverless vehicles, the next best place to run inference that can’t be run in those locations will be in the network, providing a structural tailwind to drive new workload wins.  

Although it may be later in the future before some of these inference vectors and use cases materialize in full swing, and meaningfully contribute to Cloudflare’s revenue, the company can leverage this network advantage to remain a key enabler of the AI inference era.  

Cloudflare to be Natively Available on Oracle Cloud 

In mid-October, Cloudflare announced a partnership with Oracle’s Oracle Cloud Infrastructure (OCI) platform, making Cloudflare’s services natively available to OCI customers in hybrid, multi-cloud and OCI hosted environments.  

Cloudflare says this gives it access to Oracle’s large pool of customers, and more importantly, an outlet to tap into OCI’s rapid growth runway through 2030. For example, Oracle is projecting a rapid 75% CAGR in OCI revenue, from $10 billion in FY25 to $166 billion by FY30, though OpenAI is projected to account for a majority of this, around $120 billion in FY30. Multi-cloud database revenue was a strong point for Oracle in fiscal Q1, rising 1,529% YoY, and Oracle is also projecting 8X growth in AI-powered database and AI platform revenue by 2030 to $20 billion.  

However, the more important piece was management stating that both companies are aligned on a multi-cloud future, which requires ‘one consistent interface where they can apply security rules, have consistent network performance,” with Cloudflare the provider of choice. 

A multi-cloud future could be a game-changer for both companies, with Oracle benefitting from incremental cloud workloads anchored by its extensive database integrations across AWS, Azure and GCP. In turn, Cloudflare benefits from its positioning as a ‘control plane’ offering unified security, performance and reliability across clouds, which will be likely increasingly important as AI proliferates. This positioning is anchored by Cloudflare’s R2 eliminating cross-cloud data sharing costs, thus addressing some of the main drawbacks of adopting a multi-cloud approach.  

More on Act 4: Pay Per Crawl 

Cloudflare discussed its new product, Pay Per Crawl, in more detail this quarter, aiming to solve an emerging pain point arising from growing LLM consumption – AI crawlers freely scraping websites for data. Reddit is a great example of this, as the site is a treasure trove of human-generated content perfect for improving AI models, yet it has seen AI companies scrape its site without consent.  

For example, Cloudflare noted that a global web infrastructure platform signed a $1.2 million, 14-month contract for AI Crawl Control and Bot Management as they experienced a “massive surge in AI scrapers and malicious bots hitting their origin servers, inflating costs without revenue conversion and obscuring visibility into legitimate traffic.” Cloudflare noted it was “already exploring a much larger opportunity with this customer for Pay Per Crawl.” 

Pay Per Crawl aims to put creators and publishers in control of who can access their content utilizing HTTP source codes. The feature will give creators three distinct options on regulating AI crawlers and unlock new monetization abilities: 1) allow full, free access to content, 2) block access entirely, or 3) require payment for crawling at a flat, per-request price.  

Under the new feature, if a publisher decides to charge for crawling, they still retain the choice to let certain crawlers access the site for free, and can still negotiate other content-accessing deals separate from Pay Per Crawl. With the new service, Cloudflare’s relationship with customers strengthens significantly, as it is no longer simply an infrastructure vendor but now a revenue generator. 

It is still extremely early for Act 4, but given the vast amount of data generated daily on the internet and the need for AI models to constantly crawl to retrieve up-to-date information, this holds potential to be quite an impactful product. 

Financials 

$3 Billion Revenue Run Rate by Q4 ’26, $5 Billion by Q4 ‘28 

Cloudflare provided some insights into its near-term and medium-term revenue targets, with management expecting to reach a $3 billion annualized run rate in Q4 2026, and scale to a $5 billion run rate by Q4 2028.  

At first glance, the $3 billion run rate forecast is not especially impressive, as it implies quarterly revenue of $750 million at the end of next year, whereas analyst estimates were $729 million prior to Q3’s report. This is just a 3% raise to consensus, and essentially signals that management is highly confident in maintaining a 27-28% YoY growth rate through the end of 2026.  

To reach the $5 billion annualized target, or quarterly revenue of $1.25 billion by Q4 2028, Cloudflare would need to maintain this 28% YoY trajectory for the next three years, at a minimum. This is slightly higher than consensus through fiscal 2027 for 26% growth, while exceeding this to ~30% could see revenue reach more than $1.3 billion. 

Other Key Metrics Strengthen 

Billings growth accelerated sharply, from 33% in Q2 to 40% in Q3, rising to $624.4 million. Cloudflare said close rates had notably ticked up both YoY and QoQ in Q3 and bookings from partner-initiated opportunities doubled YoY. 

Paying customer growth accelerated six points sequentially to 33% YoY, impressive at this scale considering paying customers now total 295,552. Growth was 10% QoQ, the highest on record since at least 2022. Cloudflare said the growth here was in part driven by customers graduating from free tier to small paid accounts during its AI Week and Birthday Week promotions. 

Making Progress on Margins

Cloudflare made some progress on GAAP margins and nearly broke to positive territory on the bottom line on a GAAP basis; however, gross margins continued to contract.  

GAAP gross margin was 74.0% in Q3, down 3.7 points YoY and 0.9 points QoQ. Adjusted gross margin was 75.3%, down 3.5 points YoY and 1 point QoQ, again impacted by increases in allocated costs from higher network traffic from paying customers.  

GAAP operating margin was (6.7%), up 0.5 points YoY and 6.4 points QoQ. Adjusted operating margin was 15.3%, up 0.5 points YoY and 1.2 points QoQ; for Q4, adjusted operating margin was guided to be 14%. Driving both a YoY and QoQ expansion on operating margin while gross margin contracts shows strong cost management while driving this revenue reacceleration, with opex up 24% YoY.  

GAAP net margin was (0.2%), up 3.4 points YoY and 9.6 points QoQ. Adjusted net margin was 18.3%, up 1.4 points YoY and 3.6 points QoQ.  

Earnings 

Cloudflare reported a solid adjusted EPS beat in Q3, reporting 35% YoY growth to $0.27 versus the $0.23 estimate. GAAP EPS was on the brink of shifting to positive territory at ($0.00), versus the ($0.07) estimate. 

For Q4, Cloudflare guided for adjusted EPS to be flat QoQ at $0.27, up 42% YoY. For fiscal 2025, Cloudflare raised its adjusted EPS forecast to $0.91, up from $0.85 to $0.86 previously. However, GAAP profitability is not expected on an annual basis until 2027. 

Cash Flow Margins Strengthen 

Cash flow margins strengthened in Q3, with operating cash flow margin up 11 points sequentially. 

Operating cash flow was $167.1 million for a 30% margin, up from a 24% margin in the year ago quarter and a 19% margin in Q2. Free cash flow was $75 million for a 13% margin, up from 11% in the year ago quarter and 6% in Q2. Network capex was 14% of revenue. 

Cash, equivalents and available-for-sale securities totaled $4.04 billion, while convertible notes outstanding totaled $3.26 billion.  

Valuation 

Cloudflare is second to only Palantir when it comes to elevated multiples in large-cap AI-exposed software, trading at 30.7x forward sales, more than 50% above its five-year average of 20x. Shares have pulled back quite sharply from nearly 42x forward sales at the end of October, its highest level since early 2022. 

On the bottom line, Cloudflare is not yet GAAP profitable, but on an adjusted basis, it trades at 205x forward EPS, above its 147x average but below its 278x peak.  

Cloudflare’s valuation presents the largest risk as the company is trading at the highest multiples in 3.5 years, with only one strong quarter under its belt to help confirm its AI-aided revenue reacceleration story. While key metrics are strong, the company still must prove that it can sustain >30% revenue growth through FY26 or the valuation may need to come to terms with a return to mid to high-20% growth.  

Conclusion 

There is a quiet strength in Cloudflare’s fundamentals and key metrics, and this became more evident in Q3, with revenue reaccelerating to nearly 31% YoY, its highest growth in seven quarters. Paying customer growth accelerated six points sequentially to 33%, DBNRR increased five points sequentially to 119%, and billings growth accelerated seven points sequentially to 40%. Cloudflare added a record number of >$1M and >$5M customers for a fourth consecutive quarter, with accelerating spending from these cohorts noted as a strong driver of the DBNRR expansion in the third quarter.

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

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Cloudflare: Entering Act 3 to Become a Leader in AI Inference at the Edge

Posted on by io-fund

Two years ago in the analysis Cloudflare: Bringing AI Inference to the Edge, we discussed in a deep dive on the stock why “Act 3 and the Workers platform is where the most explosive moment could occur” for Cloudflare while stating:  

“[…] what’s crazy is that Cloudflare rolls out features that exceed hyperscaler performance at minimal cost. It is this combination of competing with the hyperscalers, delivering app performance at faster speeds — while keeping prices low — that is unique to Cloudflare.” 

Act 3 refers to the Workers platform, which is the company’s attempt to compete with hyperscalers – but most importantly, it sets up the company well for AI inference at the edge.  

Cloudflare executes runtime for an application close to the user combined with removing cold starts by running isolates that create an advantage at the edge. This is distinct from pushing compute from a centralized data center to the edge. It’s also distinct from containerized processes that require cold starts. Cloudflare also offers R2 object storage, which helps developers eliminate unnecessary fees on cloud storage. This is used by AI startups to help arbitrage the lowest GPU cost to train their models. 

When it comes to AI inference-driven revenue, it’s still relatively early in the growth curve. Hyperscalers and model providers only recently began to disclose rapid AI token growth over the last three to four months. However, Q1’s earnings report shows signs of surging AI inference demand filtering into Cloudflare’s platform. For example, Q1 witnessed nearly 4,000% YoY growth in Workers AI inference requests, and more than 1,200% YoY growth in AI Gateway requests.  

These growth numbers are off a small base (which is true for all inference statistics for now), yet when you take a company with product-market like Cloudflare and combine it with a massive trend on the verge of taking off – what you get is an irresistible stock that the I/O Fund has a high probability of entering and holding for an extended period of time. 

Connecting the Dots: 

As discussed in the product deep dive two years ago, Cloudflare’s core products as a CDN and best-of-breed leader in cloud-based security and application security including Zero Trust may not seem connected its future as an AI inference leader, but they are intricately connected. You can read more on the background of the points below and Cloudflare’s core products here.  

Cloudflare references its business units as “Acts” – Act 1, Act 2 and Act 3. The company defines Act 1 as application security, Act 2 as Zero Trust and Act 3 as the Workers Platform. For our purposes as stock investors, it’s Act 3 we are most interested in. The analysis below makes it abundantly clear as to why Act 3 and the Workers platform is where the most explosive moment could occur. 

Cloudflare has a few distinct advantages as the platform of choice for AI developers. Here’s a summary: 

  • Does not rely on Big 3 infrastructure and can drive down costs 
  • Is faster on performance because of its position at the edge; this lowers costs and latency for AI inference and keeps data as close to the user as possible 
  • Geographically equipped to handle compliance issues that will inevitably result from using training data for inference.  
  • The company has moved diligently into compute, storage and application services. Combined with its global network, this positions the company for AI inference as-a-service. There is no other company doing both edge network plus compute and storage except the hyperscalers. However, in some cases such as serverless, Cloudflare exceeds the performance of the hyperscalers. 
  • CDN as a core product and security as a seamless upgrade shows the importance of being a middleman, helping to position Cloudflare to innovate around Serverless in ways that outperform even AWS.    
  • Training models is prohibitively expensive by requiring upfront costs, Nvidia GPUs are hard to obtain, and AI development is not democratized for developers with proprietary, blackbox APIs that run counter to an open-source movement (GPT-4 versus Llama). Cloudflare aims to solve these problems by allowing popular models to run closer to the user, which is the next logical step for AI. 

Ultimately, the bigger and the faster a network is, the more it’s capable of providing “as a service.” AI can create a fortuitous moment for Cloudflare because the company is both positioned to offer AI inference-as-a-service yet also solves important pain points for developers. 

Workers AI Built for High-Speed AI Inference at the Edge 

Cloudflare’s Anycast network routes traffic to the most available data centers, and can spread traffic across the entire network, improving resiliency during surges and minimizing latency. Cloudflare said in Q1 that the network now spans over 13,000 major service providers in 500 locations across 400 cities in more than 100 countries. By routing requests to the edge, Cloudflare is less than 50 milliseconds away from 99.9% of Internet traffic and 95% of the Internet-connected population.  

Cloudflare recently revealed at Morgan Stanley’s Tech, Media and Technology (TMT) Conference in March 2025 that when it first developed its Workers platform nearly eight years ago, it had no idea it would foresee what AI agents would become. The platform was originally born with the idea of creating a new way to deploy code at the edge, or as Cloudflare puts it, the “Goldilocks zone of high compute performance with low latency” as close to devices as possible.  

Workers has a unique platform architecture: it eliminates cold starts by running close to GPUs instead of in a container or virtual machine, executing code the second it is received. It also uses isolates, which run 100x faster than node processes and consume significantly less memory without requiring separate resource allocation. Essentially, developers pay for Javascript runtime once and can then run “limitless” scripts across hundreds or thousands of isolates, all without additional overhead costs.  

It is this unique isolate-based architecture, with ultra-low latency and an ability to execute thousands of requests concurrently at minimal cost, that provides Cloudflare an advantage for AI inference. What Cloudflare offers is exactly what AI inference needs – exceptionally fast performance with no lag at the edge, as that is where the data is located. 

Cloudflare is working to significantly expand GPU accessibility across its global network to serve growing inference demand, having GPUs across 190 cities worldwide as of March 2025. Cloudflare had doubled its GPU capacity in one year with more powerful GPUs as of September 2024, and is aiming to double its capacity again in 2025.

Source: Cloudflare 

Cloudflare is also expanding support for increasingly large models, such as Meta’s Llama 3.1 family, and a broader range of models with its ‘Run Any’ support feature (this is limited however to models compatible with its GPU fleet and inference stack).  

Cloudflare’s vector database Vectorize aids in the full-stack AI app development process by storing and remembering previous inputs. Vectorize can now support indexes with up to 5 million vectors, up 25x from 200,000 previously. Median query latency has been reduced nearly 18x from 549 milliseconds to 31 milliseconds. This allows AI apps to search and recall relevant data quickly while keeping costs lower.  

By expanding access to larger models and larger context windows at faster speeds, AI apps built on Workers AI now can handle increasingly complex tasks with greater efficiency at similar or lower costs. Put together, Cloudflare says that Workers platform can end up ~3x cheaper per CPU-cycle versus competing platforms like AWS’ Lambda, at $0.50 per million requests versus $1.84 on Lambda. As developers now begin to increasingly use Cloudflare and Workers for AI API requests, they benefit directly from these lower overhead costs in addition to higher performance and lower latency offered by the global network.  

These key advantages are helping Cloudflare land and expand enterprise customers with AI in mind. CFO Thomas Seifert explained that customers migrating to Workers can see cost or performance improvements of ~300% in the migration. It was this exact reason that drove its largest deal on record in Q1, a $130 million five-year deal with an existing customer, primarily for Workers. Cloudflare said this customer was deeply engaged with a hyperscaler who was confident in winning the deal, but the customer “made the decision to switch to Cloudflare when they saw our better performance, lower development costs and more modern platforms.” 

AI Gateway: Additional Benefit for Enterprise AI 

It is also no surprise that Cloudflare is becoming a platform of-choice for AI providers, with 80% of the leading AI companies as customers of Cloudflare. Yet it has one new, underdiscussed product that could help pave the way for broader enterprise AI adoption: AI Gateway. 

Although AI Gateway was launched more than a year ago, Cloudflare has been especially quiet about the new offering. Q1 saw the first mention of growth for the product, while management said at Morgan Stanley’s TMT that it was its largest new feature that “might not have gotten enough attention yet from a Wall Street perspective.” As of October 2024, Gateway had proxied over 2 billion requests in just one year.  

Gateway is a centralized AI ops platform for Workers AI. It acts as a control center for AI applications running on Cloudflare with multi-vendor observability and analytics, sitting between customer applications and AI APIs they make requests to. 

Source: Cloudflare 

With Gateway, customers have detailed insights into traffic patterns, such as the amount of requests, token usage, and costs over time. Customers can limit requests to help control costs, while custom response caching allows Cloudflare to make repeat requests, saving costs and lowering latency by serving from the cache and bypassing the original API. Gateway pairs natively with Workers AI and Vectorize to help developers build full-stack AI products within the platform.  

Cloudflare noted that it has plans to expand features to include dynamic model routing with A/B testing, usage alerts, advanced caching and more. However, its future vision for Gateway embeds more data security tools to ease enterprise adoption and smooth other privacy concerns, a major hurdle to adoption at the moment. 

Cloudflare says that in the future, its goal for AI Gateway is to transform it into a product that helps enterprises monitor how employees utilize AI. With Gateway, enterprises could route all API requests to AI providers through Cloudflare’s platform first, letting organizations log user requests, set access policies and rate limiting, and implement data loss prevention strategies. Cloudflare says that if an employee accidentally pastes sensitive data into ChatGPT, enterprises could redact that or block the request entirely, preventing it from reaching AI providers and thus into the public domain.  

The end goal with Gateway is to create a platform that lets enterprises tap into efficiencies that AI unlocks while providing a high level of data security and privacy. This is a key concern – a Deloitte survey from late 2024 found that nearly 75% of tech professionals listed data privacy as a top three concern from genAI use in the enterprise. Around 40% had listed data privacy as the number one concern, up from 25% in 2023. A survey from Reveal in June 2025 also found that while 73% of tech leaders prioritize expanding AI use this year, 78% listed data privacy as their top concern.  

For enterprises utilizing AI, costs trump all, as even small changes in token/API costs at high usage, such as hundreds of thousands of API calls daily, could quickly drive usage costs higher and adversely impact margins. Cloudflare’s focus on providing high visibility into AI usage, while simultaneously boosting data privacy and minimizing costs and latency provides an additional benefit when it comes to inference and AI application deployment.  

Workers Shows Hints of Rapid AI Momentum 

Cloudflare’s Workers platform is seeing considerable AI-driven momentum, both in active developers growth and now AI inference requests. Active developers first reached 1 million in November 2022, nearly tripling YoY. By April 2024, or approximately two quarters after the launch of Workers AI, active developers had doubled to more than 2 million.  

Though Cloudflare did not provide an update in Q1 or at TMT, active Workers developers crossed 3 million at the end of 2024, marking a 50% YoY increase. Overall, this represents nearly 9x growth in just over three years.  

Source: Cloudflare 

Additionally, Cloudflare noted that Act 2 and Act 3 products – Zero Trust and Workers – contributed significantly to its strong ACV growth in Q1. Net-new ACV recorded its highest YoY growth in three years last quarter, with products from the two acts driving two-thirds of that. 

We recently covered Workers developer growth and other strong key metrics in our free newsletter from February, Encouraging Growth in Key Metrics Drives 60% Gain YTD for Cloudflare Stock. 

When it comes to AI inference-driven revenue, Cloudflare has not offered any insights, as it’s still relatively early in the growth curve. Hyperscalers and model providers only recently began to disclose rapid AI token growth over the last three to four months. However, Q1’s earnings report did show some hints of surging AI inference demand filtering over to Cloudflare’s platform. 

Q1 witnessed nearly 4,000% YoY growth in Workers AI inference requests, and more than 1,200% YoY growth in AI Gateway requests. This builds upon Q4’s first large inference customer win of approx. $7 million. While growth is likely off a rather small base considering the relative newness of both platforms, it is a solid indicator of accelerating inference demand.  

Capex is a bit more unusual metric to point to in support of strong inference-driven growth, but Big Tech has been straightforward in saying that AI capex is correlated with demand, and higher demand necessitates higher capex. Cloudflare’s network capex has accelerated sharply, up from 6% of revenue in Q2 to 15% of revenue by Q4 and now 17% of revenue in Q1. This quick increase in capex suggests that Cloudflare is rapidly ramping up GPU and hardware purchases to meet heightened AI demand signals. 

Quarterly Growth Projected to be Flat Through 2025 

Cloudflare reported a 2% beat in Q1 with revenue increasing 26.5% YoY to $479.1 million. This growth was attributed to the strength of Cloudflare’s largest >$1M and >$5M ARR customer cohorts, which saw record customer additions in the quarter. 

By geography: 

  • US revenue rose 20% YoY to $234.9 million, or 49% of revenue. Any deceleration here as a core revenue generator could present a headwind to growth reaccelerating. 
  • EMEA revenue rose 27% YoY to $133.9 million, or 28% of revenue. 
  • APAC revenue rose 54% YoY to $73.4 million, or 15% of revenue. Cloudflare says key go-to-market strategies are producing robust growth in the region. 

Looking ahead to Q2, Cloudflare guided for 24.8% YoY growth to $500 million to $501 million in revenue, representing a 1.7 point sequential deceleration. Analysts are much more optimistic on the quarter, projecting growth above the top end of the range at $501.8 million, or up 25.1% YoY.  

Through the rest of fiscal 2025, growth is expected to be essentially flat around 25% YoY. However, management expressed confidence in driving a reacceleration through 2025, opening the door for potential upward surprises driven by AI inference. While flat growth does not usually stand out, each of the prior two fiscal years saw a notable deceleration in growth from Q1 to Q4 at ~4 points, with FY25 possibly set to break this trend.  

It's also important to note that estimates for both Q3 and Q4 been revised slightly lower over the past three months, with Q3’s estimate down (0.6%) and Q4’s down (1.0%). This represents a decline of around $3.5 to $6 million for each quarter, or 0.5 to 1.3 percentage points shaved off of growth.  

FY25 Guide Maintained at 25.3% YoY 

For FY25, Cloudflare opted to maintain its initial revenue guidance of $2.09 to $2.094 billion, corresponding to 25.3% YoY growth at midpoint. Analyst estimates call for flat growth over the next few quarters but a slightly stronger second half of the year, with QoQ growth of 8% for Q3 and 7.5% for Q4 even after some negative revisions.  

However, by maintaining guidance despite the $10M beat in Q1, Cloudflare is essentially saying Q2 could be softer than expected. With that said, Cloudflare tends to be conservative during macro events such as what we saw in April, and thus it could also be a non-issue.  

Although we are seeing a 1 to 2 point acceleration in the fiscal year consensus estimates, the hint that there could be an acceleration is what helps Cloudflare stand apart from peers since more cloud companies are decelerating sharply below 20% growth. 

For example, Snowflake’s revenue growth is forecast to decelerate from 29.2% last year to 24.7% in 2025 and below 23% next year. Datadog's revenue is forecast to decelerate from 26.1% last year to sub-19% by 2026, while MongoDB’s revenue decelerated from 31% in 2023 to a projected 13.9% this year. 

Key Metrics Support Growth Acceleration  

Cloudflare’s underlying key metrics are supportive of revenue growth accelerating. In the most recent quarter, the company reported accelerating paid customer growth and billings, stabilizing DBNRR, and record large customer additions. 

In Q1, paid customer growth accelerated 2 points sequentially to over 27% YoY, with Cloudflare reporting 250,819 paid customers. Growth has doubled from 13% two years ago, an impressive acceleration given the scale is now reaching a quarter-million paid customers.  

Cloudflare also noted it had driven record customer additions in its >$1M and >$5M ARR cohorts in Q1, with growth in both metrics up 48% and 54% YoY, respectively. 

Billings growth also accelerated 1 point to 32.8% YoY in Q1, recovering from the 20% range in 2024. Billings activity likely benefitted from QoQ improvements in sales cycles as noted in Q1, as well as stronger deal activity and larger contracts.  

Cloudflare’s DBNRR stabilized at 111%, though it has yet to see a strong acceleration like Palantir. Compared to last year, DBNRR is 4 points lower. Management did note that “churn rates improved in the quarter,” while they saw stabilization in customer businesses after April’s bout of volatility alongside reduced pricing pressures from competitors. These factors should provide more headroom for DBNRR to expand again as AI consumption increases. 

RPO also reaccelerated in Q1 to nearly 39% YoY to $1.86 billion, though there has been consistent quarterly variability in growth over the last two years. Current RPO accounted for 66% of total RPO, down from 70% in Q4. 

Margins Show NET Regressing from Path to GAAP Profitability  

Margins are the one real blemish for Cloudflare, as the company has regressed on its path to reach GAAP profitability in Q1. Gross margins have been compressing slightly, due to an increase in paid versus free traffic, while operating margins slipped sequentially in Q1. 

GAAP gross margin was 75.9% in Q1, down 0.5 points sequentially and 1.6 points YoY. Adjusted gross margin was 77.1%, down 0.5 points sequentially and 2.4 points YoY. Cloudflare said the softness was due to a significant increase in paid vs. free traffic which led to a “higher allocation of expenses to cost-of-goods-sold from sales and marketing,” similar to Q4. 

GAAP operating margin was (11.1%) in Q1, down 3.6 points sequentially and a setback from three consecutive quarters of progress towards profitability in the (7%) to (8%) range. Adjusted operating margin was 11.7%, marginally above guidance for 11.6% and down 2.9 points sequentially. For Q2, Cloudflare guided for adjusted operating margin to improve one point to 12.6%. 

As seen below, there exists a wide, nearly 23 point gap between GAAP and operating margins. This is driven primarily by high SBC at ~20% of revenue, and it highlights that either SBC would need to move much lower, or costs much lower, in order to drive Cloudflare to a sustainable path to GAAP profitability. For example, Q1’s sales & marketing expense was 38% of revenue, 10 points above Cloudflare’s long-term model of 27% to 29% of revenue. 

GAAP net margin was (8.0%) in Q1, a rather substantial decline from (2.8%) last quarter, driven by the QoQ decline in operating margin. Adjusted net margin was 12.2%, the lowest reported level since Q2 2023. 

EPS Growth Minimal in FY25 

Cloudflare reported adjusted EPS in line with estimates at $0.16 in Q1, for flat YoY growth. Q2 is expected to see adjusted EPS decline mid-single digits YoY, with the full-year on track for just mid-single digit growth with an acceleration expected in Q4. 

For Q2, Cloudflare guided for adjusted EPS of $0.18, down from $0.20 in the year ago quarter. Adjusted EPS growth is expected to resume in 2H, with EPS seen exiting the year at $0.23, up 22.6% YoY.  

For FY25, Cloudflare maintained its guidance for $0.79 to $0.80, corresponding to growth of approximately 6% YoY. For FY26, analysts are projecting EPS growth to accelerate sharply to 30.3% YoY to $1.04, which likely would require solid improvement in adjusted margins given the topline acceleration is minimal. 

Cash Flows & New Debt Raise 

Operating cash flow continues to improve, touching a 30% margin in Q1, though free cash flows remain pressured by heightened network capex at 17% of revenue. Cloudflare also raised a substantial amount of capital on June 13, an interesting move given the company still has nearly $2 billion in cash on hand. 

  • Operating cash flow rose more than 98% YoY to $145.8 million, for a 30% margin. This marked a substantial 11 point improvement from a 19% margin a year ago and a 2 point sequential improvement. 
  • However, free cash flow rose 48.6% YoY to $52.6 million, for an 11% margin, up only 2 points YoY. This was driven by heightened network capex in the quarter at 17% of revenue, increasing from 15% of revenue in Q4 and more than double last year’s 8% of revenue.  
  • For FY25, Cloudflare maintained guidance for network capex to be 12-13% of revenue with some quarterly variability, which may allow FCF margin to expand throughout the year as it suggests capex spend will normalize at a lower level.  
  • Cash and investments totaled $1.92 billion, while Cloudflare reported $1.29 billion in convertible debt still outstanding, due in 2026.  
  • On June 13, Cloudflare announced it priced $1.75 billion in 0% convertible notes due 2030. Cloudflare said the conversion price is ~$247.67, and the capital will go towards general corporate purposes, including working capital, network capex, M&A or paying outstanding debt.  

Valuation is the Primary Drawback 

The primary drawback to Cloudflare’s AI inference opportunity at the moment is its valuation. Key metrics and comments of 12x to 40x growth in AI inference requests support revenue reaccelerating, but it is hard to justify a rapid repricing from a 16x forward revenue multiple in April until there is tangible evidence of the topline accelerating. 

Cloudflare is trading at a hefty 30x forward revenue multiple, second only to Palantir’s 85x multiple. This represents Cloudflare’s most expensive valuation on a forward revenue basis since 2022, and far above historical resistance at around 22x. 

Source: YCharts 

While Cloudflare may have a clearer AI inference opportunity than other best-of-breed cloud stocks such as Snowflake and DataDog, it is trading at a significant premium to both. At 30x, Cloudflare is near a 100% premium to SNOW and a 115% premium to DDOG, despite all three are reporting revenue growth in the 25% to 27% range for the most recent quarter. 

Source: YCharts 

On a forward PE basis, Cloudflare is valued just 5% shy of Palantir, at nearly 228x forward EPS. Cloudflare is nearly 20% more expensive than SNOW at 192x forward PE, and far above DataDog’s 76x multiple. Cloudflare also has the second lowest adjusted EPS growth this year, at 6% versus 42% for Palantir, 33% for Snowflake, and (7%) for DataDog. 

Conclusion 

Cloudflare is uniquely positioned to capture AI inference at the edge, and we are seeing more signs of surging AI inference demand from hyperscalers. Cloudflare has been relatively quiet about AI inference-driven growth until Q1 when it dropped 12x growth in AI Gateway requests and 40x growth Workers AI inference requests. 

The takeoff in AI inference is expected to drive an inflection in Cloudflare’s growth, with revenue expected to begin a prolonged acceleration through FY27, starting in the back half of 2025. However, Cloudflare’s valuation presents a real drawback after a rapid rerating higher, considering the acceleration has not yet tangibly materialized and margins regressed from a path to profitability.  

For stock setups, including potential entry prices, consider upgrading to our Advanced tier with real-time trade alerts and weekly webinars held on Thursdays at 4:30 p.m. EST. To receive $100 off our Advanced tier, use code ADVANCED100 or click here and email your request to upgrade.ADVANCED100 or click here and email your request to upgrade.

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 Fund’s positions. We then share that information with our readers. This is not a guarantee of a stock’s performance. Please consult your personal financial advisor before buying any stock in the companies mentioned in this analysis.

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Palantir Stock: How High Is Too High?

Posted on by io-fund

This article was originally published on Forbes on Nov 7, 2024,09:08pm ESTForbesForbes on Nov 7, 2024,09:08pm EST

Two weeks ago, I highlighted that Palantir is “one of the rare few that sees AI drive both real returns for its business and real value for its customers,” while it continues to crush its software peers in AI-related growth. AI offerings have driven a clear acceleration in customers and overall revenue, while many SaaS peers, such as MongoDB and Salesforce, struggle to say the same.

This week, Palantir proved again in Q3 that it’s undeniably one of the stronger AI software stocks in the market outside of the cloud hyperscalers. The company reported visible AI-driven growth and persisting business momentum for AIP, strong revenue acceleration to 30% YoY, combined with strong profitability – a rare combination for growth stocks.

Despite proving again that it’s one of the only software names with real revenue in the market, Q3’s report pushed the valuation even higher. Due to an outlandish valuation, price momentum may soon be approaching a peak.

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Blistering AI Momentum Continues

Palantir’s third quarter was characterized once again by strong underlying AI momentum. Palantir beat Q3 revenue expectations by more than $21 million, reporting revenue of $725.5 million in the quarter. The FY24 revenue guide was boosted to just above $2.80 billion, up from $2.75 billion last quarter.

Revenue growth continued to accelerate, with Palantir reporting revenue growth of 30.0% in Q3, ahead of its guidance for 25.2% growth and up from 27.2% in Q2.

Palantir Quarterly Revenue Growth, YoY chart

Palantir’s Q3 highlights: Strong AI momentum with $725.5 million revenue, exceeding expectations by $21 million. FY24 revenue guidance increased to over $2.80 billion. Q3 revenue growth at 30.0%, surpassing guidance and Q2’s 27.2% growth rate. – I/O Fund

Q3’s results have marked quite the turnaround in just over a year for Palantir, with revenue growth accelerating more than 17 percentage points from Q2 2023 (AIP’s release) to Q3 2024. This was also the highest revenue growth rate recorded since Q1 2022.

AIP has been the primary driving force of this revenue reacceleration, with strong adoption in the US commercial segment. AIP’s scalability, interoperability and versatility allow it to quickly be integrated by enterprises. Commercial customers can lever Palantir’s AI and machine learning tools to harness the power of the latest large language models (LLMs) within Foundry and Gotham for near-instant analytics & insights, and productivity & efficiency gains.

For a closer look at AIP and how it separates Palantir from the rest of the SaaS universe, read This Stock Is Crushing Salesforce, MongoDB And Snowflake In AI Revenue.This Stock Is Crushing Salesforce, MongoDB And Snowflake In AI Revenue.

AIP Aids US Commercial Growth

What’s interesting to note in Q3 is that government revenue growth outpaced commercial growth, at 33% YoY versus 27% YoY, a contrast to recent quarters where commercial had been the primary driver. Government’s outperformance was driven by 15% QoQ growth in US government revenue, its fastest growth rate in 15 quarters, while commercial was impacted by a 7% QoQ decline in international commercial revenue due to European headwinds and “a step down in revenue from a government sponsored enterprise in the Middle East.”

However, US commercial growth remained strong in the quarter, with a growth rate nearly in line with Q2’s. Management said that AIP drove “new customer conversions and existing customer expansions in the US,” as AI models continue to be deployed into production. Here’s what the growth in US commercial revenue looks like:

Palantir US Commercial Revenue chart

Palantir’s US commercial revenue rose 54% YoY and 13% QoQ to $179 million, slightly decelerating from 55% YoY growth in Q2. FY24 US commercial revenue is expected to exceed $687 million, indicating at least $199 million in Q4 revenue, with ~52% YoY growth. – I/O Fund

US commercial revenue increased 54% YoY and 13% QoQ to $179 million, slightly decelerating from 55% YoY growth in Q2. Palantir guided for US commercial revenue to exceed $687 million, or 50% YoY growth, for FY24, implying Q4 revenue of at least $199 million, or ~52% YoY growth, representing a 2 point deceleration should it meet that target.

US commercial customer growth remained strong, with customers rising 77% YoY to 321 in Q3. This decelerated from 83% YoY in Q2. Here’s what the US commercial customer growth looks like:

US Commercial Customer Count chart

US commercial customer growth remained strong, rising 77% YoY to 321 in Q3, slightly down from 83% YoY growth in Q2. Here’s what the US commercial customer growth looks like. – I/O Fund

US commercial customer count has essentially doubled since AIP’s release, but Q3 was the second quarter to show slightly slower customer growth, indicating that Palantir may be relying on existing customers to drive revenue, whereas customer acquisition should be monitored moving forward. Most importantly, NRR has risen to a two-year high, while RPO is surging, suggesting customer spend could remain elevated for the next few quarters.

Every Thursday at 4:30 pm Eastern, the I/O Fund team holds a webinar for premium members to discuss how to navigate the broad market, as well as various stock entries and exits. We offer trade alerts plus an automated hedging signal. The I/O Fund team is one of the only audited portfolios available to individual investors. Learn more here.Learn more hereLearn more here.

Net Retention, RPO Strong, but Watch US Net New Adds

In Q3, net dollar retention expanded to 118%, up from 114% in Q2, 111% in Q1, and 107% a year ago. Management said that this “increase was driven both by expansions at existing customers and new customers acquired in Q3 of last year, as we see the effect of the AI revolution in both industry and government.” Net dollar retention has reached the highest level in two years, but still has room to expand, given that rates were >120% in 2021 and 2022.

Net Dollar Retention chart

In Q3, Palantir’s net dollar retention rate increased to 118%, up from 114% in Q2 and 107% a year ago. This growth was driven by expansions at existing customers and new acquisitions, reflecting the impact of the AI revolution in both industry and government. Net dollar retention reached its highest level in two years, with further growth potential, previously exceeding 120% in 2021 and 2022. – I/O Fund

Palantir has an advantage over other software peers due to its differentiated AI offerings, while adding significant new customers this year and expanding deal sizes with new customers (with FY24’s additions not appearing until FY25) — this provides a path forward for NRR to continue expanding. Initial AIP customers are beginning to appear in NRR, and a few more quarters will provide a clearer picture of how far NRR could expand and at what level it will plateau.

RPO is also sharply rising, implying that customer spend is likely to remain strong over the next few quarters. RPO growth has accelerated over the past four quarters, from 27.8% in Q4, breaking a string of declines in the rest of 2023, to 58.6% YoY by Q3. This is the highest RPO and growth rate since the I/O Fund began tracking Palantir in late 2023, and another data point underlying its AI-driven momentum.

RPO ($B) chart

Palantir’s RPO (Remaining Performance Obligation) is sharply rising, indicating strong customer spending over the next few quarters. RPO growth accelerated over the past four quarters, from 27.8% in Q4 to 58.6% YoY in Q3. This is the highest RPO and growth rate since the I/O Fund began tracking Palantir in late 2023, highlighting its AI-driven momentum. – I/O Fund

However, net additions in the commercial segment are slowing, both in the US and overall. In Q3, Palantir added 31 net new customers in its commercial segment, down from 40 net new customers in Q2 and 52 net new customers in Q1.

This has been predominantly driven by the US, as international commercial has yet to scale. In the US, net new commercial customers have dropped over the past two quarters, falling from 41 net new adds in Q1 to 26 net new adds in Q3. There is a clear deceleration from peak customer acquisition following AIP’s ramp, where net new adds surged from 6 in Q2 2023 to 41 by Q1, before slowing again. Palantir has acknowledged hiccups and issues in its sales cycle, saying in Q1 that they are “at the way early days of figuring out how to actually get customers to buy [AIP]” and “we're not flawlessly executing on our sales motion.” The friction is appearing within lumpy net new adds.

US Commercial Net Customer Additions chart

US commercial has been a driving factor for Palantir, as the primary segment adopting AIP and concentrating AI momentum. Palantir guided for a larger QoQ revenue deceleration for Q4 than in Q3, implying ~26.4% YoY growth, a 3.6-point deceleration from 30% YoY. Last quarter, Palantir’s guidance implied a 2-point deceleration from 27.2% YoY in Q2 to 25.2% in Q3, but a significant beat pushed growth to 30%. – I/O Fund

US commercial has been a driving factor for Palantir as the primary segment adopting AIP and where this AI momentum is concentrated. Palantir guided for a larger QoQ revenue deceleration for Q4 than it had in Q3 – guidance implies revenue growth of ~26.4% YoY, a 3.6-point deceleration from 30% YoY. Last quarter, Palantir’s guide implied only a 2-point deceleration, from 27.2% YoY in Q2 to 25.2% in Q3 – the large beat pushed growth to 30% in the quarter.

Analyst estimates do support this, with Q4 revenue estimated at $777 million, nearly 1% above Palantir’s guide as the market expects a beat once more; yet given the size of the recent beat, estimates may be lagging the underlying business momentum. The estimates correlate to 27.8% YoY growth, a 2.2 point deceleration, while Q1 is expected to decelerate further to 24% YoY before continuing to decelerate in each quarter of FY25.

Cash Flow and Margins are Bonkers

Palantir is in uncharted territory, as it is separating itself as a rare breed in SaaS to see both strong and profitable AI-driven growth. The company’s revenue growth plus GAAP operating and net margins have been in the double-digit range for four consecutive quarters. Additionally, Palantir’s Rule of 40 (revenue growth + adjusted operating margin) reached 68%, up from 46% last year.

To be consistently expanding on the Rule of 40, from the ~40% range at the end of 2022 to nearly 70%, is important as it shows that Palantir is efficiently investing in AI to drive revenue growth higher while increasing its profitability.

Cash flow margins were bonkers in Q3 — operating cash flow was nearly $420 million, or a 58% margin, while adjusted free cash flow was $435 million, a 60% margin. This was a large step up from cash flow margins in the low-20% range in the first half of 2024.

For FY24, Palantir is targeting adjusted free cash flow in excess of $1 billion, implying a margin of ~36%. Fundamentally, to have revenue growth around 30%, free cash flow margin of 30%, and adjusted operating margin nearing 40% is impressive, to say the least.

Valuation is Stretched

Palantir is at Mount Everest valuations, trading at topline multiples more than double the next three most expensive enterprise and AI-exposed SaaS stock in the market – Cloudflare, ServiceNow, and CrowdStrike. At $55, Palantir is valued at 50x TTM revenue, and 45x forward revenue – its highest ever multiples, exceeding even 2021’s peak – versus 18x to 20x forward revenue for those three peers. Even down the line, Palantir is trading at double its peers, at 146x forward earnings, versus 88x for CrowdStrike and 71x for ServiceNow.

Palantir, Cloudflare, ServiceNow, Crowdstrike Forward PS Ratio chart

Palantir is trading at Mount Everest valuations, with topline multiples more than double those of Cloudflare, ServiceNow, and CrowdStrike. At $55, Palantir is valued at 50x TTM revenue and 45x forward revenue, the highest ever, surpassing 2021’s peak. In comparison, its peers trade at 18x to 20x forward revenue. Palantir’s forward earnings multiple is also double, at 146x, compared to 88x for CrowdStrike and 71x for ServiceNow. – YChartsYCharts

Growth investors should not forget when we saw this happen before; which was Snowflake, a Wall Street darling trading 2X more than any other cloud stock at 45X Forward PS with retail investors cheering Warren Buffet’s participation in the IPO. It currently trades at an 11.7 forward PS.

The primary question here is not whether Palantir is a strong AI stock, but will buyers continue to step-in?

Conclusion

Palantir’s Q3 report was met with quite the enthusiasm from the market, but the fundamentals must be immaculate at this valuation. RPO growth has surged over the past four quarters, while Palantir’s Rule of 40 continues to rise as adjusted operating margins expand and revenue growth accelerates. Net retention has risen to two-year highs, reaching 118% in Q3, as deal expansion continues.

However, Q4’s revenue guidance implies a larger sequential deceleration than what was expected for Q3, while US commercial net new adds continue to decline sequentially. This may sound like splitting hairs, but the company is priced far above what any peer is trading, and that typically doesn’t resolve well for tech investors.

Given the outsized valuation, the I/O Fund is looking for a lower entry in Palantir before adding the stock to our portfolio. Join the I/O Fund’s next webinar on Thursday, November 14th where Knox Ridley, Technical Analyst, will discuss the firm’s buy zones and targets for AI leaders. Learn more here.

Please note: The I/O Fund conducts research and draws conclusions for the Fund’s positions. We then share that information with our readers. This is not a guarantee of a stock’s performance. Please consult your personal financial advisor before buying any stock in the companies mentioned in this analysis.

Recommended Reading:

Cloudflare Q1: H2 Deceleration to 26.5%, CEO Spooked by Macro

Posted on by io-fund

Cloudflare reported a razor-thin beat in Q1, with revenues increasing 30.5% YoY to $378.6 million, marginally ahead of the company’s guide for $373 million by $5.6 million. The guide next quarter is for $394 million at the midpoint. Analysts were expecting $393.5 million. The stock is selling off because although Cloudflare beat for two quarters, management is not raising full year guidance.

If you do the math, the current guide implies a growth rate in the second half of 26.5%. The growth rate for H1 was:

  • Q1 actual of $373M
  • Q2 guide for $394M
  • H1 of $767M compared to H1 revenue last year of $598.7 for H1 2024 growth of 28.1%
  • H2 will be revenue of $883M compared to H2 revenue last year of $698M for H2 2024 growth of 26.5%. Notably, H1 2023 had higher comps (53% both qtrs) than H2 2023 (47% and 41%) so that doesn’t help explain the deceleration, in fact, it would make the decel stand out more.

The interesting part is that Cloudflare’s key metrics are not throwing any major flags as to what is causing the deceleration. Paying customers accelerated by 20 basis points from 17% to 17.2%. Customers above $100K were up 33.5% compared to 35% in the prior quarter. RPO increased 8% QoQ from $1.245 billion to $1.343 billion for growth of 40% YoY. This is an acceleration from growth of 37% YoY in the previous quarter. 

When asked why management didn’t raise full year guidance, the answer was macro concerns. Essentially, what this earnings report is communicating is that Cloudflare is quite strong, but the macro environment is not, per signals Cloudflare is seeing from their vantage point as a company that has visibility into many industries.

Revenue and EPS:

Management said Q1’s results were “fueled by a record number of net-new customers year-over-year spending more than $100,000, $500,000, and $1 million with Cloudflare on an annualized basis.”

Although adjusted EPS increased 100% to $0.16 and beat estimates by 23%, Cloudflare struggled to make improvements down the line on a GAAP basis, with GAAP operating loss widening YoY and GAAP net loss showing little improvement. Cloudflare has stubbornly high SBC expense, at $69.7 million in Q1. This is about 18.4% of revenue, meaning that Cloudflare’s path to GAAP profitability will rely on continual improvements in gross profit growth and minimizing SBC growth.

  • For Q1, Cloudflare reported revenue of $378.6 million, increasing 30% YoY and beating estimates by 1.4%.
  • Adjusted EPS of $0.16 increased by 100% YoY, and beat estimates by 23.1%. GAAP EPS was ($0.10), an increase of 16.6% YoY.
  • For Q2, Cloudflare guided revenue of $393.5 million to $394.5 million, representing YoY growth of 27.7%.
  • For Q2, Cloudflare guided adjusted EPS to be $0.14, a slight sequential decline but a YoY increase of 40%.
  • For FY24, Cloudflare maintained its revenue guidance for $1.648 to $1.652 billion, for YoY growth of 27.3%. Management increased its adjusted EPS forecast by $0.02, now seeing full-year adjusted EPS of $0.60 to $0.61.

Margins:

A higher mix of Zero Trust and SASE revenue contributes to the gross margin expansion. Zero Trust and SASE are discussed in more detail here.

A closer look at Cloudflare’s report shows that as revenues increased $88 million YoY, operating expenses increased $81 million, more than offsetting improvements in gross margin. However, Cloudflare reported a one-time sales & marketing compensation expense of $15 million, which was likely the primary reason for a ~41.6% YoY increase in sales & marketing spend. Stripping out this one-time expense would see GAAP operating loss improve by nearly $8 million YoY, from ($47.3 million) in Q1 of last year to ($39.5 million), instead of slipping deeper into the red at ($54.6 million).

  • GAAP gross margin in Q1 was 77.5% for profit of $293.6 million, a 180 bp YoY and 50 bp QoQ expansion.
  • Adjusted gross margin was 79.5%, a 170 bp YoY and 60 bp QoQ expansion for $301.1 million.
  • GAAP operating margin was (14.4%), a 190 bp YoY improvement but a 260 bp QoQ contraction from (11.8%) in Q4 2023 for operating losses of (-$54.6) million. As stated, stock-based compensation is $69.7 million which drags down GAAP profits into the red.
  • Adjusted operating margin was 11.2%, a 450 bp YoY and 20 bp QoQ expansion for adjusted operating income of $42.4 million.
  • GAAP net margin was (9.4%), a 370 bp YoY improvement but a 170 bp QoQ contraction to ($35.5) million.
  • Adjusted net margin was 15.4%, a 500 bp YoY and 80 bp QoQ improvement for $58.2 million.
  • For Q2, based on management’s guidance, adjusted operating margin is expected to be ~9%, a 220 bp QoQ contraction. They expect FY adjusted operating margin of 9.8%.

Cash and Debt:

Free cash flow decelerated from 14% last quarter to 9% this quarter for a total of $35.6 million. Operating cash flow of $73.6 million had a margin of 19.4% down from 24% last quarter. On a YoY basis, Cloudflare is trending up on cash flows but the market is sensitive right now on this line item. Despite the QoQ deceleration, the CFO stated on the call that cash would increase in H2: “We expect free cash flow to be relatively consistent with operating profit for the full year 2024 with the first half lower and the second half higher compared with operating profit.”

Network capex is expected was 8% this quarter and is expected to be 10% to 12% for FY2024, which is in line with prior comments, yet will be up from FY2023 by 200 basis points, at the midpoint.

Essentially, the 10,000-foot view is that Cloudflare is competing with hyperscalers who have very large capex budgets. The concern is that Cloudflare may not be able to keep up — where will the cash come from to build a larger footprint given the cash flow margins are fairly thin with $1.7 billion on the balance sheet although net cash is $432 million when you consider the $1.28B in debt.

The CFO pointed out why capex should remain reasonable: “We were at 8% to 9% of revenue with network CapEx in the first quarter. We said the year will be close in the range of 10 to 12, and this includes the rollout of GPU capacity pretty much to every server and every location we have.”

The CEO said something similar later in the call – that capex will remain reasonable as a percentage of revenue: “If we have to — we — so it may be that we — on a just pure dollars basis, end up spending more on GPUs. But as a percentage of revenue, we feel very comfortable that we can service these applications very well at the percentage of revenues that it is in our forecast going forward.”But as a percentage of revenue, we feel very comfortable that we can service these applications very well at the percentage of revenues that it is in our forecast going forward.” There was additional discussion from the CEO on the call quoted below.

  • Operating cash flow was $73.6 million in Q1, or 19% of revenue, compared to $85.4 million or 24% of revenue in Q4.
  • Free cash flow was $35.6 million, or 9% of revenue, compared to $50.7 million or 14% of revenue in Q4.
  • Cash and equivalents totaled $1.72 billion.
  • Debt totaled $1.28 billion.

Key Metrics:

RPO increased 8% QoQ from $1.245 billion to $1.343 billion for growth of 40% YoY. This is an acceleration from growth of 37% YoY in the previous quarter. 

DBNRR was 115% in Q1, flat QoQ but down from 117% in the year ago quarter.

  • Customers with ARR of >$100K grew 33.5% YoY to 2,878. This customer cohort accounted for 67% of revenue in Q1, compared to 66% in Q4 and 62% a year ago.
  • This is down from last quarter with 35% YoY growth.
  • This is down from the year ago quarter with 40% YoY growth.
  • Paying customers of 197,138 accelerated both YoY and QoQ
  • This is up 20 basis points from 17% growth last quarter
  • This is up from 13% growth in the year ago quarter

Cloudflare is reporting 2 million developers on their Workers platform. This is up from “more than a million” in a press release in November of 2023 and is up from 450K developers in May of 2022 per a corporate blog. Per the opening remarks: “The last few months were incredible for the entire workers' ecosystem. First, we crossed over 2 million active developers building applications on Cloudflare Workers. Second, in April, we GA-ed a number of key products like DY, our serverless SQL database; hyperdrive, which makes any traditional database perform like it's globally distributed; and Workers AI, which allows developers to run and tune AI models across our global network.”

Earnings Call:

The earnings call can be boiled down into two key discussions. The first was on capex, which was a very important discussion for the longer-term thesis of AI inference at the Edge and the Workers Platform, which we discussed here.

The second important discussion was analysts grilling management on why they didn’t raise guidance for the back half of the year. The brief answer is macro reasons, but the discussion addresses the primary reason the stock is down after hours.

Network Capex:

Today, for this report, network capex is not an issue. However, we did recently note that Super Micro has a fundamental problem where the company must raise cash to grow. Investors should pencil-in that Cloudflare could be in a similar issue someday. The management team is pulling a lot of levers to make sure this isn’t a serious concern, and ultimately if they can time their need to scale to when cash is cheap, then all will be well.

Here is what management said regarding why their approach is different from the hefty cash approach the hyperscalers take.

Answer
Matthew Prince (Executives)

[…] the thing which is really magical about Cloudflare's business, which is really elegant is that it all fits together so well. So for instance, as we sell more of our Zero Trust and SASE products, those are extremely high-margin products, and they don't require a significant additional amount of CapEx. That then frees up our ability to invest that CapEx in other areas, including in the AI space.

[…] That means that as we deploy CapEx, it's literally not shipping an entire server to support AI, but shipping just the GPU cards that go into existing servers that are in the field. That reduces the amount of CapEx that has to be deployed. And again, it works because it is all running on 1 unified network. The fact that every server across Cloudflare's entire platform is capable of performing any function that we need. That has allowed us an enormous amount of flexibility in how we can deploy things and has helped us. 

[…] But in the average hyperscaler, if they're getting maybe 20% utilization out of a CPU or GPU resources that they've deployed, we can often be many times that in terms of the utilization where in CPUs we're seeing almost 80% utilization. So that efficiency allows us to get more out of every CapEx dollar. Finally, I would say that inference is different than training. And so you need different resources for that. You don't mean necessarily the most cutting-edge GPUs in order to do inference tasks. And so that has meant that we haven't had to chase down what is a — GPUs that have limited quantity. It's also meant that we can be much smarter about picking and choosing between different GPU vendors and matching workloads to whoever it is that can provide the best service. And I think over time, that gives us a significant advantage over people who are just trying to rent 1 particular type of GPU or rent that and let their customers figure out how to be as efficient as possible.

–End Quote

Workers Platform:

As we likely face some turbulence in the near-term (defined as next couple quarters) due to cloud valuations being quite high, it’s important to remember the medium-term thesis (next 1-2 years). When asked what was special about the Workers Platform, the CEO stated the following, some of which we described in detail in the October deep dive.

Answer
Matthew Prince (Executive)

In terms of why, what is it about Cloudflare that's unique? I think there are sort of 3 things that stand out to me about it. The first is just the performance of Cloudflare Workers AI because we are distributed around the world and today, over 150 locations globally, as we serve customers that serve a global audience, we can just give them a much better experience in having to ship all of your code back to some central location. 

The second is that we can actually be significantly more cost effective. If you're using one of the big hyperscale cloud in order to do any sort of AI task, it's up to you to manage efficiency. You have to make sure that you're getting the most out of the GPU that you're renting whereas what we do is much more of a serverless AI model where you only pay for the task that you actually run. So especially in a lot of the start-ups, they're finding that they can just get significant better efficiency, significant better cost if they use our platform in order to deliver that AI experience. And then the third thing is that because we got it distributed globally and because of the fact that we have such a rich ecosystem that we've built, where you can get a AI experience that's allowing people to actually fine-tune their models […] We can actually correspond all of the local and regional differences all around the world. That's something that you don't get anywhere else. 

—End Quote

Macro Concerns:

The tone on this particular call was that macro is providing early signals of a H2 slowdown. This was not your typical “oh, macro is hard to predict” discussion. When they discussed the H2 slowdown, it was not Cloudflare specific at all, rather that Cloudflare would have better visibility than other companies due to where they sit in terms of the internet.

This was a sample of the opening remarks:

“In the short term, however, my crystal ball is less clear. We see a lot of signals based on our privileged position running a good chunk of the Internet […] The short term is uncertain, the long term is bright, and so in the medium term, we're going to keep our hands firmly on the levers of our business […]”

Here’s an additional glimpse into the tone on the call, at times:

Question
Jonathan Ho (Analysts)

Excellent. And just a quick follow-up. Is there something specific in the macro that's maybe causing you a little bit of pause? Anything that you can sort of point to in terms of that additional concern on the outlook.

Answer
Matthew Prince (Executives)

I think that we we get a lot of signal based on where we sit on the Internet. And what I would say right now is that it's not any one thing pointing in any one clear direction. But there's a lot of noise pointing in a number of different directions that give us, I think, reason to be cautious and I think that, that is in our very nature is always taking as much signal being data-driven and making sure that we're making investments in a responsible way. And so I think the obvious thing is the geopolitical uncertainty around the world. That absolutely causes changes in buying behavior. On the other hand, some of that — those changes in buying behavior have been positive for us as we're seeing, especially in our government business, pick up because of that uncertainty. 

So there are puts and takes that are out there. What we want to do is just make sure that we are being prudent and responsible and thoughtful as we make investments and as we think through how to handle the responsibility that we have with investors capital and that they've trusted us with.

–End Quote

Additional discussions on macro had a similar tone, such as this one from the CEO: “We can make investments and we can think through what that future looks like in part because we just get much more signal than I think the average enterprise SaaS company gets. And I think that, that has served us well. And I think we try not to be surprising in any way. And so as we see — I would say that there is certainly an uptick in uncertainty and sort of potential downside this quarter over last quarter.”I would say that there is certainly an uptick in uncertainty and sort of potential downside this quarter over last quarter.”

Here is more along those lines: “I think my level of concern is not at the same level that it was in Q1 of 2022, but it is definitely heightened over a lot of what we've seen in more recent quarters.”

However, one analyst didn’t let them off the hook so easily, and so to really drive home the tone of the call, I’m quoting in full one of the last questions where the analyst pushed for management to be crystal clear.

Question
Alex Henderson (Analysts)

So if nothing is really spooking you here, I'm still struggling with the guidance and the outlook for the back half of the year. You've given guidance that — or commentary that you're seeing significant strengthening of your pipeline, you're saying you're duration stable. You're seeing solid closure rates. You're adding more sales capacity, you're winning large customer deals at an accelerating rate. You’re spending more on hiring people and productivity in your sales force is significantly improving. Yet your guidance implies with the first quarter beat and the second quarter are above the Street, the back half is much more conservative. So I guess the question is, is that a function of specific weakness in a particular geography or due to political issues? Or is it just trying to feather in more opportunity for the sales organization to be realigned as Mark comes on and drives things because ultimately, it sounds like the mechanics imply an acceleration, not a deceleration.

Answer
Matthew Prince (Executives)

Yes. Alex, I'll start and then Thomas can give a little bit more color. I would push back on your initial statement, which was that nothing spooks me, a lot spooks me right now. So just because just — and I want to make it clear, we are in a much more uncertain environment and the signal that we're seeing is that uncertainty is up. In addition to that, I think you're correct that whenever you have a sales leadership change, there is risk that comes with it. And so there's a bit of that. But the primary factor here is that as we look at the signals in the overall macro economy, it is — it feels like a much more — it feels like there's much more reason to worry in Q1 than there was in Q4. But that doesn't mean that it was the same, just sound the alarm bells that we were seeing back in Q1 of 2022.

–End Quote

Conclusion:

Cloudflare’s valuation at 18x forward sales is hovering at the 20x forward PS level that ‘best-of-breed’ cloud stocks struggle to maintain. If macro does weaken, cloud stocks will get slammed for their thin FCF margins (far majority have negative FCF) and lack of GAAP profitability. Remember, I’m simply the messenger here. The reality is that cloud gets hit hard. We trimmed the position over the past quarter or so because cloud simply doesn’t sustain well at certain valuations. Had we not already trimmed Cloudflare, we would be doing so today – primarily based on valuation, secondly due to this management team being better than most at giving investors a heads-up when something is off. Meaning, management stated their crystal ball was “cloudy,” but in reality, if you’re listening, they’re being crystal clear.

With that said, Cloudflare is one of our favorite choices for the medium-term. The company sits in an enviable position for AI inference at the Edge. The key metrics are strong incl an acceleration in RPO, and I suspect that won’t be the case with most cloud peers this quarter. The developer growth on Workers to 2M is fire. I liked management’s response on network capex as it shows they have a strategy, and it’s showing up today with cash flows remaining at an acceptable percentage of revenue – although, notably, we do want to stay neutral here in terms of what the network capex reports in the future and also continue to scrutinize cash flow margins.

Recommended Reading:

Palantir Stock Surges From Artificial Intelligence Platform

Posted on by io-fund

This article was originally published on Forbes on Feb 15, 2024,04:51 pm ESTForbes Forbes on Feb 15, 2024,04:51 pm EST

Palantir’s Q4 earnings confirmed an acceleration in its US commercial business as it closed out its first GAAP profitable year. Shares are reflecting the optimism surrounding Palantir’s commercial segment and bottom line expansion, with shares up more than 47% YTD and nearly 280% since the start of 2023.

We noted in our stock newsletter in December that Palantir was “exhibiting multiple signs of acceleration heading into 2024 with an improved fundamental backdrop driven by increasing AI demand. Palantir’s Artificial Intelligence Platform (AIP) is driving a significant acceleration in its US commercial business, while underlying metrics and the bottom line are rapidly improving.”

Revenue acceleration stemming from the commercial business is the major story for Palantir through 2024 and into 2025, with revenue growth poised to accelerate from 17% last year to 20% this year and nearly 21% in 2025.

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Strong Acceleration in US Commercial Is Driving Growth

In a deep dive at the time of Palantir’s direct listing, our firm said in 2020 that the “commercial sector is the growth story.” Palantir’s public offering was seen as a way to facilitate attracting and acquiring commercial clients before AI brought a wave of competition. The fruits of Palantir’s labor are beginning to pay off, with a newfound rapid acceleration in its US commercial business after AIP’s launch in Q2 was met with “unprecedented” demand. At its core, Palantir’s AIP is a comprehensive AI solution that lets customers lever Palantir’s AI and machine learning tools and harness the power of the latest large language models (LLMs) within Foundry and Gotham. Customers can deploy LLMs on their own private networks using their own private data, maximizing data security and improving efficiency by helping reduce data transfer and storage costs.

Although its US commercial segment accounts for less than 25% of quarterly revenue — it just surpassed a $500 million annual run rate in Q4 — it is now becoming the dominant factor behind the strong business momentum Palantir has seen over the past few quarters.

US commercial revenue rose 70% YoY to $131 million, a 37 percentage point acceleration from Q3 and a 58 percentage point acceleration from the year ago quarter. For the full year, US commercial revenue rose at more than double Palantir’s growth rate, increasing 36% YoY to $457 million.

The graph below illustrates just how strong the recent quarter was:

Palantir US Commercial Bank Revenue Trends

Source: PALANTIR

This acceleration in the US over the past two quarters is driving global commercial revenue higher. Palantir’s global commercial revenue accelerated by 22 percentage points, from 10% growth in Q2 to 32% in Q4. The segment topped a $1.1 billion annual run rate last quarter, up from a $920 million run rate two quarters ago.

Palantir Commercial Revenue Trends

Source: PALANTIR

While the revenue acceleration was the main headline for the US commercial business, a closer look reveals that the segment also drove more than 90% of Palantir’s customer additions with very strong underlying metrics.

Palantir reported 55% YoY and 22% QoQ growth in US commercial customer count to 221 in the quarter, as customer growth continues to accelerate. Over the past two quarters, Palantir has added 60 net new US commercial customers with 40 customers added in Q4 alone. This is more than 3X higher than the previous period of just 18 net new US commercial customers from Q4 2022 to Q2 2023.

US Commercial Customer Count

Source: PALANTIR

Global commercial customers increased 44% YoY and 14% QoQ to 375 customers – representing 45 net new customer additions in the quarter. This means the US commercial segment drove more than 90% of Palantir’s net new customer additions in Q4. That compares to below 63% of net new customer additions in Q3 and just 20% in Q2.

This growth was “meaningfully driven by AIP” with Palantir saying that “demand is off the charts” for its new product. AIP is “propelling growth both through new customer acquisitions and expansions with existing customers,” with evidence of AIP bootcamps “helping to significantly compress sales cycles and accelerate the rate of new customer acquisition.”

Palantir had set a goal in October to hit 500 AIP bootcamps to drive top of funnel growth, and it has already surpassed that target, completing 560 bootcamps in just four months.

CRO Ryan Taylor commented on how this translates through to growth in the US commercial segment, with “70% year-over-year growth in revenue in Q4, 55% growth in customer count year-over-year, and a 107% growth in TCV closed on an adjusted basis […] Either it's — first, it's bootcamps that are quickly converting to paying customers or its expansion of existing customers or it's customers where maybe we've been engaged for a while and introduction of AIP, that whole process has been accelerated. We're seeing that across the board, and yet at the same time, we barely touched that addressable market.”

Engaging customers via bootcamps to then translating that engagement into new customer deals or expanded deals sets the foundation for sustained revenue growth at a higher rate, more so if it can drive its net retention rate higher.

Every Thursday at 4:30 pm Eastern, the I/O Fund team holds a webinar for premium members to discuss how to navigate the broad market, as well as various stock entries and exits. We offer trade alerts plus an automated hedging signal. The I/O Fund team is one of the only audited portfolios available to individual investors. Learn more here.Learn more hereLearn more here.

A Note on Net Retention Rate

Palantir reported a company-wide NRR of 108% in Q4, but noted that it “does not yet fully capture the acceleration in our US commercial business” since customers acquired over the last twelve months are not reflected in the calculation. A majority of the net new customer additions have come in the last two quarters, suggesting US commercial NRR will be higher than 108% come the end of FY24 when this customer cohort is reflected. For context, Palantir reported an NRR of 150% at the end of FY21 in US commercial, but that likely fell significantly when growth slowed to a crawl at the end of FY22.

If AIP can continue to drive a high level of customer acquisition and expansion through FY24, this can help drive and maintain the revenue acceleration we’re seeing in the segment through FY25 and into FY26.

Valuation Remains a Risk Despite Strong Improvement in Fundamentals

Fundamentally, Palantir has seen major improvements throughout FY23, as it became the company’s first GAAP profitable year.

Gross margin has expanded consistently throughout the year, rising 300 bp YoY from 79% to 82% in Q4. GAAP operating margin shifted positive and expanded in each quarter in 2023, rising from (4%) in Q4 2022 to 11% last quarter.

Net income growth has been particularly strong, with Palantir generating nearly $210 million in net income during the year, compared to nearly ($374 million) in 2022. Cash flow generation has improved substantially, with operating and free cash flow both more than doubling QoQ in Q4 to over $300 million. Palantir ended the year with a 32% OCF margin and a 33% adjusted FCF margin.

Palantir Financials Charts

Source: YCHARTS

While the fundamentals are certainly supporting an increase in Palantir’s share price, the AI hype may be overshooting the near-term potential for returns at this level. What’s striking is that investors are paying prices last seen when the market set a major top in November 2021, meanwhile the 2021 growth story is decoupled from management’s long-term 30% revenue growth target.

In early 2021, Palantir’s management expected to reach $4 billion in revenue by 2025 as they expected more than 30% annual revenue growth each year for the next five years, or through 2026. Palantir exceeded this target with 34% growth in 2021, but a macro-inflicted deceleration in late 2022 and early 2023 has practically nullified its ability to reach that $4 billion target after posting 24% growth in 2022 and just 17% in 2023. Current analyst estimates point to nearly 21% growth to $3.22 billion in revenue in 2025, meaning Palantir is one year off track – it’s projected to reach the $4 billion milestone in 2026, one year later than expected.

To reach $4 billion by the end of 2025, Palantir would need to record 35% growth this year and next, about 15 percentage points above estimates for both years. While AIP is aiding strong acceleration in the US commercial segment, it’s unlikely to drive revenues to that target. As a result, shares may be pricing in perfection for AIP and AI-related stock performance.

Palantir P/S Charts

Source: YCHARTS

Prior to Q4’s earnings, Palantir was trading near its average P/S ratio of 18x, but the strong rally has now taken shares to over 26x P/S and 20x forward P/S – this is the highest level since late 2021 yet growth has slowed. On a cash flow basis, shares are trading at around 60x 2024’s projected $800 million to $1 billion in adjusted FCF.

Palantir’s shares are no longer cheap. It’s the third most expensive enterprise software stock on a forward P/S basis, behind Cloudflare and Snowflake, despite having the slowest forward revenue growth rate by more than 700 basis points, at 20% compared to 27% to 30% for the other two. This valuation may open up the door for downside throughout the year as it leaves no room for error, considering its lower revenue growth rate compared to peers; in addition, any dampening to growth stock sentiment from higher-for-longer rates with cut expectations being pushed back further in the year also presents a potential headwind for shares.

Conclusion

Enterprises are showing elevated interest in Palantir’s Artificial Intelligence Platform, which is translating to new customer additions. AIP’s early success in the US commercial segment drove Palantir’s new customer additions in Q4. US commercial revenue is accelerating significantly, reaching 70% YoY growth in Q4 from 33% in the prior quarter.

Management’s commentary about how Palantir is engaging and converting customers via bootcamps sets a foundation for a sustained acceleration thanks to a rapid customer acquisition cycle. However, the size of the US commercial business at less than 25% of quarterly revenues means that the AI-related acceleration may not be enough to sustain the stock’s current valuation.

Every Thursday at 4:30 pm Eastern, the I/O Fund team holds a webinar for premium members to discuss how to navigate the broad market, as well as various stock entries and exits. We offer trade alerts plus an automated hedging signal. The I/O Fund team is one of the only audited portfolios available to individual investors. Learn About our Premium Services

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

Please note: The I/O Fund conducts research and draws conclusions for the Fund’s positions. We then share that information with our readers. This is not a guarantee of a stock’s performance. Please consult your personal financial advisor before buying any stock in the companies mentioned in this analysis.

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CrowdStrike Q3 Earnings: Net New ARR Accelerates, Billings Decelerate

Posted on by io-fund

The word “record” was emphasized in the opening remarks as CrowdStrike put up a record quarter in many regards: record net new ARR of $223 million, record non-GAAP subscription gross margin, record GAAP and non-GAAP operating profitability, and record free cash flow.

What is weighing on CrowdStrike after hours is the deceleration in billings. CrowdStrike prefers to focus on ARR and Net New ARR, yet the market is keeping an eye on billings, especially this earnings season, considering we’ve seen mixed results on billings from cybersecurity peers. We detail this for you below.

The other blemish, if you will, was when the CFO stated: “our dollar based net retention rate was slightly below our benchmark in Q3.” This means DBNRR was below 120. Looking back, the July 2022 quarter was at 120%. However, I believe this is the first time that DBNRR was below 120.

Beyond this, the company had a solid report. It was the first quarter the company was profitable from operations (as you’ll recall, CrowdStrike was profitable from interest income in the past). Net new ARR also accelerated nicely from (-10%) last quarter to +13% this quarter. This helps to set the stage for more growth in the future.

Key Takeaways:

CrowdStrike delivered a 1.1% revenue beat and 10.8% EPS beat relative to consensus estimates, and guided fiscal Q4 marginally above consensus; however, the quarter was relatively strong, as net new ARR rose to a record at $223 million. ARR growth decelerated slightly to 35%, but topped the $3 billion mark for the first time. CrowdStrike re-emphasized its goal to reach $10 billion in ARR over the next five to seven years. The company also stated “we are maintaining our net new ARR assumptions which call for in-line to modestly up net new ARR for the full year and double-digit year-over- year net new ARR growth in the second half.” This implies net new ARR will be strong again next quarter.

Revenue growth remained strong at +35%, but billings growth looked to decelerate to the high-single-digit range YoY, compared to prior growth rates above +20%. A key item in the report was that Q3 marked CrowdStrike’s first quarter with positive operating income. CrowdStrike now has to prove that it can continue to expand operating margin further into positive territory.

Financials:

Revenue and EPS:

  • Revenue of $786 million beat consensus estimates by $8.6M. This represented growth of +35% YoY
  • Subscription revenue was $733.5 million, up +34% YoY.
  • ARR increased +35% YoY to $3.15 billion, marking the first time that ARR has surpassed $3 billion.
  • Net new ARR reached a record at $223.1 million, and was +12.6% higher compared to $198.1 million in the year-ago quarter.
  • Adjusted EPS of $0.82 beat estimates by $0.08, or 10.8%. This represented YoY growth of +105%.
  • GAAP EPS of $0.11 compares to a GAAP loss of ($0.24) in the year-ago quarter.

Margins:

  • Gross margin of 75.2% increased ~240 bp YoY ~20 bp QoQ.
  • Subscription gross margin of 78.2% increased ~270 bp YoY and ~40 bp QoQ.
  • Operating margin of 0.4%, compared to an operating margin of (9.7%) in the year-ago quarter and (2.1%) in fiscal Q2.
  • Net margin of 3.4% expanded ~225 bp QoQ, and marked the third straight quarter with a positive net margin.

Cash & Debt:

  • Cash and short-term investments of $3.17 billion.
  • Total debt was $742.1 million.
  • Operating cash flow reached a record at $273.5 million, representing an increase of +12.6% YoY from $242.9 million. Operating cash flow margin was 34.8%.
  • Free cash flow reached a record at $239 million, an increase of +37.3% YoY from $174.1 million. Free cash flow margin was 30.4%.

Noteworthy:

Net new ARR growth and a first quarter with positive operating income were the two major positives from Q3’s report. Net new ARR rebounded to a record $223.1 million after falling to $174.2 million in fiscal Q1, a strong recovery and setting the stage for another possible record to close out FY24.

CrowdStrike also recorded its first quarter to generate operating income, albeit at a razor-thin 0.4% operating margin. However, this shift to a positive margin benefited the bottom-line, allowing net margin to expand ~225 bp QoQ to ~3.4%. This marked CrowdStrike’s third straight quarter of GAAP profitability, with sequential growth in each of the three quarters.

We had mentioned in the pre-ER write-up that while CrowdStrike had begun to post GAAP profitability, it was preferable that the company be GAAP profitable from operations – now, the next task is for CrowdStrike to show further growth in operating income. You can read our last earnings report write-up following Q2 earnings here.

Another interesting snippet was an increase in the number of customers deploying 7+ modules. Whereas customers deploying 5+ remained the same QoQ at 63%, the amount deploying 7+ increased from 24% last quarter to 26% this quarter. Those deploying 6+ modules also increased by 1 percentage point to 42%. CrowdStrike has done an excellent job of upselling existing customers to higher amounts of deployed modules, so this 2 percentage point increase was a healthy figure to see.

Billings:

However, there was one glaring negative from the report – billings growth has decelerated to the single digit range. Billings was calculated to have fallen (2%) QoQ and +9% YoY to $821.5M for Q3, a significant slowdown from the +13% QoQ and +22% YoY growth rate recorded in the prior quarter.

Pictured Above: I/O Fund calculations for CrowdStrike’s Billings growth/decline

This deceleration matches what peers are reporting:

  • Fortinet guided for billings to decline (-1%) to (-9%) in its upcoming quarter after reporting just +5.7% YoY growth.
  • Palo Alto lowered its full-year billings forecast while it reported a slowdown to +16% growth compared to +27% in its year-ago quarter.
  • Zscaler reported +34% YoY billings growth on Monday, but maintained its full year guidance calling for +24% to +26% YoY growth, suggesting that a deceleration is set for the next few quarters.

Earnings Call:

Billings:

Given Billings is where the potential weakness resides, there was a question from an analyst regarding the decline. Since this was the most important question on the call in regards to the price action, I’m quoting it below.

Q: “And then quarter was phenomenal. But I do see some weakness across the board of cyber companies with billings. In your case it was down about 2%. I also see some weakness in deferred revenues. How do I reconcile what I see with billings with deferred, with the underlying drivers that are very strong and your strong execution? Why is why are we seeing weakness not just with you, maybe with the entire space, but why are we seeing weakness with billings across the board? Thanks.”

A: CFO: I'm going to start with billings. Yeah. You're correct. For us specifically, we don't manage the business to billings. And we feel ARR gives you the absolute best proxy to revenue. And we felt that that's the right metric. As you know, since we went public to give you more transparency into the health of our business. And that's the metric that really guides you on health.

[…] We think that billings has certain things that just are not as relevant as a metric like ARR, you're comparing a balance sheet item to a P&L item and for us, the P&L is going to dictate the health of the business. So for us billings obviously is going to be impacted by duration and there are many things that go into that. And remember also that when you think about on a year-on-year basis, we're still up on billings. And I think that's the one thing that you want to take away. For us, when we think about how we want to continue to be transparent, ARR really gives you that notion of where we're going and how we're doing. And I think that that's the focus and it has been, by the way, since we've been public. Even as a private company, that's the one that we manage the business to, that's how we look at how to give out quotas to our reps, et cetera, et cetera. So for us that's not going to change. And, I hope that answers that question.”

Translation: CrowdStrike’s CFO did not really answer the question, such as perhaps seasonality contributed or some deferred revenue will be realized in Q4 that would have been realized in Q3 (these are hypothetical answers). Instead, the CFO answered that analysts should focus on ARR instead of Billings, but the problem is that ARR is not a GAAP metric and this is why Billings remains important for an apples-to-apples comparison with peers. This is something to monitor, yet given net new ARR accelerated, the market may conclude these two cancel each other out. 

Macro Environment Weak:

The other takeaway was CrowdStrike’s discussions that the current environment is tough. CrowdStrike may be less susceptible, yet management made it quite clear they are facing challenges. Here is what the CEO said when asked if October was strong (given other cybersecurity peers have stated it was a weak month for them):

“Yeah, we certainly had a strong October. I think as I said in my prepared remarks, the macroenvironment is still is still challenging. And we make no mistake about that. Deals take longer, a lot more scrutiny a lot of sign-offs, and there's a lot more work that goes into these larger enterprise deals. Getting deals done, even like Falcon Flex, which are more enterprise-like in their nature, takes time. So, we had a great October, but in general, buyers are still cautious. And I think the fact that we're able to provide a real platform play that allows them to consolidate in other technologies and ultimately save money accrues values to us, but it certainly takes a lot of time and effort to get the deal over the goal line, but team did a great job, and October was strong for us.”

Management also stated they are not counting on a Q4 budget flush in their guide, which translates to a weaker environment: “As George outlined, strong demand for the Falcon platform is driving our pipeline to new heights. However, the macroenvironment remains challenging with continued increased budget scrutiny, and as a result, we are not expecting to see the typical Q4 budget flush.”

You can read our previous write-up on CrowdStrike’s product including AI-driven automation.

Conclusion:

As redundant as it may sound, we will rely on technicals to manage this position. We tend to rely heavily on fundamentals during pullbacks/selloffs or when the risk/reward is favorable for another leg up in the market. However, we use technicals for risk management when the market appears overextended. There were some weak areas in the report that were canceled out by a few metrics that really matter in terms of a strong foundation, such as operating profitability and accelerating/return to growth in net new ARR. We continue to see CrowdStrike as a strong choice within cybersecurity and this earnings report does not change our view.

You can read the current technical setup here in terms of what we want to see in terms of price levels.current technical setup here in terms of what we want to see in terms of price levels.

Equity Analyst Damien Robbins contributed to this analysis

 Recommended Reading:

Cybersecurity Stocks Overview

Posted on by io-fund

Cybersecurity was a wild ride this earnings season with stocks such as Fortinet down (25%) after its report, yet stocks like Palo Alto Networks up 15% following its report. This is important to dissect as Palo Alto is the leader YTD in gains while Fortinet is the laggard (see chart below).

Source: YCharts

We think the market is more forward-looking than ever when it comes to the cybersecurity space as the key metrics is what separates these names. Below, we look into the key metrics to help predict where the market will go next.

Revenue and EPS

Before we go into key metrics, let's first review top line and bottom-line numbers. Here is how the leading cybersecurity stocks stack up on revenue. Zscaler and CrowdStrike are leading in revenue growth in the recent quarter with YoY growth of 43.1% and 36.7%, respectively.

Zscaler’s revenue grew by 43.1% YoY to $455 million and CrowdStrike’s revenue grew by 36.7% YoY to $731.6 million in the recent quarter.

Forward looking, CrowdStrike leads highest revenue growth rates in the next two quarters and yet Cloudflare edges out CrowdStrike in the early part of next year – per analyst consensus.

  • CrowdStrike’s revenue is expected to grow 33.8% YoY in Q3 2023 and 31.3% YoY in Q4 2023.
  • Cloudflare’s revenue is expected to grow 29.6% YoY in Q1 2024 and 30.2% YoY in Q2 2024.

Source: Seeking Alpha

CrowdStrike’s adjusted EPS is expected to grow the fastest in the next three quarters with 85.6%, 66.3%, and 36.6% YoY growth. Zscaler beats CrowdStrike in Q2 2024 with 21.1% YoY growth while CrowdStrike’s EPS is expected to grow 15.1% YoY in that particular quarter.

Source: Seeking Alpha

Margins

We'd also like to discuss margins as a group before we break the stocks down individually. For brevity’s sake, we are placing the most importance on GAAP operating margin. This highlights why Palo Alto Network has led cybersecurity stocks this year, as the company’s growth profile is balanced with operational efficiency.  

Source: YCharts and Company IR

Palo Alto’s operating margin improved to 13% from 1% in the same period last year. CrowdStrike and Zscaler are also improving as can be seen in the below chart.

  • CrowdStrike improved to (2%) from (9%) in the same period last year.
  • Zscaler improved to (10%) from (26%) in the same period last year.

Source: YCharts

Key Metrics

Below, we look at key metrics among cybersecurity stocks to help determine which companies may be stronger than they seem, or the opposite, weaker than they first appear.

CrowdStrike

For CrowdStrike ending ARR and net new ARR are two important key metrics. Per CrowdStrike’s management: “And as you know, the business is focused on ARR, as opposed to billings, which can be — which can have whipsaw effects and the focus on ARR, just gives you an idea about the overall health of the business.”

Ending ARR grew by 37% YoY in the recent quarter to $2.93 billion. This was partly helped by the rapid growth in cloud security, identity protection, and LogScale Next-gen SIEM, which together surpassed $550 million in ARR with very high growth rates:

  • LogScale SIEM ending ARR grew by over 200% YoY in the recent quarter and is approaching $100 million and the management expects to achieve in Q3.
  • Falcon modules deployed in public cloud grew by 70% YoY to $296 million.
  • Identity Protection ending ARR grew by 194% YoY to over $200 million.

Source: Company IR

Net new ARR declined by (10%) YoY to $196.2 million yet was better than management’s guidance of a decline of (11%). In the earnings call, management pointed toward net new ARR returning to growth in the second half of the year: “With the business momentum we see and competitive market dynamics, we believe our second half performance will yield double-digit net new ARR growth.”

Source: Company IR

Palo Alto

For Palo Alto, billings and RPO are the two key indicators. Palo Alto’s billings grew by 18% YoY to $3.2 billion. Despite billings growth showing a deceleration, it’s actually quite strong due to the tough comps as billings grew by 44% YoY in the same period last year.

The management guided billings to grow in the range of 17% to 19% for the next quarter. They also expect billings to grow in the range of 17% to 19% for the next three years. Dipak Golechha, CFO of the company said in the earnings call, “We have the product portfolio that makes us an attractive partner to these players, along with the scale to make the investments to support the success of these partners. Bringing this together on the top line, as Nikesh noted, we're targeting growth of 17% to 19% in revenue and billings over the next three years, which is ahead of the cybersecurity market growth rates.”we're targeting growth of 17% to 19% in revenue and billings over the next three years, which is ahead of the cybersecurity market growth rates.”

Source: Company IR

Remaining Performance Obligation (RPO) grew by 30% YoY in the recent quarter to $10.6 billion. The management believes RPO is a better metric than billings since it is not impacted by billing terms that impacted billings due to customers preferring deferred payments in the current environment. Per the earnings call: “The percent of bookings that included deferred payments increased approximately 45% year-over-year […] and also: “RPO is becoming a more important leading indicator for our business as it's not impacted by billing terms [..] As a reminder, RPO represents the booked business we expect to recognize as revenue in future periods. Also, all customers' purchases, including in RPO, are noncancelable.”

Source: Investor Presentation

Fortinet

Billings grew by 18% YoY to $1.54 billion in the recent quarter, which was a disappointment to the market. Ken Xie, CEO and Founder of the company, said in the earnings call, “Billings growth of 18%, led to more normalized product revenue growth of 18%. We believe our billing performance reflects large enterprises’ concerns with the macro environment, in addition to some inventory digestion after two years of elevated 30%+ of product billing growth during the supply chain shortage.”product revenue growth of 18%. We believe our billing performance reflects large enterprises’ concerns with the macro environment, in addition to some inventory digestion after two years of elevated 30%+ of product billing growth during the supply chain shortage.”

The management cited macro uncertainty led to shorter contract duration and enterprise deals getting pushed out to future quarters for the slower billing’s growth of 18%. Keith Jensen, CFO of the company, said, “We saw shorter contract duration with the average term decreasing 1.5 months to 28 months, creating a 4 to 5-point billings headwind year over year. Normalizing billings growth for the change in contract duration, yields billings growth in the low 20% range. Having some level of enterprise deals push to future quarters is not unusual. In Q2’23, however, an unusually large volume of deals that we expected to close in June, instead pushed to future periods.”

The above explanation from the management was not convincing as it lowered the company’s revenue guidance to $5.35 billion to $5.45 billion, representing a YoY growth of 22.3% at the mid-point from an earlier estimate of $5.425 billion to $5.485 billion.

  • Revenue for Q3 is expected to be $1.315 billion to $1.375 billion, representing a YoY growth of 17% at the midpoint.
  • Billings in the range of $1.56 billion to $1.62 billion, representing a YoY growth of 12.8% at the mid-point.

Source: Company IR

Cloudflare

The company’s paying customers grew by 15% YoY yet large customers (> $100,000 annualized revenue) grew by 34% YoY to 2,352.

Thomas Seifert, CFO of the company said in the earnings call, “Turning to our customer metrics. In the second quarter, we had 174,129 paying customers, representing an increase of 15% year-over-year. We ended the quarter with 2,352 large customers, representing an increase of 34% year-over-year and an addition of 196 large customers in the quarter. In fact, we added a record number of customers spending more than $500,000 on an annualized basis with Cloudflare. And the second quarter was also one of our highest quarterly additions of customers, spending more than $1 million annually, including our largest Zero Trust contract to date.”

The dollar-based net retention rate was 115% compared to 117% in Q1 23 and 126% in the same period last year. He further said,

“Importantly, renewal rates in the second quarter were consistent with the quarterly average in 2022, which was an all-time high for the company. Instead, similar to the last two quarters, the decline in DNR was again primarily driven by slower expansion in our larger customer cohort. We calculate DNR by comparing the analyzed revenue from paying customers four quarters prior to the annualized revenue from the same set of customers in the most recent quarter. As a result, this will be a lagging indicator of Cloudflare’s underlying business trends. Based on our visibility, we believe the deceleration in DNR is nearing a bottom.”Based on our visibility, we believe the deceleration in DNR is nearing a bottom.”

Source: Company IR

Zscaler

  • Customers with over $100,000 in ARR grew by 25% YoY to 2,609.
  • Calculated billings grew by 38% YoY and up 49% QoQ to $719 million. The total billings benefitted from $20 million upfront billing on a multiyear deal. The calculated billings grew 40% YoY in Q1 and 57% YoY in the same period last year. 

Source: Company IR

Conclusion

We are currently looking to add cybersecurity exposure to our portfolio, ideally on a pullback, to position into 2024. There are many strong candidates highlighted here that are performing better than other cloud cohorts. In particular, there are many mentions throughout of the key metrics listed above bottoming. Should these key metrics bottom on any particular stock, the market will likely reward that stock. Our plan is to front-run this bottom with a small allocation and then layer-once the bottom has been confirmed.

 Recommended Readings:

Cybersecurity Continues To Lead Cloud Stocks

Posted on by io-fund

This article was originally published on Forbes on Sep 16, 2022,03:24pm EDTForbes on Sep 16, 2022,03:24pm EDT

Last June, we discussed key reasons that cybersecurity stocks would hold up particularly well compared to other cloud verticals. The analysis pointed to enterprise spending expected to increase in 2022 from the previous year, according to Chief Information Security Officer (CISO) surveys.

Considering the level of cloud spending in both 2020 and 2021, an increase on already high budgets is impressive. The CISO surveys state that 44% will increase budgets in 2022 compared to 41% in 2021 and only 2% are expect to decrease compared to 6% the previous year.

In a similar study from PricewatershouseCooper, 69% predict a rise in cyber spending for 2022 and 26% expect a surge of 10% or higher spending year-over-year. This survey was done across a broader C-suite and executive sampling. 

Our analysis in June also pointed out that according to a Gartner survey, 88% of the Board of Directors viewed cybersecurity as a business risk. According to Paul Proctor, VP at Gartner, “The influx of ransomware and supply chain attacks seen throughout 2021, many of which targeted operation- and mission-critical environments, should be a wake-up call that security is a business issue, and not just another problem for IT to solve.”

We had also stated on Fox Business News that a small cohort of companies emerged this past quarter to increase the top line while also reporting narrowing losses on the bottom line. We feel not losing site of opportunities during selloffs is how generational wealth is built.

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Cybersecurity Stocks Report Another Strong Quarter in 2022

In Q2, cybersecurity stocks did not disappoint with revenue beats across the board. Although SentinelOne had the largest revenue beat, Crowdstrike had the largest beat from a higher revenue base.

Chart: Cybersecurity Stocks Q2

Source: YCHARTS

We pointed out on Twitter that one reason for the strong beats is that cybersecurity is not subject to discretionary spending.

Cybersecurity stocks tweet by Beth Kindig

Source: Beth Kindig

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Palo Alto Networks and Crowdstrike have strong bottom lines and this is one reason both stocks have outperformed the Nasdaq this year. With that said, high growth is starting to gain traction again as SentinelOne and Zscaler have the stronger price action in the last 30 days.

Chart: Cybersecurity stocks Adj. EPS

Source: YCHART

In the chart below, we see a handful of cybersecurity stocks have been able to grow free cash flow, such as Crowdstrike, Zscaler and Palo Alto Networks. The strong free cash flow is occurring in addition to growing the top line, which indicates cybersecurity is not a “growth at all costs” industry.

Chart: Cybersecurity stocks free cash flow growth

Source: CHARTS AND INVESTOR RELATIONS

Conclusion:

Cybersecurity continues to be a top priority in budgets and the results are showing up again in Q2. We found a strong pattern with cybersecurity stocks sustaining growth rates and strong bottom lines in Q1 and also in Q2. The cybersecurity sector overwhelmingly beat estimates compared to other sectors within tech and investors should take notice of this strength.

Please note: The I/O Fund conducts research and draws conclusions for the Fund’s positions. We then share that information with our readers. This is not a guarantee of a stock’s performance. Please consult your personal financial advisor before buying any stock in the companies mentioned in this analysis.

Zscaler Stock: Solid Growth for this Cybersecurity Company

Posted on by io-fund

Zscaler’s product has done exceptionally well considering the crowded cybersecurity market. This is due to its best-of-breed, singular focus on security edge and zero trust. Primarily, Zero Trust architecture began to replace VPNs in a meaningful way in 2020 and this has sustained due to the Zero Trust model offering deeper and more scalable protection by eliminating implicit trust. 

Zero Trust Security is built on the premise that no one should be trusted within or outside the network. In the traditional security systems, it is difficult to obtain access from outside the network while those located inside the network were trusted. With Zero Trust, these trust assumptions are removed with tools such as multi-factor authentication, giving access for a limited time and to also verify, authorize and to have a continuous check on all the data points that are given access.

Zscaler released its third-quarter fiscal year 2022 results on May 26th with revenue accelerating 63% year-over-year to $286.8 million, which beat consensus by 5.6%. The company also raised full-year revenue guidance by 2.9%. The stock rose 13% the following day from the results.

On the bottom line, Zscaler has a 15% free cash flow margin with a goal to increase this to 20% FCF margin this year. The company saw an increase in adjusted operating income and adjusted net income yet is reporting slightly higher losses on a GAAP basis from (25%) to (30%) due to stock-based compensation. 

Cybersecurity Spend is Increasing in 2022

We will copy a few points from our upcoming Forbes analysis on Cybsersecurity stocks here for easy reference. Note: we covered these points in our Q2 2022 analysis. For the full article, please check the forum on Friday.our Q2 2022 analysis. For the full article, please check the forum on Friday.

Enterprise spending is expected to increase in 2022 from the previous year, according to Chief Information Security Officer (CISO) surveys. Considering the level of cloud spending in both 2020 and 2021, an increase on already high budgets is impressive. The CISO survey states that 44% increase budgets to increase in 2022 compared to 41% in 2021 and only 2% expect a decrease compared to 6% the previous year. 

In a similar study from PricewatershouseCooper, 69% predict a rise in cyber spending for 2022 and 26% expect a surge of 10% or higher spending year-over-year. This survey was done across a broader C-suite and executive sampling.

According to a Gartner survey, 88% of the Board of Directors viewed cybersecurity as a business risk. According to Paul Proctor, VP at Gartner, “The influx of ransomware and supply chain attacks seen throughout 2021, many of which targeted operation- and mission-critical environments, should be a wake-up call that security is a business issue, and not just another problem for IT to solve.”

According to Global Market Insights, the cybersecurity market is expected to reach $400 billion by 2027 from $170 billion in 2020, representing a compound annual growth rate (CAGR) of 15% during this period. 

Although that’s a small CAGR, many best-of-breed companies are only reporting around $1 billion in annual revenue right now, therefore, the size of pie is quite substantial for those that outperform competitors.  

According to Gartner’s CIO survey concluded in 2021, cyber and information security is the top priority of planned investments by companies for 2022. Monika Sinha, VP at Gartner, said, “There is a continued need to invest in cybersecurity as the environment becomes more challenging. A high level of composability would help an enterprise recover faster and potentially even minimize the effects of a cybersecurity incident.” 

Zscaler’s Product Leadership

Zscaler has been successful in capturing the cybersecurity growth trend with evidence the growth can sustain post-Covid. This is key as Covid was a major catalyst as Zero Trust began to replace VPNs. Although employees are returning to the office, the hybrid nature of work will persist, which means companies will face challenges in protecting their network since most of the information is stored in the cloud and the applications are SaaS-based. 

Companies have realized that VPNs and firewalls are no longer safe, and the majority of them are adopting Zero Trust Security. The main reason is allowing remote workers to access through a VPN makes it easier for attackers to gain access through the internet to the company’s networks and gain access to data points. This can be efficiently tackled only by Zero Trust Security which is built on the premise that no one should be trusted within or outside the network.

The company has a large serviceable market of $72 billion. The company is benefiting from the shift from traditional cybersecurity solutions to cloud-based Zero Architecture. The Internet of Things and remote working has further increased the long-term opportunity for the company. 

Source: Company PresentationCompany Presentation

Zero Trust Product Leadership

Zscaler primarily protects cloud workloads by controlling access through implementing policy-based access and interconnects for a company’s data centers, cloud infrastructure, software and third-party services. Zscaler is cloud native and its growth is related to growth in cloud migrations. SASE and zero-trust became especially important during the hybrid work-from-home rush that occurred during Covid. 

The company offers the following products, Zscaler Internet Access (ZIA), Zscaler Private Access (ZPA), Zscaler Digital Experience (ZDX), and Zscaler Cloud Protection (ZCP). The company offers the flexibility for its customers to purchase products separately, which allows for flexibility in pricing.

ZIA is a security stack that offers reliable access to the internet and apps regardless of their location. ZIA is suited for connecting to external apps like Zoom or Office 365. Since it goes to third-party applications and the public internet, all the traffic is inspected so that no malware attacks occur and the data is secure. 

ZPA provides secure access to internal applications that are hosted in data centers or in private/public clouds. ZPA offers secure private app access to its users across all locations with the company’s Zero Trust Network Access (ZTNA) platform. The main advantage is that the apps are not exposed to the internet, limiting external cyber-attacks. 

Traditional network performance analysis tools have become obsolete due to the applications moving to the cloud and users being in various locations. Previously, enterprises used to own the network and the applications used to run in their own data centers to identify any issues efficiently. ZDX solves this problem in the modern cloud environment since it helps companies know exactly where the issues lie and how many users are affected.

The company is a leader in the Zero Trust Platform, particularly in the Security Service Edge in the Gartner Magic Quadrant which can be seen in the graph below. The company’s demand for products remains strong, evident from the large multi-year contracts signed by the company. In the recent earnings call, the management mentioned they witnessed solid growth in $1 million annual contract value deals broadly across business verticals and geographies. The remaining performance obligation (RPO) grew by 83% YoY to $2.21 billion, indicating future revenue for the company. 

Source: Company PresentationCompany Presentation

Zscaler has a strong base of growing enterprise customers. The company also has been able to increase the number of Global 2000 customers. In the last two quarters alone, the company added 80 Global 2000 customers. It currently has 30% of the Global 2000 companies and 40% of Fortune 500 companies as its customers. 

The company has been able to upsell its products which is evident with the company maintaining the dollar-based net retention rate of over 125% for the sixth consecutive quarter. The company had 288 customers in the recent quarter with annual recurring revenue (ARR) of over $1 million, up 77% YoY.

How is Zscaler Different?

Zscaler management is often asked how the company is different from its competitors. The main thing Zscaler accomplishes when competing against more legacy virtual private network (VPN) offerings is they are able to replace global load balancers, DDoS protection, external firewalls, intrusion prevention system (IPS) and also VPNs. Hackers use numerous attack vectors and Zero Trust is a solid replacement for VPN systems because it aggregates the appliances while broadening the protection. 

One way that Zscaler offers enhanced protection for the attack surface is that nothing sits between Zscaler Private Access and the applications and workloads. Rather than build a VPN replacement, the company has extended ZPA to include browser isolation, app protection, interior deception and EIM based policy. This equates to Zscaler offering the widest and deepest coverage.

Secondly, attackers have a hard time finding where to attack with Zscaler’s Zero Trust architecture because the products act like a shield with the applications hiding behind Zscaler. The company’s proxy architecture scales rapidly as applications and workloads scale rapid. The CEO has said “[Zscaler] scales like nothing else out there.”

Regarding CDNs such as Cloudflare entering the market, Zscaler’s response in the earnings call is that it will take a long time for a CDN and DDoS provider that is focused on servers to catch up to the best-of-breed, singular focus Zscaler has. “We start focusing on users to start with. It takes a lot of time and experience to build our richness and breadth of functionality we have built with ZIA, ZPA and associated functionality. I think it will take a long, long time for someone to try to catch us. And we are setting. We are innovating at a very fast pace.”

With that said, certainly Cloudflare aggregates many products under its umbrella and does well on Zero Trust against more VPN-related solutions. 

Notably, Zscaler is moving into machine learning-based cybersecurity. Zscaler processes more than 240 billion transactions per day and the company’s AI/ML models can block many types of known threats in real-time before the endpoint delivery. They are also designed to identify unknown phishing webpages before they appear in the end user’s browser. This proactive approach was not possible with traditional cyber security solution providers.

Financials

The company continued to deliver strong revenue growth. Revenue accelerated by 63% YoY to $286.8 million in the recent quarter. This is the seventh consecutive quarter of above 50% growth. The growth was led by strong adoption of the company’s Zero Trust Platform, as discussed above. The management expects revenue to grow 55% at the mid-point of the guidance in the Q4 FY2022 ending July. 

Source: YCharts

The company’s key metrics are growing, indicating that growth is expected to continue. The remaining performance obligation grew by 83% YoY to $2.21 billion. The company’s billings grew by 54% YoY to $346 million.  

The company reported GAAP operating margin of -30% compared to -25% in Q3 FY2021. The rise in operating expenses is partly due to the return of travel expenses which was absent during the Covid lockdowns. The company’s adjusted operating margin was 9% compared to 13% in the same period last year. The difference in GAAP and non-GAAP operating margins is primarily due to the stock-based compensation. The management mentioned in the earnings call that it should come down as a percentage of total revenue over a period of time. Recently, the market has been concerned about companies using high stock-based compensation, so this is a risk to watch in the coming quarters.

The company reported a net loss of $101.4 million compared to a net loss of $58.5 million in Q3 FY2021. The adjusted net income was $24.7 million compared to $21.4 million in the same period last year. 

The company has strong cash flow. In the recent quarter, the free cash flow margin was 15%, and the management expects it to be 20% for the full year. 

Conclusion

The strong revenue growth has given the company a premium valuation. The stock is currently trading at a P/S ratio of 22 with year ending in July and forward one-year P/S ratio of 15. The company is not without GAAP losses yet adjusted operating margin and cash flow margin helps offset profitability concerns. 

We had discussed cybersecurity being strong this quarter going into Q2 2022 with our Quarterly Webinar presentation and the current earnings season supports this prediction. Primarily, the cybersecurity sector is insulated from supply issues (which we do expect to ease eventually) and also is a #1 must-have in budgets, per the many CISO and C-suite surveys published by multiple third-party consultants. 

Undoubtedly, cybersecurity was the strongest category in tech this past earnings season and Zscaler was one of handful that put up a strong report.