This article was originally published on Forbes on May 13, 2022,01:26pm EDTpublished on Forbes on May 13, 2022,01:26pm EDT
This year, cloud investors have been given a dose of reality on how the market prices growth in this category. For Cloudflare, revenue growth is not an issue at this time. Yet, revenue growth is less meaningful in the current macro environment if the growth does not translate to a healthier bottom line.
It’s true that cloud is deflationary, which is why companies in this sector may continue to see growth during times of inflation. Yet it’s also true that cash is becoming more expensive, and therefore growth must be balanced with a stronger bottom line.
Product Overview
Cloudflare has a formidable customer base and owns the predominant share of the Content Delivery Network market. According to the data from W3Techs, 81% of the websites that use CDN or reverse proxy rely on Cloudflare with a strong presence in small to medium-sized businesses (SMBs).
We had discussed in a podcast on tech stocks last year that Cloudflare is strong in the small to medium-sized business (SMB) category and offers free entry-level services. The company benefits by converting the free customer base to paid services, and it can also use the free customer base to test any new features before they are launched. Cloudflare has been able to upsell its products with a dollar-based net retention rate that increased by 400 basis points YoY to 127% in the recent quarter.
Zero Trust Security is gaining prominence due to rising security threats as the data is not stored in one place. Secure access service edge (SASE) is a cybersecurity concept that utilizes Zero Trust to identify users and devices to deliver secure access to specific applications or data.
Cloudflare One is the company’s flagship Zero Trust network-as-a-service. The need for this has grown due to remote teams as SASE allows policy-based security no matter where the user, application or device is located. 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.
Zero Trust has helped the company to increase its Total Addressable Market from $32 billion in 2018 to about $100 billion in 2024. The company is playing a major role in the transition from a traditional hardware-based security approach to modern zero-trust security.
In late September, Cloudflare company announced its R2 storage product. You can see the dark purple line start a sharp rise upward following the start of October. R2 storage allows unstructured data to be stored without egress bandwidth fees, which are charged when developers retrieve data from a cloud provider like AWS. The egress fees are essentially a tax without any value. Markups are as high as 7900% in the United States region when calculating what AWS charges. This is an 80X bandwidth markup and was detailed here by Cloudflare’s management.
Primarily, Cloudflare is hoping to attract developers for its Workers product, which is a serverless compute service for developers to build applications and deploy code at the edge. This removes the need for developers to maintain servers or spin-up containers. The cloud service provider (in this case, Cloudflare) provisions, scales and manages the infrastructure required to run the code. Cloudflare wants developers to choose them over the larger cloud providers because of their location at the edge.
Cloudflare’s Q1 Earnings
At the time the low-cost R2 cloud storage service was launched, Cloudflare’s CEO has stated “we’re aiming to become the fourth major public cloud.” Big Tech has the advantage of strong margins and quite a bit of cash on the balance sheet to build out cloud infrastructure. For this ambition to materialize, not only must Cloudflare build more Points of Presence (PoPs) but the company must also undercut AWS on egress fees, for example, in order to remain competitive.
In the current quarter, network capex was 9% of revenue. For the full year, the network capex is expected to increase to 12% to 14% of revenue. I believe this is a primary reason Cloudflare’s valuation could come under pressure.
I think the thing which is powerful about as we build out more POPs is that counterintuitively, because of the design of our network and because of the efficiency of our network that both Thomas and I just alluded to, it actually drives our cost down over time rather than driving it up. It takes a certain amount of servers in order to process a certain number of requests. So your CapEx is actually driven by the amount of usage of your service more than anything else.
What is powerful is because we have done the hard work on the networking and software side to make it so that any server, anywhere can handle any request, that means that as we continue to expand our network out that we're able to directly interconnect with the various ISPs and eyeball networks around the world and drive our cost down for things like bandwidth, co-location and other variable costs that are part of our business.
At this time, revenue growth is not an issue for Cloudflare as it’s been quite robust for many quarters. The company reported 54% revenue growth beating estimates by 6% with 49% growth expected next quarter. The company raised full year revenue guidance to $957 million, at the mid-range, for growth of 46%.
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There is additional supporting evidence that growth will not be an issue for Cloudflare, including remaining performance obligations (RPO) up 57% year-over-year and dollar based net retention up 400 bps YoY. Customers paying over $100K increased 63% year-over-year to 1,537. This outpaced total customer growth of 29%. Notably, the >$100K segment was a deceleration from 71% in the previous two quarters.
Large customers contributed 58% of revenue. There was solid growth in the >$500K customer base of 68% year-over-year growth and >$1 million customer base grew by 72% year-over-year.
The company has a gross margin of 77.80% but had a GAAP operating margin of (18.90%) and adjusted operating margin of 2.30%. The primary difference being stock based compensation which doubled to $34 million in Q1, up from $18 million in the year-ago quarter.
Similar to the note about network capex, the company is stating they will not see improvement to operating margin in the near term. I believe this could put pressure on valuation if cloud peers are able to improve operating margin during the current macro environment.
Here is what management said:
“We intend to grow our operating expenses in line with the revenue staying here or at breakeven and reinvest excess profitability back into the business to address the enormous opportunity in front of us.”We intend to grow our operating expenses in line with the revenue staying here or at breakeven and reinvest excess profitability back into the business to address the enormous opportunity in front of us.”
Free cash flow was negative $64.4 million (30% of revenue) in comparison to a negative $2.2 million (2% of revenue) in Q1 2021. Of this, $30 million was due to a unique withholding tax payment in the recent quarter. This would still show a marked decline in free cash flow from last quarter during a time when the market is especially sensitive to cash flows. The company reported positive free cash flow of $8.6 million in Q4 2021, and it was the first positive free cash flow quarter since the company became a public company. Management stated they will be cash flow positive in the second half of the year while the first half of the year will have negative free cash flow due to the investment in network and redesigning of physical offices post Covid-19.
The company had cash and available-for-sale securities of about $1.7 billion, out of which cash is $152 million.
Conclusion:
Cloudflare is showing strong customer growth and its steady revenue growth also helps substantiate that cloud is, indeed, deflationary. What is likely weighing on the market’s mind is what the CapEx will be to become the fourth cloud provider. Management has confirmed that operating margin will not improve anytime soon as the company plans to re-invest and the company’s recent quarter showed a decline in free cash flow. The I/O Fund exited the stock based to focus on higher conviction companies that have a better cash flow margin.
Maintaining focus can be really tough when the market is penalizing tech stocks across the board. How do we determine which ones to trim/exit and which ones to add/enter? Despite it being counterintuitive, usually the best entries are made when the market is in a state of fear.
My first instinct is to protect our stocks with the highest allocations with a few of these certainly in the cloud category. I am less concerned with near-term price action and much more concerned with how the fundamentals mesh with the current macro environment. If a company has a strong report (AMD, Datadog) then I don’t stress market moves as fundamentally these companies are showing strength. It’s not an investor’s job to control the market or change positions based on 6-month price action. That’s why we haven’t changed positions such as AMD or Datadog. I’m using them as an example because they already reported.
The I/O Fund is positioned for an ad-tech rebound in H2. We’ve published quite a bit on this. We understand this requires a bit of speculation and we have been keeping our members up to date on this over the past few months with this research here and here. Ultimately, ad-tech valuations are well below the median in 2018 and 2019.
Strong growth in ad-tech is often awarded a 10 Forward EV to Revenues. The bottom line can fluctuate depending on how much a company is investing in growth, yet rarely does ad-tech have cash flow issues at scale. Snap and Roku are certainly at the scale where the path to profitability has been proven. Ultimately, we believe there is alpha here due to the market over-reacting to macro which is why we own ad-tech positions. There are many more ad-tech positions than the ones we own for investors to consider.
This analysis goes over cloud as what happened last Friday to Bill and Cloudflare caused me to shelf a deep dive on ad-tech post-earnings in favor of a cloud overview of our holdings. Many cloud companies have not been public during a rising rate environment (2017- early 2019). With the FOMC decisions being out of a tech investor's control, we have been forced to evaluate our cloud stocks to look for expanding margins and positive cash flow. There was some evidence last week that the market’s appetite for growth in this category has changed if the growth doesn’t contribute to the bottom line. I understand there is a relief rally today but my job this week has been to make sure fundamentally our cloud stocks can withstand macro pressure.
It’s true that cloud is deflationary but it’s also true that cloud can have profitability issues. As you saw last Friday, cloud is quite resilient in terms of growth, due to being deflationary, but those weak bottom lines may be questioned over time. Cash came easy over the past decade, and as cloud investors, we need to reframe our thinking on what constitutes an attractive cloud stock.
For long-term cloud investors that hold sizable allocations, like the I/O Fund does, I believe the following has to be answered:
1. Is there something inherent to the product that weighs on margins? If so, these companies have an additional hurdle beyond rising rates that must be resolved.
Cloudflare could fall into this category due to CapEx (something to monitor – we closed this position for now). The CapEx went from 9% in the current quarter to 12% to 14% for the year, and the market is likely assessing the cost it requires to become the fourth cloud provider.
Twilio falls into this category until Segment and other products can improve its core product gross margin (I believe it will and we will layer back in when it does). I expand on this more below.
2. GAAP operating margin versus Non-GAAP operating margin; this is where stock based compensation can affect a company’s GAAP profitability and companies that recently went public or had an acquisition often see an impact. There are also many cloud companies that invest their cash to grow rapidly, yet the leniency for “growth at any cost” may shift substantially.
3. Free cash flow is probably the most important in a rising rate environment for a sector that is often unprofitable and/or must spend heavily for growth. Below, we examine our top cloud holdings on the basis of their ability to become free cash flow positive.We need to recognize that the innovation cycle is such that venture capitalists exit through public offerings and there is often no path to profitability at the time a tech companies goes public. When you couple the historically loose FED policy we’ve had, it compounds the issue of figuring out which companies can become profitable and sustain in a slowing economy. Cloud will be put to the test the longer interest rates remain elevated and/or slated to rise, and I believe this will catch tech investors off guard because the sector has treated them so well. These relief rallies also do not help to distinguish which are fundamentally stronger as the price action reflects more of a rising of all boats.
Our Cloud Stocks
SentinelOne
SentinelOne is a company where we like the product very much. However, there is no denying that this company has weak margins albeit the margins are improving quite rapidly.
SentinelOne leads the cloud category in growth at 120% last quarter. In the previous quarter, SentinelOne accelerated to 128%, up from 121%. The company is expected to report $74.7 million in revenue for growth of 99.5%, assuming they come in at this number, that would be a deceleration in revenue.
Full year revenue is expected to be $370 million, up 80%. The 1-year forward for fiscal year 2024 ending in January is expected to be $605 million, up 64%. The main key metric that forecasts strong revenue growth is that ARR was up 123% year-over-year. This is a highlight from the last earnings report.
SentinelOne has a particularly weak operating margin of (108%) last quarter. The adjusted operating margin was at (66%) compared to (104%). The management guided for (85%) this quarter. The company emphasized this is improving with a full year adjusted operating margin guide of (55%) to (60%) for full year.
I believe this improvement in the guide is why the stock recovered after hours the evening of its earnings report. Will SentinelOne be able to provide a meet/beat on operating margin in the upcoming quarter and a meet/beat for the full year guide? This must happen and we also need revenue to remain strong.
We covered here in the Q2 2022 webinar how cybersecurity budgets are indicated to grow this year over 2021.
Management seemed to be quite sensitive to understanding this is key as it was the second thing they mentioned in the opening remarks:
I'm pleased to share that we ended the fourth quarter with double-digit year-over-year improvement in both our gross and operating margins. Our gross margins expanded 12 percentage points year-over-year, and our operating margin improved 38%. This progress reflects our growing scale and increasing efficiency.
The number of shares owned by institutions and the percentage of shares owned by institutions is also high at 92% (compared to Cloudflare at 80%). However, the number of institutions has declined by about 13%.
For SentinelOne, weighing on operating margin is also sales and marketing expenses at 64% of revenue and R&D at 65% of revenue. Compare this to Crowdstrike with S&M at 38% of revenue and R&D at 24% of revenue. To be clear, Crowdstrike has a better bottom line than SentinelOne. The operating margin has been at (10%) over the past few quarters and is at (5%) in the most recent quarter.
SentinelOne’s free cash flow has been improving but certainly needs work, which is common for a company that has not reached scale. The company reports cash flow of ($7.1) million improving from ($25.6) million in the same period last year.
SentinelOne has $1.67B in cash and the company burns about $400M so that’s three years. If we assume the margins improve, and the company reaches profitability by 2025 (analyst consensus believes this will happen) then the negative free cash flow should not hinder the stock. We had discussed why SentinelOne is similar to Crowdstrike at this stage of growth here.
Notably, last year, SentinelOne was weakest in Q1 and they’ve mentioned strong seasonality in Q4.
“The strength of our performance was broad-based, coming from a healthy mix of new customer additions, existing customer renewals and upsells. All of this was further magnified by the strong underlying seasonality of our fourth quarter.”All of this was further magnified by the strong underlying seasonality of our fourth quarter.”
Here was their comment about the upcoming Q1 quarter:
“Our ARR and revenue growth track very closely. Our revenue guidance for Q1 implies that we should be at or better than typical Q1 net new ARR seasonality, which has been down between 25% to 35% sequentially in the past 2 years.”
Here was our comment about Q1 following the last earnings report:
“Total ARR is nearing $300 million while annual revenue for the upcoming fiscal year 2023 is guided at $368 million, with ARR suggesting this guide could be easily met over the next four quarters. Most importantly, customers over the $100K range are growing at a rate that is double overall customer growth at 137% and 70%, respectively.
The overall customer growth represents a slowdown from 79% YoY to 70% YoY while larger account growth was fairly flat at 141% in Q3 to 137% in Q4.
The company guided for Q1 revenue of $74.5 million, compared to revenue in Q4 of $65.6 million. This is important because management has stated in the past, Q1 revenue was down sequentially by 20% to 25%. “Our revenue guidance for Q1 implies that we should be at or better than typical Q1 net new ARR seasonality, which has been down between 25% to 35% sequentially in the past 2 years.”
Notably, the I/O Fund is unable to track where the ARR was down “for the past 2 years” but the sequential growth is headed in the right direction. The numbers we have show Q1 FY2021, net new ARR declined 37% QoQ to $8 million yet in Q1 FY2022 it grew +8% QoQ to $30 million. This year, the sequential growth will be +13.5%.
Higher ARR sequentially for the upcoming Q1 is likely driven by the record number of 100,000-plus deal and a record number of million-dollar plus deals. International is another area of strength as the company saw revenue grow 140%. This represents 31% of revenue – so something to watch closely as a near-term driver.”
Takeaway: No changes to our position right now, if there is a meaningful change to operating margin, we will update you.
MongoDB
MongoDB had an acceleration in revenue from 50.1% in Q3 to 55.85% in Q4. The market rewarded this earnings report with an increase in price, moving from $280 to $338 on the report. At the beginning of April, the stock price was nearly flat YTD.
There was an acceleration in revenue for FY2022 to 48% year-over-year, up from 40% growth in FY2021. Looking forward, FY2023 revenue growth is expected to be 35% year-over-year.
Key metrics supporting future revenue growth include customers over $1 million in ARR growing 67% and customers over $100,000 growing 34%. Atlas customers outpaced total customer growth at 35% compared to 33% growth, respectively.
MongoDB has a 72% gross margin and GAAP operating margin of (29%) due to stock-based compensation, or a loss of $78.6 million. The adjusted operating margin is (0.49%) or essentially a loss of $1.3 million. The net margin is (32%) or a loss of $84.4 million with adjusted net margin of (2%), or a loss of $6.3 million.
With that said, MongoDB is cash flow positive. It needs to remain cash flow positive for the market to be confident in its valuation. I do believe where Cloudflare was penalized was the surprise to the downside in cash flow. This is a marked change to how the market treated cloud companies in the past.
MongoDB has $474 million cash on its balance sheet with operating cash flow of $22.3 million and free cash flow of $16.8 million. This represents a free cash flow margin of positive +6%. The company holds $1.2 billion in debt.
The difference between MongoDB’s GAAP EPS and Non-GAAP EPS is primarily due to SBC. Here we have a forward GAAP EPS of ($1.22) and Adjusted EPS of ($0.10). Overall, MongoDB has improved it’s adjusted EPS as it was typically in the ($0.20) range.
MongoDB’s catalyst for growth is Atlas, which we covered in a deep dive here. We also covered how this company fits into our Big Data and Analytics positioning here. We are more likely to hold a cloud stock that falls into the Big Data theme and/or cybersecurity due to seeing evidence of growth in these markets. Primarily, Microsoft pointed towards the following trends in the recent earnings report, which we covered here:
Starting in September, we began to position for Big Data, Analytics and ML. Microsoft has grown their Cosmos database (DB) transactions and data volume by 100% year-over-year for the third quarter in a row. Synapse data volume has also doubled. Monthly machine learning inference requests increased 86% year-over-year. for Big Data, Analytics and ML. Microsoft has grown their Cosmos database (DB) transactions and data volume by 100% year-over-year for the third quarter in a row. Synapse data volume has also doubled. Monthly machine learning inference requests increased 86% year-over-year.
As stated above, MongoDB’s cash flow margin is what can keep the stock strong given stock based compensation is weighing on GAAP operating margin. We want a meet/beat on revenue, strong Atlas growth (bonus for acceleration) and we must continue to have a healthy, positive cash flow margin.
Analyst consensus has MongoDB reaching profitability on an adjusted basis by calendar year 2023.
Snowflake
Snowflake is seeing a deceleration in revenue yet is reaching adjusted profitability this year.
The company is expected to report revenue of $412 million, representing growth of 80%. The previous quarters the company reported revenue growth of 101% in Q4, 109% in Q3, and 104% in Q2. For the fiscal year 2023 ending in January, the company is expecting revenue growth of 67% for revenue of $2.03 billion. Analyst consensus shows revenue of $3.17 billion, or growth of 56% for fiscal year 2024.
There has been an outflow of institutional shares since December with a 30-day change from 330 million shares to 305 million shares.
As Snowflake continues to grow revenue, the losses are narrowing. When the company reported roughly $300 million revenue, the GAAP operating losses were around $200 million. The company is now reporting a little over $400 million in revenue with GAAP operating losses of about $150 million. What you don’t want in this environment is an inverse relationship to where losses increase as revenue increases.
Snowflake is steadily improving its margins from 58% gross margin a year ago to 65% gross margin in the recent quarter. The company has improved its GAAP operating margin from (90%) a year ago to (40%) in the recent quarter. The company has a positive adjusted operating margin of 5% and has stated they will end the year with a positive 1% adjusted operating margin. They have to deliver on this promise to maintain a category-high valuation.
Revenue grew 64% to $126 million and customers over $100K grew 41%. Analyst consensus on revenue was for $127.4 million. The company reported EPS of (0.19) and analysts were looking for (0.20).
However, free cash flow for Confluent is a blemish at ($58.4) million, or 46% of revenue. Adjusted operating margins are at (41%) and GAAP operating losses of (88.4%). Adjusted gross margin is 69.7% with employee bonuses and employee stock purchase plans hurting the operating margin. FCF is to be the lowest in Q1.
Confluent has cash and marketable securities of $2.0 billion with cash of $1.05 billion.
Adjusted operating margin is expected to be (38%) on revenue growth of 44% for FY 2022.
We all know how the market feels about those margins right now – Confluent was not alone in the AH bloodbath.
On a positive note, Confluent Cloud is ripping at 180% YoY growth. This has led to RPO accelerating to 96% YoY. The company signed an 8-figure deal that was not recognized in Q1. Cloud net retention rate is 150%.
Analysts on the call were excited about the net new add in customers and the company reiterated its goal of positive FY2023 operating margin.
Note: We believe the negative free cash flow margin is too steep for Confluent to be a high conviction company at this time. We very much like the Confluent Cloud growth and will look for the more normalized growth rate once it scales. If Knox asked me where to raise cash in cloud, I would choose Confluent although we do not have all earnings reports yet.
Datadog was down after putting up a solid report and we bought a small tranche following the earnings report.
The company beat and raised on all accounts. Customers over $100K grew were up 54%, growing from 80% of revenue to 85% of revenue. The company also said the magic words: “36% free cash flow margin” in Q1 with a TTM cash flow margin of 28%. Free cash flow (FCF) grew from $250 million in Q4 to $335 million in Q1.
The company was expected to report 70% revenue growth and instead reported 83%, with revenue up 11% sequentially. Guidance also impressed at $378 million at the midpoint, or 62% growth. That should be enough to keep Datadog in the top 5 on forward growth in the cloud category. FY2022 guidance raised to $1.61 billion for growth of 56.4% at the midpoint, up from $1.53 billion.
They said the other magic words which is that “dollar based net retention rate continued to be over 130% as customers increased their usage and adopted newer products.” During covid, this DBNRR wouldn’t be as meaningful as many cloud companies were at the 130 mark but Datadog proving itself best-of-breed here by maintaining this level for 19 consecutive quarters.
Datadog’s strength is cross-selling or standardization, which we’ve covered in detail. Number of customers using 2 or more products increased to 81%. The company signed its largest contract in terms of ARR (they said it was 8-figures with a next-gen fintech company). There were examples on the call of customers consolidating monitoring tools from 5 products to 10, and from 1 product to 6.
Notably, on top of accelerating revenue growth YoY from 51% in Q1 last year to 83% in Q1 this year, Datadog also improved operating margin from 10% to 23% in the current quarter.
Note: Datadog is the strongest cloud company on the market if you look at the relationship between the top line and the bottom line.
Twilio
We covered Twilio pre-earnings here and also post-earnings here on the forum. We ultimately trimmed our position due to the reason stated post-earnings: “Analysts asked if increased costs in core product could affect gross margin and/or user fall-off. This comment is probably the most concerning to me. Lots of questions on Gross Margin, which the main concern being any fluctuations here if there's pricing pressure from telcos.”
Ultimately, we will layer back into Twilio when we see the software business help to sustain the gross margin.
Here is what was asked on the call:
Michael TurrinMichael Turrin
Gross margin saw a meaningful improvement sequentially. The prepared remarks still referenced just some near-term fluctuation potential. Just in sort of adding some more context around that. I guess the question is just why wouldn't that be at least somewhat bottoming if we're looking at sort of a point in time where U.S. growth is moderating? Some of these 10DLC impacts are playing through. Are you at all comfortable that gross margin can at least remain around a similar ZIP code regardless of our messaging mix plays through? Or anything else you could just provide to help us think through normalization of what these fluctuations can look like?. I guess the question is just why wouldn't that be at least somewhat bottoming if we're looking at sort of a point in time where U.S. growth is moderating? Some of these 10DLC impacts are playing through. Are you at all comfortable that gross margin can at least remain around a similar ZIP code regardless of our messaging mix plays through? Or anything else you could just provide to help us think through normalization of what these fluctuations can look like?
Khozema ShipchandlerKhozema Shipchandler
Yes. That's a good question. I mean I think with respect to the gross margins in Q1, we are obviously happy with them improving to 53%. I think, Michael, the thing I'd encourage you to keep in mind is that just the size and scale of our messaging business is what tends to drive it. And so that's why we're kind of signaling some level of fluctuation in gross margins in the near term. I think it'll be in the ZIP code. I mean I'm not going to be prepared to call the bottom or anything like that. But I'd also remind you that we like the messaging business a lot. And while it does carry that lower gross margin, it also generates a lot of gross profits that we reinvest back into the business.And so that's why we're kind of signaling some level of fluctuation in gross margins in the near term. I think it'll be in the ZIP code. I mean I'm not going to be prepared to call the bottom or anything like that. But I'd also remind you that we like the messaging business a lot. And while it does carry that lower gross margin, it also generates a lot of gross profits that we reinvest back into the business.
If you go back to Q1 of 2020, Twilio’s growth rate in customers was about 23.5% from 190K customers to 235K customers. The most recent year-over-year growth was 14% from 235K customers to 268K customers. The company does not break out the growth rate but the presentations provide number of customers. This would imply some churn due to increased fees passed onto customers on the core product.
In terms of margins, the company guidance missed expectations at adjusted EPS of ($0.23) to ($0.20) compared to consensus of ($0.13). The forward growth of 27%-29% is to be expected during this pivot. I want to emphasize the management has been preparing for the core product to hit saturation essentially which is why we want to remain invested to participate in this management team bringing API-driven marketing to marketing departments. Twilio certainly is consumer-facing and thus what we are seeing with ad-tech affects Twilio, as well. This is unique from more deflationary cloud products at the enterprise-level.
Cloudflare
We covered Cloudflare this week for the free newsletter, which will hit your inboxes soon. The stock hit our stop and here is the main thing that drove our decision on fundamentals.
At the time the low-cost R2 cloud storage service was launched, Cloudflare’s CEO has stated “we’re aiming to become the fourth major public cloud.” Big Tech has the advantage of strong margins and quite a bit of cash on the balance sheet to build out cloud infrastructure. For this ambition to materialize, not only must Cloudflare build more Points of Presence (PoPs) but the company must also undercut AWS on egress fees, for example, in order to remain competitive.
In the current quarter, network capex was 9% of revenue. For the full year, the network capex is expected to increase to 12% to 14% of revenue. I believe this is a primary reason Cloudflare’s valuation could come under pressure.
Here is what the company said on the call:
I think the thing which is powerful about as we build out more POPs is that counterintuitively, because of the design of our network and because of the efficiency of our network that both Thomas and I just alluded to, it actually drives our cost down over time rather than driving it up. It takes a certain amount of servers in order to process a certain number of requests. So your CapEx is actually driven by the amount of usage of your service more than anything else.
What is powerful is because we have done the hard work on the networking and software side to make it so that any server, anywhere can handle any request, that means that as we continue to expand our network out that we're able to directly interconnect with the various ISPs and eyeball networks around the world and drive our cost down for things like bandwidth, co-location and other variable costs that are part of our business.
At this time, revenue growth is not an issue for Cloudflare as it’s been quite robust for many quarters. The company reported 54% revenue growth beating estimates by 6% with 49% growth expected next quarter. The company raised full year revenue guidance to $957 million, at the mid-range, for growth of 46%.
There is additional supporting evidence that growth is not an issue for Cloudflare, including remaining performance obligations (RPO) up 57% year-over-year and dollar based net retention up 400 bps YoY. Customers paying over $100K increased 63% year-over-year to 1,537. This outpaced total customer growth of 29%. Notably, the >$100K segment was a deceleration from 71% in the previous two quarters.
Large customers contributed 58% of revenue. There was solid growth in the >$500K customer base of 68% year-over-year growth and >$1 million customer base grew by 72% year-over-year.
The company has a gross margin of 77.80% but had a GAAP operating margin of (18.90%) and adjusted operating margin of 2.30%. The primary difference being stock based compensation which doubled to $34 million in Q1, up from $18 million in the year-ago quarter. The market has not been very friendly to companies diluting GAAP operating margins due to SBC, and we see evidence this may have impacted Cloudflare.
Similar to the note about network capex, the company is stating they will not see improvement to operating margin in the near term. I believe this could put pressure on valuation if cloud peers are able to improve operating margin during the current macro environment.
Here is what management said:
“We intend to grow our operating expenses in line with the revenue staying here or at breakeven and reinvest excess profitability back into the business to address the enormous opportunity in front of us.”We intend to grow our operating expenses in line with the revenue staying here or at breakeven and reinvest excess profitability back into the business to address the enormous opportunity in front of us.”
Free cash flow was negative $64.4 million (30% of revenue) in comparison to a negative $2.2 million (2% of revenue) in Q1 2021. Of this, $30 million was due to a unique withholding tax payment in the recent quarter. This would still show a marked decline in free cash flow from last quarter during a time when the market is especially sensitive to cash flows. The company reported positive free cash flow of $8.6 million in Q4 2021, and it was the first positive free cash flow quarter since the company became a public company. Management stated they will be cash flow positive in the second half of the year while the first half of the year will have negative free cash flow due to the investment in network and redesigning of physical offices post Covid-19.
The company had cash and available-for-sale securities of about $1.7 billion, out of which cash is $152 million.
Clearly, many investors like Cloudflare and the company is not without merit by any means. Rather, I can’t rely on cash flow improving in H2 and/or CapEx not rising beyond the current 12% to 14% to personally maintain conviction in the current environment.
For costs inherent to the product, my personal choice is Twilio as I can see the product road map a bit more clearly on Segment/software side and how this can expand the company’s gross margin.
Asana
Please note, Asana is a small 1% position and we covered the company’s financials here and the unexpected rise in expenses. We will update you on the next earnings report. We hold the stock because the product should be deflationary (more than most).
We are eyeing a LTBH position for Microsoft. As many of you remember, we’ve owned Microsoft in the past following a spree of analysis published in 2018-2019.
In our latest Q2 webinar, I discussed why reducing cloud costs is a key trend for 2022 and beyond. Most investors on our site agree that cloud is a critical trend to have in a portfolio as it increases productivity and reduces costs. This is especially true for software-as-a-service whereas cloud infrastructure as-a-service does not always result in lower costs compared to on-premise servers.
The overall cost savings and/or overhead can often rely on the size of company, where it’s a no-brainer for startups to rent servers as they don’t have the budget to own servers and manage an IT department. However, we’ve pointed out in an analysis and on our webinar that companies of Dropbox, Asana or Datadog’s size are seeing a hit to their margins. If you add up the cloud infrastructure, platforms and software costs across a company, it can often become costly to manage and deploy a full cloud stack.
To put it simply, Sayta Nadella said in yesterday’s call: “More value for less price means you win.” In the same breath, he also said: “Most businesses are not looking to their IT budgets or to digital transformation for budget cuts.” These two statements echo my first point in the webinar which is that both are true: increase in cloud spending and wanting to lower costs. This is differentiated from budget cuts, such as headcount. Most importantly, our slides showed that despite Gartner’s forecast for 2020-2021 shifting by $100 billion to what became actual spend (or essentially a pull forward). Pull forward might not be the right term, however, as cloud growth is not slowing down as a result, instead it’s predicted to be a tick higher from 2019 to 2022, if we remove the anomalous 2020-2021.
Therefore, we wanted to emphasize that the trend towards reducing costs should not be confused as being prohibitive to the trend for cloud adoption, rather, it can offer investors an edge if they identify what companies serve both needs.
As you can see from our portfolio, we are best-of-breed investors and I do not believe Microsoft is a best-of-breed company, rather they aggregate cloud services to help drive down costs. This is especially attractive for the Fortune 500 whereas startups, SMBs and mid-sized enterprises are likely to seek out and manage a larger portfolio of cloud services from various vendors. We can easily evidence this by Microsoft’s Fortune 500 penetration with 95% using Azure, which was achieved through hybrid computing where Microsoft was first-to-market on serving a mix of on-premise, private and public clouds for their large enterprise customers. Secondly, as this analysis is about, Microsoft is undercutting other services on price to win the aggregate, long-term contract.
Microsoft is using the term Tier 1 workloads to not exclude those outside of the Fortune 500, and the company stated the following in terms of deal size: “The number of $100 million-plus Azure deals more than doubled year-over-year. “
As stated on the I/O Fund Wire, Azure growth of 46% is performing quite well given the tough comps it has overcome, and Microsoft’s best financial metric during this tech selloff is that commercial bookings increased 28% this quarter following 32% increase last quarter. I would look for Azure to remain elevated against AWS and Google Cloud for those two reasons – hybrid cloud leader which attracts large enterprises and its ability to reduce costs with its tech stack.
Despite overall revenue softening from 20% to 18%, Azure remained flat at 46%. This is quite remarkable considering Azure has overcome incredible growth over the past two years. Operating income was up 19% and EPS up 9%. The lower overall revenue guide is driven by gaming and Office 365, both expected to be lower by single digits. Azure growth is also guided to be sequentially lower yet Intelligent Cloud is a stronger-than-expected guide at $21.1 billion and $21.3 billion. This is what is meant by the analyst on the call when they stated: “
Starting in September, we began to position for Big Data, Analytics and ML. Microsoft has grown their Cosmos database (DB) transactions and data volume by 100% year-over-year for the third quarter in a row. Synapse data volume has also doubled. Monthly machine learning inference requests increased 86% year-over-year. Takeaway: Let’s hope this translates well for our larger holdings MDB and SNOW, and our placeholder on CFLT. This was also covered in the Q2 2022 webinar.
According to our research, cybersecurity is the top tech vertical for increased spending from 2021 to 2022. Microsoft is increasingly becoming a cybersecurity company, as well, with $15 billion in revenue and growing at a rate of 45%. Microsoft was careful to build a multi-cloud product and is the only Big 3 cloud vendor to be multi-cloud on security right now.
On a side note, not only does Datadog, SentinelOne and Cloudflare participate in cybersecurity here but they also reduce costs through standardization and/or eliminating object storage fees.
Catalysts
There are a few reasons Microsoft can continue to do well, in addition to its proven strategy to onboard large enterprises and lock them in by optimizing workloads for Azure and its broader suite of cloud platforms and services. The first reason is that I believe Microsoft will own the edge. The company is closely partnered with many telecoms and has the most data centers in the world. Another reason is that when more enterprises adopt AI/ML, whether it’s automation, super computers and/or other use cases for training and inference, it will a natural decision to use Microsoft if they’re already optimized for Azure. In other words, Tier 1/Fortune 500 are likely to be the largest customers for AI/ML. Power Automate was up 72% year-over-year, surpassing $2 billion in revenue, although not vendor agnostic like UiPath. Third, the company ranks with Nvidia and Unity for inroads to the Metaverse as it owns many gaming publishers now and is the most widely used VR headset (HoloLens). The company also has Teams to introduce Metaverse-like qualities to business meetings. It will be industrial that drives forward 3D worlds (not consumer) and Microsoft is auspiciously positioned.
These catalysts matter a little less when macro is so tough but worth mentioning as to why investors should look beyond Azure growth when it comes to Microsoft.
The founding team of Apache Kafka worked at LInkedIn before leaving to start Confluent. Apache Kafka is used by thousands of companies for message streaming, such as LinkedIn, where a publish/subscribe model allows applications to share and create data in a serverless and microservices architecture. What Kafka solved for is the ingestion of events data in real-time with low latency.
At the time that Kafka was developed, LinkedIn was ingesting 1 billion events a day. The company is now ingesting 1 trillion per day. Kafka does this through a log that writes messages to a topic and is able to retain messages for a long time. Kafka is also used in stream processing by parallelizing the pipelines. Kafka Streams were built to increase simplicity while retaining the same amount of performance as a Spark streaming job.
As with Spark and other open-source projects, there is a marketplace for making the frameworks easier to use. Confluent Kafka opens up the amount of data that can be integrated, for example, to combine transactional data (orders, inventory) with sentiment-driven data (likes, page clicks). This helps with predictive analytics and also machine learning because the “data flow” allows for algorithms to work as they are intended to. This is what is meant by the title slide of the S-1 filing “Set Data in Motion.” In order for data to be in motion, Confluent’s platform connects data from many different sources.
Note: We first covered Confluent here and there is more additional information in that write-up on Spark, etc.covered Confluent here and there is more additional information in that write-up on Spark, etc.
Confluent created a Community License to help stave off companies like Amazon from commercializing its contributions. The Confluent license is a re-architected cloud-scale Kafka framework that is compatible with and improves on existing Kafka systems. Kafka sits in the middle of data analytics/warehousing and databases, which is technically above the operation layer and below the application layer. Rather than focus on data in rest, Confluent is reimagining what data in motion and in real-time looks like by introducing tools, connectors and a stream processing layer for Kafka workloads.
This is a good quote from the S-1 filing: “It is not just that companies are using more software–in a very real sense, they are actually becoming software.” By becoming more software driven, more businesses will rely on real-time data. Confluent believes that data in rest is not able to meet the current and future demands of software-driven businesses. Daily batch processing and static real-time queries or “point-in-time” queries with stored data lead to an unnecessarily large and tangled architecture that is not capable of data flow between applications.
“I would say there's really no reason you want things to be processed in batch. Like it doesn't — there's nothing in the world that happens batch. Things in the world happen all the time, continuously and in real time” … “I touched on this a little bit in the call, is it's kind of just the digitization of business, like as the actual operation of the business moves into software, not just the analysis, not just the report you get in the morning, but the actual carrying out of the business as it plugs into e-commerce things, as it drives operations out in the world, as IoT bridges into other parts of the world, as machine learning kind of closes the loop on some of the decision-making and processes, that's really where you have to do it.”there's really no reason you want things to be processed in batch. Like it doesn't — there's nothing in the world that happens batch. Things in the world happen all the time, continuously and in real time” … “I touched on this a little bit in the call, is it's kind of just the digitization of business, like as the actual operation of the business moves into software, not just the analysis, not just the report you get in the morning, but the actual carrying out of the business as it plugs into e-commerce things, as it drives operations out in the world, as IoT bridges into other parts of the world, as machine learning kind of closes the loop on some of the decision-making and processes, that's really where you have to do it.”
Big data is more relevant for companies like LinkedIn where Kafka was developed. Big data is not the thesis rather the thesis is the increase in the number of companies that will need real-time data processing and real-time data analytics due to the increase in software driven architectures. The idea is that “data in motion” will replace data at rest, or batch data processing from traditional databases. This is also important for the real-time data streams that machine learning requires.
Confluent/Kafka is Built for the Constant Flow of Data (i.e., Event Streaming)
In our write-up on Big Data, Analytics (and ML) we discussed event streaming and the importance of Apache Kafka. Data streams are created from real-time events, such as messages, transactions or traffic conditions. Confluent opens up the amount of data that can be integrated, to combine transactional data (orders, inventory) with sentiment-driven data (likes, page clicks). This allows large amounts of data to be moved quickly especially for machine learning algorithms that are very data hungry for training models. Specifically, building an analytic model that is trained and makes predictions requires current information, will make predictions on new events in real time, and requires monitoring the infrastructure for accuracy and errors. With Confluent, this can be done by building streaming analytics on top of Kafka using compatible languages, such as Java, .NET or Python, or data scientists can use the SQL engine.
The goal is to reduce operational complexity, deliver optimal user experience and increase accuracy. Kafka Streams through Confluent do not require a cluster to be spun up, offers a single framework for streams of events, and reduces the number of pieces in a stream architecture. Kafka is already a popular framework that can handle trillions of events in one day, has over 5 million downloads from developers, and is used by Big Tech, stock exchanges and car manufacturers.
Kafka is used by 70% of enterprises and this is helpful for Confluent, as the company offers a managed Kafka system. The company believes Kafka is the correct framework to lead a new data flow due to its high throughput of 600 megabytes per second and 5 milliseconds of latency. The maturity of the Kafka ecosystem is also large in terms of number of developers and partners. This important as it prevents Pulsar from taking market share from Kafka.
The three main improvements that the Confluent team made are:
1. to re-engineer Kafka to be cloud-native; especially easy management of elastic quotas (i.e., reads and writes on usage) and offering security with multitenancy.
2. offer a more complete Kafka ecosystem with over 120 connectors and a control plane that automates limit handling; also a SQL layer to bridge current database skills with streaming.
3. is more geographically inclined through cluster linking and other improvements for geographically distributed data; cluster linking allows Kafka clusters in different geographies to be connected for more real-time data flow.
Amazon MSK is a competing managed streaming service that is a good option for developers provisioning a Kafka cluster and a new streaming platform may not be needed in this case. Rather than re-architect Kafka to be cloud-native, Amazon MSK cloud-enabled it as provisioned infrastructure. This means Confluent is stronger than MSK with scaling elastically by offering elastic quotas, which eliminates the need to size clusters for spikes. It’s also stronger on multi-tenancy security. Amazon MSK also does not offer Kafka Connect or Kafka Streams. For more enterprise uses where Kafka Connect or Kafka Streams is required, then Confluent is more likely to be used to save development time and learning curve in writing Kafka Connects sinks and source.
The majority of the information above focuses on Confluent creating a new kind of data pipeline for streaming, yet Confluent will have another catalyst down the line when more streaming applications come to the market. The company wants to disrupt data at rest, and on the other hand, Confluent wants to reimagine the kind of applications that are available once data is in motion. The obvious example is machine learning applications yet the Metaverse will also need data to be in motion.
Confluent is partnered with nearly every database and data warehouse on the market, including Snowflake, Databricks, Google’s database and warehouse products like BigQuery and BigTable, Amazon DynamoDB and RedShift, Microsoft Azure Synapse, Cosmos Data Lake Storage and SQL Server, MongoDB Atlas, Redis, Oracle, My SQL, etcetera. For observability, Confluent is partnered with Datadog. Most recently, the company announced a partnership with Alibaba Cloud – which a bit surprising considering China’s hard stance against United States-based tech.
Q3 Earnings Overview
By Bradley Cipriano, CFA, CPA
In Q3, revenue grew 67% year-over-year to $102.6 million which is an acceleration from 64% growth last quarter. Confluent Cloud drove this acceleration with cloud revenue growing from 200% in the previous quarter compared to 245% in the current quarter. Remaining performance obligations also showed a slight acceleration from the previous quarter at 75% in Q3 compared to 72% in Q2.
The above $1 million ARR customer segment grew 90% year-over-year. Customers above $100,000 slightly decelerated from 51% growth to 48% growth. Due to the size of companies that need a managed solution for Kafka, this is an important key metric to determining Confluent’s growth in the future. Confluent does have a pay-as-you-go option yet managed services for Kafka will likely attract a higher paying customer.
Covid may have affected Confluent’s net retention rate, which declined from 134% in 2019 to 125% in 2020. This number has accelerated to being greater than 130% in Q3. The company is providing near-term targets of 120% and long-term targets of 130% because of Confluent Cloud’s consumption model. Here’s a quote regarding a higher target for NRR in the future: “We're actually at our longer-term target of above 130% and the profile of like in the dynamics of NRR as it relates to our two main products, Confluent Platform and Confluent Cloud, our thesis is that Confluent Cloud will have a higher NRR profile over time because it's elastic, it's consumption-based and there's very little friction in terms of expansion, whereas with Confluent Platform, we're renegotiating deals, etc.”
Adjusted operating losses increased to ($42.6) million from ($19.7) million in adjusted operating losses in the year-ago quarter. The fiscal year estimate for operating losses is ($169) million or adjusted EPS of ($0.91). Free cash flow decreased from ($10.3) million to ($20.6) million.
Confluent Cloud can impact gross margin, at 69.4% down from 71.6%, and subscription margin at 76.8% down from 78.9% a year ago. As the company reaches scale, this is expected to remain around 70%. The company had $1.3 billion in cash as of Q3, which was relatively flat QoQ, and no long-term debt outside of $34 million in lease liabilities. Confluent also receives a significant portion of its revenue upfront in cash, which helps pay for working capital and reduces the need for immediate outside financing. By netting AR from DR (net DR), we can see that upfront cash payments (proxied by net DR) slightly increased QoQ from 83% to 84% of quarterly sales.
Furthermore, there was a degree of conservatism in Confluent’s deferred revenue balance. Revenue recognized from deferred revenue was $118 million YTD, or 74% of beginning deferred revenue. This was down from 77% in the prior quarter, signaling that the recent acceleration in sales was organic and was not driven by pulling forward deferred revenue recognition. This trend also provides more support for future sales, as there is relatively more deferred revenue on the balance sheet, providing a ‘floor’ for future growth.
Confluent also states that RPO is an important metric to monitor in order to measure the health of the sales pipeline. In Confluent’s first conference call as a public company (Q2), CFO Steffan Tomlinson explained that:
“Given the various revenue components and billing terms in our model, remaining performance obligations or RPO and current RPO rather than billings, are important metrics to measure the health of the business. RPO provides insight into the organic momentum of our business as it represents contractually committed revenue to be recognized in the future regardless of billing terms and variability in cloud consumption pattern. RPO provides insight into the organic momentum of our business as it represents contractually committed revenue to be recognized in the future regardless of billing terms and variability in cloud consumption pattern”
As mentioned above, RPO was up 75% YoY to $385 million and RPO to be recognized in the NTM was up 65% YoY to $258 million, both of which represented an acceleration from the 72% and 63% YoY growth rate in the prior quarter, respectively. The acceleration in RPO provides support for future sales. Coupled with the relatively higher rates of upfront cash receipts, Confluent appears well positioned to continue to grow strongly in the near term.
Looking forward, management guided that Q4 revenue will rise 55% YoY $109 million, which would mark a deacceleration from the most recent growth rate of 67% YoY growth. However, this estimate is likely conservative, as management guided that Q3 sales would grow 46% YoY to $90 million and actual Q3 sales grew 67% YoY to $103 million. If we assume that Confluent beats it guide by a similar amount in Q4 as it did in Q3 ($13 million), then Q4 sales growth will accelerate to 73% YoY (this is merely an observation – no guarantees). To be complete, management also guided for Q4 EPS to be a loss of-$0.22.
For fiscal year 2021, the company is guiding for revenues to grow 60% at the midpoint to $377 million, up $27 million from its prior guide of $350 million. For fiscal year 2022, the company is guiding for sales to grow 36% YoY to $511 million, and for Q1 ’22 sales to be flat on a sequential basis, while Q4 ’22 is expected to be the strongest quarter.
Management’s back-end weighted guidance is due to two key trends: 1) the timing of large enterprise deals which are clustered near year-end and are recognized in the quarter of signing, skewing revenue and 2) the recent ramp in sales hiring, which management noted that it takes “roughly four quarters for folks to get fully productive”.
We suspect that management’s forward guide is likely conservative. For instance, cash support for sales increased and RPO also accelerated. Looking forward, Confluent has 64% of its NTM sales guide already secured via RPO commitments, which is high relative to peers. For example, MongoDB’s NTM RPO is 20% of its NTM sales estimate. Furthermore, 70% of Confluent’s NTM RPO is locked-in with upfront cash payments (deferred revenue), further increasing the quality of its forward guide.
Confluent is being conservative with their forward guide likely to ensure that they beat expectations as a new company. While there is limited financial history, there are signs of conservatism as upfront cash receipts increased and RPO accelerated. Confluent remains well positioned to benefit from the secular tailwinds driving “data in motion” in the cloud environment and should continue to grow strongly in 2022.
The most exciting products and the most rewarding tech stocks on the market today are the ones that challenge Big Tech. This is because the market will often underestimate the ability of an agile team to disrupt the incumbents despite substantial evidence that this is exactly what the tech industry is built to do.
What’s remarkable about Cloudflare is how the company has leveraged its content delivery network footprint to simultaneously be a leader in application and website security, then to further innovate with Zero Trust security combined with SASE network connectivity, and more recently to leverage the elimination of egress fees for object storage to attract developers. The latter is the most exciting as Cloudflare has already proven its ability in driving down costs and will now take on AWS head-to-head.
However, in light of Cloudflare’s impressive price movement this year, the company is now priced to perfection. When looking at its peers with similar or higher growth rates, which we discuss below, Cloudflare could see a 35% cut in its price to 40X forward sales and the company would still be fully valued.
Below, we look at the products driving Cloudflare to trade at a higher valuation and whether it’s a valuation the company can sustain.
Cloudflare’s Core Products:
Cloudflare is a well-known company that owns a predominant share of the CDN market. Content Delivery Networks contain a cached copy of website content on multiple servers located across the world to help improve page loading times. When a person visits the website, it will provide the content from the server closest to the end-user, which helps increase the delivery speed of the content. When a website is hosted on a server in the United States, the person browsing the website from any part of the globe, like Asia or Europe, will receive the content from the nearest location instead of the server in the USA. The Fastly outage this year shows the prominence of these CDN providers to where one outage can create downtime for sites, such as Amazon, Reddit and the New York Times.
According to data from W3Techs, 81.2% of all websites that use a CDN or reverse proxy rely on Cloudflare. We had discussed in a podcast earlier this year that Cloudflare is strong in the small to medium-sized business (SMB) category and offers free entry-level services. The penetration among SMBs is one reason why Cloudflare has an estimated annual revenue of $648 million this year with over 1 million customers compared to the enterprise-focused Akamai at $3.48 billion with roughly 50,000 customers. The overall revenue is low for its high customer count compared to Akamai partly because of the free-entry level.
According to Intricately, the cloud Content Delivery Network market is expected to grow at a compounded annual growth rate of 28% between 2020 and 2025. Cloudflare has the highest number of customers (this data includes free users). As of June 2020, Amazon Web Services has the highest share among enterprise customers with Cloudflare is in second place. Among the SMB customers, Cloudflare is leading all the other players. Cloudflare also has a better overall rating when compared to Fastly and also compared to Amazon Web Services in the Gartner Peer Insights.
The company has a large free customer base. In addition to the benefit of converting the free base to paid services it can use the free base to test the features before they are launched.
The free user base was mentioned by management in the earnings call,
“One of our secret to success is our broad customer base that we have millions of customers, many of whom use our services for free means that we have an eager pool excited to test new features before they're released.While traditional B2B companies have extensive QA team, we regularly ask volunteers from our community to be our earliest alpha testers. Our iteration cycles can then be extremely fast. And by the time a feature makes its production at one of our enterprise customers, it's full of proof, having been through the paces under real network conditions.”
Cloudflare has built a large footprint, which means the company already owns a large portion of the TAM for CDNs. The 81% footprint is impressive but one could argue this leaves little room for growth. Cloudflare’s potential in a largely-commoditized CDN market will come from the “extremely fast” iteration cycle. There’s ample evidence the company can execute as it now owns a large portion of the application and website security market, especially for DDoS attacks (distributed denial-of-service).
Because Cloudflare has a large global presence of servers and data centers, it’s particularly well suited for analyzing traffic to determine security risks. The company is able to analyze and detect attacks by running a background program known as a daemon on every server in every data center. The scans are shared as threat intelligence among the servers in each data center without affecting the latency of the CDN.
Cloudflare is able to mitigate at optimal locations in the tech stack, for example at L4 inside the firewall or at L7 inside the reverse proxy with a 403 error page. The company is advanced at preventing L3 DDoS attacks, which targets network equipment and infrastructure. The benefit of having access to more of the stack for security purposes is that CPU consumption and intra-data center bandwidth remains relatively unaffected. It’s also autonomous so Cloudflare is not using manual employees for this process.
DDoS attacks are essentially bots that send millions of requests to overload servers and to shut down a specific website by targeting its IP address. Often times, these bots are run from devices infected with malware and operated remotely by an attacker. Cloudflare recently detected and mitigated a 17.2 million request-per-second DDoS attack, which was three times larger than any previous DDoS attack on record. This is two-thirds the average rate per second that Cloudflare had served in all of Q2.
DDoS is one example of what the company offers and certainly Cloudflare has other security and network offerings based on their large footprint. They can also cross-sell security and CDN customers with WAN-as-service, or Magic WAN, which connects office networks through the local area network. The company also offers application delivery controllers located centrally within a customer’s infrastructure for Layer 3 through Layer 7 security for applications and APIs.
Cloudflare’s Move into Zero Trust
Across Cloudflare’s security products, an important one to focus on moving forward is Cloudflare One, which is a Zero Trust network-as-a-service. Zero Trust is gaining increasing acceptance due to rising security threats from data not being stored in one place. Secure access service edge (SASE) is a cybersecurity concept that utilizes Zero Trust to identify users and devices to deliver secure access to specific applications or data. The need for this has grown due to remote teams as SASE allows policy-based security no matter where the user, application or device is located.
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.
In the earnings call, the company’s CEO assured that the company’s proxy infrastructure could be used for both reverse proxy and forward proxy. He stated, “but it turns out that it's as easy to make the traffic flow one way through the pipe as it is to make it flow the other way through the pipe.” Its proxy has security features built-in and also has the capacity to increase customer’s traffic.
Earlier this year, the I/O Fund covered the launch of Cloudflare One, and the management’s belief in the shift from a traditional hardware-based security approach to a modern zero trust approach, and the company’s confidence to be a leader in making that transition.
Cloudflare One has been getting a good response from customers due to mitigating attacks and improving overall performance. On the earnings call, the company discussed a Fortune 500 pharmaceutical company which was using Cloudflare One that signed a $600,000 expansion deal to increase the total contract value to over $2 million. Another large European software company signed a three-year deal worth $600,000. According to October numbers, Cloudflare signed a social network company which has a contract value of more than $1 million annually. Another video conferencing company also moved to Cloudflare which has a contract value of about $8 million.
Due to the increasing hybrid work conditions, Cloudflare has announced new cloud firewall functionality for distributed environments to overcome the issues with traditional firewalls. The company’s rating on TrustRadius and also on capterra shows that it rates higher than Zscaler, which has also performed well in the market.
Cloudflare R2 storage
Cloudflare began to lead its cloud peers when the company announced its R2 storage product on September 28th, 2021. You can see the dark purple line start a sharp rise upward following the start of October.
R2 storage allows unstructured data to be stored without egress bandwidth fees, which are charged when developers retrieve data from a cloud provider like AWS. The egress fees are essentially a tax without any value. Markups are as high as 7900% in the United States region when calculating what AWS charges. This is an 80X bandwidth markup and was detailed here by Cloudflare’s management.
Eliminating egress fees with R2 Storage places Cloudflare in direct competition with Amazon’s S3. Cloudflare’s motivation is to win over developers and their loyalty.
In the words of Matthew Prince, “We want developers to keep developing, not worrying about their storage bill. Our aim is to make R2 Storage the least expensive, most reliable option for storing data, with no egress charges. I’m constantly amazed by what developers are building on our platform, and look forward to continued innovation as we expand the tools they have access to.”
Primarily, Cloudflare is hoping to attract developers for its Workers product, which is a serverless compute service for developers to build applications and deploy code at the edge. This removes the need for developers to maintain servers or spin-up containers. The cloud service provider (in this case, Cloudflare) provisions, scales and manages the infrastructure required to run the code. Cloudflare wants developers to choose them over the larger cloud providers because of their location at the edge. This is ambitious as most developers are accustomed to AWS, Google Cloud and Microsoft Azure, all three of which also offer serverless at the edge with plans to aggressively expand, such as AWS Lambda and its extension Lambda@Edge.
R2 Storage will help Cloudflare grow its addressable market and will help the company compete as a best-of-breed player in the trends towards multi-cloud. In response, Amazon has lowered prices by up to 31% but this may not be enough if Cloudflare plans to get rid of egress fees entirely. When Cloudflare announced R2 storage, the company’s co-founder and CEO, Matthew Prince, tweeted, “Why R2? Because it’s S3 minus the one most annoying thing: egregious egress.” The product will be launched soon and has a waitlist for customers.
Notably, the outcome from Cloudflare’s R2 Storage, and also the Bandwidth Alliance, which is a consortium of cloud providers who address bandwidth pricing issues, could end up forcing Amazon to drop its egress fees rather than lose customers. Also, as an investor, it’s not clear how much R2 Storage will contribute to Cloudflare’s top line considering the markup will be eliminated. Regardless, the market has rewarded the company for taking on AWS and my hunch is developers will support the cause regardless of AWS’s response.
Cloudflare has done well since its initial focus on the CDN and web security market, increased its TAM with Zero Trust Security, and now adds object storage as a way to attract developers for products like Workers. It is interesting to note that Amazon successfully grew by targeting companies that had good margins with a famous quote from Jeff Bezos, “Your margin is my opportunity.” Now, companies like Cloudflare are doing what Amazon did in its early days by toughening the competition. Amazon’s AWS is a profitable powerhouse, and if Cloudflare can disrupt this, it could be another game-changer for the company.
Financials
The market is excited about how Cloudflare has performed post-Covid as it’s clear the company did not need the one-time bump from 2020 as growth has been stable throughout 2021. Cloudflare decelerated in the most recent quarter —- but not by much; from 54% revenue growth last year to 51% revenue growth in the most recent quarter. The guide for next quarter is also a slight deceleration from 50% revenue growth last year to 47% this year.
The company’s revenue growth was partly helped by growth in large customers with annualized revenue greater than $100,000. We also noticed a similar trend of large customer growth in the last quarter. The company exited the 3Q with 1,260 large customers, a net addition of 172 in the recent quarter for 71% growth. The company had 132,390 paying customers, which represents total customer growth of 31% YoY.
Cloudflare has also demonstrated its ability to be profitable. The company reported break-even adjusted earnings per share, which beat estimates by $0.04. The gross profit margin improved to 78.2% compared to 76.3% in the 3Q 2020. Adjusted gross margin improved to 79.2% compared to 77.3% in the 3Q 2020.
Adjusted net income came at $1.4 million or $0.00 per share compared to an adjusted net loss of $7.3 million or ($0.02) per share in the 2Q 2021 and adjusted net loss of $5.8 million or ($0.02) per share in the same period last year.
Net cash flow from operations was negative $6.9 million compared to a positive $2.0 million for the 3Q 2020. The company had cash and investments of about $1.8 billion at the end of the quarter, including about $790 million of net proceeds from the convertible note issuance in August.
The dollar-based net retention was 124%, the same as the 2Q 2021 and higher than the 3Q 2020 that was 116%.
The company’s revenue guidance for the 4Q is $184 million to $185 million, represents an increase of 46% to 47%. The adjusted earnings are expected to be between ($0.01) to break even. The full year revenue guidance is $647 million to $648 million, representing an increase of 50% and adjusted earnings per share are expected to be between ($0.06) to ($0.05).
Valuation:
Cloudflare has an eye-watering valuation of 47X EV to 1-year forward revenue. As a tech growth portfolio, the I/O Fund is certainly not the valuation police as we often find our best winners carry high valuations if a company is executing against the competitors.
However, it’s the growth rate of Cloudflare that makes me question if this valuation is appropriate. In regards to Cloudflare’s high-valued peers, we see that Cloudflare has one of the lowest revenue growth rates at 51% in the most recent quarter and free cash flow isn’t a strong factor here either. As mentioned, the only other stock on our list carrying this 1-year forward valuation is Snowflake, which had nearly double the growth.
Cloudflare’s analyst consensus for next year is revenue of $886 million with 20 analysts providing estimates. This represents growth of 37.2%. The analysts covering the stock are modeling Cloudflare to be profitable next year with $0.02 EPS. At this valuation, investors should feel confident there will be a beat and raise to at minimum 50% growth although the data above suggests revenue growth must be in the 60% range to be in the top 10 for valuation.
Conclusion:
By the sweat of its brow, Cloudflare has expanded a commoditized content delivery network footprint to become a leader in website and application security, and is not standing still with products such as Zero Trust and R2 Storage. However, being a great company is sometimes confused for a great stock. At the current valuation, Cloudflare has no room to explore these new markets and find its footing.
I have no doubt the company will execute, how it goes about this and if the timing of execution can meet Wall Street’s often unrealistic standards of quarterly perfection is the risk that investors take. This is certainly one to watch, or one to hold if you’re already in the stock, but to enter as of October requires hardened conviction in Cloudflare surprising to the upside on the 37% forward growth estimates for FY2022. We prefer to wait from the sidelines for a more attractive entry.
Please note: The I/O Fund conducts research and draws conclusions for the company’s portfolio. We then share that information with our readers and offer real-time trade notifications. This is not a guarantee of a stock’s performance and it is not financial advice. Please consult your personal financial advisor before buying any stock in the companies mentioned in this analysis. Beth Kindig and the I/O Fund do not own Cloudflare and there are no plans to enter the stock in the next 72 hours.
Hybrid and work from home environments are a fundamental tailwind for cloud-based tools that help facilitate this key micro trend. Due to the inherent benefits of hybrid/remote environments, such as decreased fixed expenses (rent) and increased access to global talent, along with the necessary infrastructure in place from the rise of cloud computing, this trend will gain momentum going forward.
Asana is one of the key cloud-based tools that facilitates efficient hybrid work environments and stands to benefit from the structural shift underway that is transforming how people work. Asana is a work management platform that helps teams orchestrate work across an entire enterprise, connecting teams around the globe in an easy-to-use platform. The thesis is fairly easy: do you think workers will go back to being in-office full-time? If not, then more cloud-based tools will be required to perform work efficiently. Notably, these tools were already rising in popularity prior to Covid based on the efficiency factor alone.
Customers use Asana to improve team collaboration and workflow management, helping teams track their progress on projects, assign tasks and responsibilities to employees, set deadlines and keep a record of data related to their work. The company was founded in 2008 by Facebook executives Dustin Moskovitz (co-founder of Facebook) and Justin Rosenstein in 2008.
The two had worked together at Facebook and experienced firsthand the coordination challenges the company faced as it rapidly scaled its business. The two realized that they were spending a significant amount of time trying to figure out who was responsible for what, essentially creating ‘work about work’. This unproductive bottleneck inspired them to create a product that would help organizations coordinate their work.
One of the company’s main focuses has been to increase employee productivity by helping them focus on priority tasks and avoid distractions. Asana has been used by a wide range of companies for multiple uses, such as product launches and marketing campaigns. It helps its users know in real-time what each member of the team is working on and allows managers to easily check project progress to ensure that tasks are completed successfully and on time.
With the rise of remote work environments, Asana’s solutions have experienced rapid growth and demand for its solutions has been especially strong with enterprise customers. Asana went public via a direct listing in September 2020 and the company’s stock is up about 135% since its listing and had gains of about 390% during its peak a month back. Despite the recent pullback in Asana’s stock price, the company remains well positioned to continue to gain share in the rapidly growing work management market (i.e., same story a month ago at a discounted price).
Hybrid-work-from-home will be the future working environment for many organizations, with 73% of employees wanting a flexible remote work option. I am bullish on this micro trend and believe that companies in this space will continue to grow going forward. Asana is a beneficiary of hybrid work environments, evident in its exceptional strong revenue growth, which recently accelerated to 70% in the most recent quarter. The I/O Fund noticed Asana’s rapid growth earlier this year and took a position, realizing an 85% gain in under a month.
Asana, at the time, was quite undervalued based on their expected growth, so we initiated our 1st buy in February at $40. We decided to ride the volatility in Asana in March, and instead looked for breakout, which manifested in May when we added again at $33.25. We became fully allocated in Asana on May 20th, and set our targets above. We trimmed this position 3 times, locking in gains between 65%, 115%, and 224%. We closed the position on November 8th for a 285% gain. Recently, we started accumulating again in the $70s and again in the $60s.
We still like Asana at the I/O Fund, however it’s a position we decided to actively manage rather than buy-and-hold. It could turn into a buy-and-hold but for now requires a more active stance. In the article that follows, I discuss Asana’s market opportunity, product roadmap, financial performance, competitive landscape, and key risks that investors should be aware of.
Market opportunity
The company operates in a large market that is rapidly expanding. According to Allied Market Research, the team collaboration market size is expected to grow at a compounded annual growth rate of 13% for the next decade and reach a total addressable market of $27 billion by 2027. Furthermore, Grand View Research estimated that the global productivity management software market was $43 billion in 2020 and is expected to grow at a CAGR of 14% from 2021 to 2028. In Asana’s recent presentation, they estimate that their total addressable market for workplace solutions will be nearly $51 billion by 2025.
To give a sense of the large market opportunity in front of the company, a recent Forrester Research report estimates that there are about 1.25 billion information workers that would benefit from using Asana’s solutions. The company believes that it is still in the early innings of its the market opportunity and estimates that its market penetration is less than 3% of its addressable population of information workers. Looking forward, there is ample room for Asana’s topline to continue to expand as more information workers take advantage of work management solutions.
Product Roadmap
The company’s platform is built on its proprietary, multi-dimensional data model that it calls the Asana Work Graph. It has features like boards that allow users to easily create tasks for the team, view what other team members are working on, and create different views like calendar list views. Furthermore, the timeline feature allows decision makers to quickly learn the status of a task, who is responsible for executing the work, and helps reduce redundancies.
There are also reporting tools that provide key information about work, such as files, comments and metadata. The result is that Asana helps teams collaborate across an entire organization and ensures that projects are completed on time and efficiently. Asana’s benefits compound in large, complex hybrid work environments such as large enterprises, which I touch on in more detail below.
Another key advantage of the Asana platform is that it has integration capabilities with major apps, such as Microsoft Teams, Okta and Dropbox. These integrations and partnerships with other cloud-based tools help further facilitate the transition to hybrid work environments and improve efficiencies.
With the rising number of information workers who are increasingly working remotely, Asana’s products help employees coordinate core projects, improve productivity across the enterprise and remove information silos that have historically separated teams across an enterprise. Asana’s solutions also yield a solid return on investment for its customers. According to a study conducted by the IDC, respondents reported that Asana has increased organizational efficiencies by reducing time spent on emails by 33%, improved process execution by 42%, and has yielded a 224% 1-year return on investments for its customers.
Asana has also partnered with numerous technology firms to add more features and functionality to its platform. A standout that management highlighted during the Q2 earnings call was Zoom’s integration within Asana. This unique feature allows Asana customers to create a Zoom meeting while they are performing a task directly inside the Asana platform. Once the Zoom meeting is over, the Zoom recording and the transcript can be added to Asana and tasks discussed during the meeting can be assigned to owners. This functionality improves the efficiencies of meetings and helps reduce the amount of time spent “working on work”.
As mentioned above, work complexity compounds as organizations increase in size and become more dispersed with hybrid work environments. Asana’s Work Graph helps reduce the growing complexity for enterprises and replaces micro-management with macro-management, “by aligning [leaders] around key objectives and the work needed to achieve them no matter where they are in the world” (Q3 Earnings Call). We can see the success that Asana has had reducing hybrid complexities by observing growth trends with large enterprise customers, which have accelerated recently. I discuss this trend and Asana’s financials in more detail next.
Financials
Asana released its Q3 FY2022 results on December 02, 2021, which beat both on the top and bottom-line. Revenue growth accelerated to 70% YoY and quarterly sales were $100 million, which beat analysts’ estimates by $6 million. Revenue has increased sequentially for at least 11 consecutive quarters and Asana now has an annualized topline run rate of over $400 million. The growth was led by strong customer metrics as total paid seats surpassed 2 million and total paying customer increased 28% YoY to 114,000.
However, the real story is Asana’s success with enterprise customers, which generally pay more and sign longer-term contracts. Because of this, enterprise customers are generally the most valuable type of customers for a software provider. Asana’s success with this cohort speaks to the overall value that its workplace solutions provide.
For example, while total paying customers increased 28% YoY to 114,000, customers spending $50,000 or more per year (enterprise customers) grew by 132% YoY to 739. This represented an acceleration from the 111% and 92% YoY growth rate in enterprise customer count in Q2 and Q1 FY2022, respectively. The accelerating growth in enterprise customer count highlights the benefits that Asana provides to large, complex hybrid environments. Further highlighting this strength, Asana’s dollar-based net retention ratio for enterprise customers was 145%, up from 140% in the prior Q3 period and exemplifying that enterprise customers are expanding their usage of Asana overtime, a sign of strength.
Some of the large key customer wins in the quarter included Warner Music Group, which chose the company’s enterprise solutions “to organize, manage and track the end-to-end process of how they identify, evaluate and bring new artists into its various labels faster and more effectively”. Asana also expanded its deal with a Japanese customer, which is one of the largest automotive manufacturing companies in the world. Management explained that the Japanese auto customer’s expanded agreement was to help manage their software and product developments (Q3 2021 Conference Call). These customer wins highlight that Asana is useful across multiple industries and different geographies.
It is noteworthy that while Asana is growing its enterprise customer base, it is doing so on a global scale. This provides support that Asana is still early in its topline run rate and has amble room to expand both domestically and globally. Furthermore, Asana is preparing for global growth as it recently expanded its support to 13 different languages, which will help the company capture customers is numerous markets around the world.
Looking forward, Asana expects Q4 revenue to be in the range of $105 million to $106 million, representing a 53% to 54% YoY growth rate. While this represents a deceleration from recent growth rates, the company is likely being conservative with their topline guide. For instance, management guided Q3 sales to grow 59% YoY (at the mid-point) and actual Q3 sales growth came in at 70% YoY.
Management also expects Q4 adjusted operating loss of $53 million to $51 million and adjusted net loss per share of ($0.28) to ($0.27). This represents a larger loss than the Q3 adjusted operating loss of $41 million and adjusted loss per share of ($0.23). While the guide for larger losses is somewhat concerning, the company is investing to grow rapidly to capture market share in the large, untapped work productivity market. As a result, Asana is front-loading investments today that will pay dividends in the future.
We can see the front-loading of expenses by observing trends in sales and marketing (S&M) expense. As shown below, the company’s S&M expense increased as a percentage of total revenues to 73%, which was up 200 bps QoQ but down 900 bps YoY. Asana’s COO Anne Raimondi explained on the Q2 call that the company has been ramping hiring to support international expansion. Specifically, she stated that the company has been “increasing sales and marketing capacity across all of these new offices and regions. So, lots of hiring to support our customers”. Ultimately, I am not concerned with the rise of S&M expense margin since the company is investing in its future growth, which will help the company quickly scale its operations, improving both earnings and cashflows in the long run.
Moving to cashflows, quarterly free cash flow was -$30 million as of Q3 FY2022, down YoY from -$20 million for the same period last year. However, YTD free cash flow -$46 million, an improvement from the prior year metric of -$58 million. Cashflows can be lumpy, but as enterprise customers continue to increase as a percentage of total sales, their recurring upfront cash payments will lead to improving cashflows overtime.
Stock-based compensation and insider purchases
It is also noteworthy that Asana pays some of its salaries with stock-based compensation (SBC), which cosmetically improves the presentation of cashflows. For instance, in the latest quarter, Asana issued $26 million in SBC, up from $9 million in the prior year quarter. However, quarterly free cashflow improved $18 million YoY, or $1 million absent the benefit from increased stock-based compensation. The increase in free cashflow after adjusting for the rise in SBC highlights that Asana has been able to leverage its scale to a degree. Nonetheless, cashflows will remain lumpy going forward and SBC growth may outpace free cashflow generation in the near term.
A benefit of rising SBC is that it makes employees owners in the business, giving them a vested interest in the company’s success. This in turn should improve employee retention and lower turnover, which will help Asana better scale its operations as seasoned employees are generally more efficient than new hires.
Management has also been purchasing shares, which can be a sign that management believes that the company is undervalued. For instance, board member Lorrie Norrington recently purchased 3,733 shares on December 6th for a total purchase value of $248,000 (~$66.51/share). This was the second time she had purchased shares this year after spending $199,000 for 6,200 shares in March 2021(~$32.12/share). Ms. Norrington’s purchases follow a drop in Asana’s price following the general tech sell off that occurred in the back half of 2021. Given the company’s continued strength with enterprise customers discussed above, Asana may be at a decent risk/reward right now.
Another insider that has been purchasing shares is CEO-founder Dustin Moskovitz. CEO Moskovitz has purchased over 6 million shares year to date, which is generally a very bullish signal. However, the purchases likely relate to the redemption of a convertible bond that CEO Moskovitz holds in a trust. As disclosed in Asana’s 10Q, the company elected to convert a convertible note that was “held by a trust affiliated with Mr. Moskovitz and the shares were accordingly issued to the trust. The conversion of the Convertible Notes therefore increased Mr. Moskovitz’s voting power”. Nonetheless, the increase in CEO Moskovitz ownership further aligns his incentives with shareholders, which is generally a positive development.
Competition and why Asana is winning
The work management platform space is very competitive and there are numerous public and private companies competing with Asana. Asana’s main publicly traded competitors are Atlassian (Jira) and Monday.com, but they also compete with Smartsheet and other private companies such as Airtable. For the sake of brevity, I will only be discussing Monday.com and Atlassian’s Jira offering and what sets Asana apart from these competitors.
One of the key pillars separating Asana from Jira is that Asana is built for all teams within an enterprise, while Jira was specifically designed for software developers. Asana claims that Jira is not flexible enough to be applied to teams across an entire enterprise, while Asana was built to be applicable to all employees within an organization. However, the two are not mutually exclusive and users are able to integrate the Jira cloud within the Asana platform, brining Jira’s software development focus into Asana’s easy to use workflow platform. This integration allows all employees to remain in sync and helps various teams, such as business and software development, collaborate across the organization. To remain competitive, Atlassian bought Trello in 2017.
Possibly Asana’s most direct competitor is Monday.com, which went public in June 2021. The two are the leading providers of workflow solutions and both are growing strongly. Asana differentiates itself by being easy to use, transparent and user friendly, making it accessible to all users in an organization, even the non-technical ones. On the other hand, Monday.com claims that it is a Work Operating System, that is more advanced and customizable.
Without getting into the differences in the platform offerings, the key differentiator between the two is likely price. Given that enterprise customers are important to both of these companies’ success, and that neither company directly discloses enterprise pricing, I relied on enterprise customer metrics to get a sense of which platform is favored by large organizations.
As mentioned above, Asana’s enterprise customers growth recently accelerated from 111% to 132% YoY growth, the fastest pace of YoY growth in FY2022. Similarly, Monday.com also reported an acceleration in enterprise customer growth, as customers with annualized recurring revenue >$50,000 grew 231% YoY, up from the Q2 growth rate of 226% YoY.
While Monday.com is growing enterprise customer’s faster than Asana, Asana’s enterprise growth is accelerating more rapidly. For instance, Asana’s enterprise customer growth accelerated 2,100 bps in the most recent quarter, versus to 500 bps acceleration for Monday.com.
Moreover, Asana had 739 enterprise customers in the latest period, which was 20% higher than Monday’s 613 enterprise customers. However, Monday.com was founded in 2012 while Asana was founded in 2008, so Asana’s head start may be the reason why Asana currently has more enterprise customers.
Unfortunately, neither company directly discloses enterprise pricing, but Asana did announce that they have some seven and eight figure deals, highlighting how not all enterprise contracts are not the same. It is noteworthy that both companies report high gross margins, with Asana reporting a GAAP gross margin of 91%, which is about 300 bps higher than Monday.com’s GAAP gross margin of 88%. Asana’s higher gross margin suggests that it is not sacrificing price to drive sales growth, which can be a sign of competitive strength, especially given its recent acceleration in enterprise growth. However, both companies have very similar metrics and are valued about the same (Asana’s market cap is $13 billion while Monday.com market is $12 billion as of publication).
The market likely needs more time and information to fully understand who the winner will be in the work management platform space. However, recent trends suggest that Asana may be pulling ahead given its rapid acceleration with enterprise customers and higher gross margins. We are still early in Asana’s growth story, and there are plenty of risks ahead of the firm, which I discuss in more detail next.
Risks:
Asana faces significant competition in the fast-growing work management space and it is not yet clear who the winner will be. Furthermore, larger companies could very well enter the space and compete with Asana’s solutions, possibly turning customers into competitors.
Asana has also experienced rising losses as it scales its business. The company’s operating expenses are expected to be high as it invests in human capital and office space to expand its operations globally. There is also no clarity as to when the company will be profitable, and shareholders may be diluted if cashflows do not improve going forward. Furthermore, the company recently reported a deceleration in bookings growth, which may forewarn a broader slowdown in sales in the near term. CFO Tim Wan addressed this concern during the Q3 call and explained that bookings are not a great barometer for growth, due to the large amount of customers still on monthly billing plans. Since monthly customer do not impact deferred revenue, they skew the calculation of bookings. Nevertheless, bookings growth will need to be monitored going forward since it is an important metric for Software-as-a-Service companies.
Conclusion
Looking forward, Asana appears well positioned to continue to capture share in the work management space. Hybrid and remote work environments are a structural tailwind that will drive demand for work management solutions. Furthermore, these tailwinds will likely gain momentum due to the inherent benefits they provide to both employees and employers. Asana recently reported an acceleration in topline growth, and enterprise customer metrics accelerated even faster. While it is not yet clear who the winner will be in the work management space, Asana appears well positioned given its high gross margins and strong customer metrics. Asana has a large addressable market in front of it and its penetration is very low, suggesting that we are still very early in the company’s growth story.
Royston Roche contributed to this article.
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. The I/O Fund has owned Asana stock in the past and currently owns Asana stock at time of writing. There are no plans to change the position in the next 72 hours.
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The reason we think that UiPath has winning potential is that RPA is in its infancy and historically the company’s retention and upgrades are second-to-none. RPA is one of the best ways to participate in the benefits of AI/ML early-on with UiPath’s scalable automation solutions used by early adopters. As the market matures, we think the analyst jitters over a new business model will clear up over time. This is because it’s clear that once customers adopt PATH, they stay and upgrade – which consequently, a lack of upgrades is one reason why we exited DocuSign. My goal is to get you an update on DocuSign by Monday at the latest.
UiPath:
We’ve covered in the past that UiPath’s annual recurring revenue (ARR) is important to pay attention to and management emphasized again this in the latest call. Prior to the billing change, UiPath’s revenue led ARR growth, yet due to a billing cycle change, this is not the case temporarily. The billing cycle change could be misinterpreted as a sign of weakness, when in reality, it’s is motivated by UiPath wanting to attract a wider range of customers with shorter 1-year billing cycles. If the graph below is any indication, then revenue should normalize in time to where revenue again leads ARR, which is of course, an annual metric unaffected by this billing cycle change.
“We have a structured process in place to calculate and report ARR, because it is invoice based, we believe that it is the most accurate and reliable measure of our true business activity. It most closely aligns to long-term cash flow and best aligns to renewals and given our strong dollar based gross retention rate, which was 98% in the third quarter. ARR is most reflective of customer commitment, regardless of deployment model.”
The global market size for RPA is at $2.07 billion in 2021, up from $1.23 billion in 2020. UiPath is expected to report $885 million in revenue for fiscal year ending in January. This means UiPath owns up to 42% of the RPA market and we expect this lead to continue given the remarks on the call about market share and competitors.
With the market expected to reach $7.01 billion by 2025, UiPath’s 40% penetration would equate to $2.8 billion or 3.3X growth. In 2030, UiPath could be reporting as much as $5.5 billion in revenue or 6.5X growth in revenue. This is all while nearing profitability, which is rare this soon after going public. According to other estimates, RPA services will expand the addressable market to $4.3 billion by 2022, which is higher than the estimates previously listed.
I think these estimates could be low given the cost savings that RPA offers. Below, we see enterprises saving millions of hours per year with savings in the millions of dollars from automation. Morgan Stanley seems to agree with a note that the RPA market could reach $56 billion with the firm concluding UiPath owns 30% to 32% of the market. Notably, Gartner has also pointed out that UiPath’s revenue growth is higher than overall RPA market growth.
We had covered in our original research report that owning Path and RPA is attractive for our portfolio because of the pain point the company solves. Automation is truly unique in terms of the benefits it provides to the enterprise. Here were a few states we had quoted:
“The ROI is astounding when you have an error-free employee who works 24/7 and does not tire or need bathroom breaks. To illustrate, a few automations can save 20 minutes of work per person daily and enabling 10K employees with a software robot could save more than $30 million a year (based on an average salary of $35/hour).
According to analysts like Forrester, 14.9 million jobs will be created by 2027 to work alongside robots. It’s not clear though how many jobs robots will replace and if the 15 million is actually a deficit.
According to McKinsey, $3.6 trillion of work can be automated. The piece of the pie that UiPath is after is the automation of applications for enterprises. The number of applications deployed by enterprises has increased by “approximately 70% over the past four years,” according to Wall Street Journal.
According to McAfee, the average enterprise has deployed 464 custom applications and deploys an additional 37 new applications in a 12-month time span. Companies with fewer than 1,000 employees run 22 custom applications while companies with over 500,000 run 788 custom applications, on average. The majority of these applications (58%) are used internally while 36.2% are used by customers, partners and suppliers. These larger enterprises – with the 788 applications on average — are the companies that UiPath is targeting.”
There are a few stats the company gave in the most recent earnings report, as well:
· Hana Bank has applied automation to 80 processes, an estimated saving of around 1.5 million hours per year.
· Saudi Ministry of Tourism reduced the time needed to collect process and analyze data by 95%, from 30 minutes per record to 40 seconds
· Toll Group freed up 170,000 hours and they are on track for savings of $1.6 million annually.
On the competitive front, the earnings call was quite direct about UiPath outpacing competitors. The primary competitors are Blue Prism, Automation Anywhere and Microsoft.
Microsoft is not building a best-of-breed product and there’s no indication they plan to take UiPath head-on right now.
“Our own data, if we take into account the deals where Microsoft is participating versus the deals where Microsoft is not participating, we are not seeing material changes in our winning rate. So right now currently, I can say Microsoft has — doesn't have a meaningful impact on our ability to win customers. What is going to happen in the next couple of years, first of all, I would like to make a case that Microsoft is focused with their RPA mostly on citizen developer and personal productivity. This is a small part of our overall TAM. So I don't see that in the coming years, Microsoft investment and competing with us will materially derail us from our growth trajectory that we are seeing and we are building right now.”I would like to make a case that Microsoft is focused with their RPA mostly on citizen developer and personal productivity. This is a small part of our overall TAM. So I don't see that in the coming years, Microsoft investment and competing with us will materially derail us from our growth trajectory that we are seeing and we are building right now.”
Regarding Automation Anywhere and Blue Prism, an analyst said the following:
“So Daniel, at your User Conference in Las Vegas, one of your partners was saying that this market in the past was a three-horse race and the two of the horses got broken legs. And there were so many stories of Blue Prism and automation anywhere customers migrating to UiPath, I'm just wondering if you can shed some light on whether you have a little extra tailwind from that type of activity?”one of your partners was saying that this market in the past was a three-horse race and the two of the horses got broken legs.And there were so many stories of Blue Prism and automation anywhere customers migrating to UiPath, I'm just wondering if you can shed some light on whether you have a little extra tailwind from that type of activity?”
The management responded by saying geographies like the Nordics, Canada and the United States are regions where competitors are “withdrawing their presence significantly.” However, management points towards the market being too new for this to be a tailwind (usually this becomes more important in a mature market). Instead, the growth is coming from keeping their current customers happy with the platform and also from new customers for growth.
A Note on Cloud …
There was some discussion on the forum over UiPath’s ability to perform well in cloud-native environments.
We had pointed towards the acquisition of Cloud Elements to expand UiPath from UI-based process automation to also include API-based could be an important competitive advantage for UiPath as it now operates with the same integrations as its competitors yet is more end-to-end. The analyst above is also implying that UiPath is taking market share from Automation Anywhere, the cloud-native automation platform. Here is what management said:
“Automation suite enables our customers to leverage the power of the full UiPath platform with the benefit of a cloud native architecture. However they choose, on-prem, public cloud or third-party hosted with the single install on Linux. 21.10 also included the introduction of Linux based software robots, a capability that is required to be a truly cloud native company. This allows our customers to achieve scalability and auto scalability in a cost-effective manner.”
The integrations with Crowdstrike, Snowflake, Qlik, AWS, etcetera, also point towards cloud-enabled solutions. Gartner seems to agree that UiPath has no issues competing in the cloud with the following analysis on the company’s weakness:
“Web-based development: Despite its strong focus on cloud-based RPA, and its existing web based UX App builder, UiPath still lacks a web-based RPA development environment — a shortcoming that will limit adoption by enterprises that prefer a minimal hardware footprint. However, UiPath does offer cloud orchestration capabilities and plans to build a web-based developer environment soon.”: Despite its strong focus on cloud-based RPA, and its existing web based UX App builder, UiPath still lacks a web-based RPA development environment — a shortcoming that will limit adoption by enterprises that prefer a minimal hardware footprint. However, UiPath does offer cloud orchestration capabilities and plans to build a web-based developer environment soon.”
As far as a decreasing TAM due to on-premises, I don’t see any evidence of this. UiPath’s end-to-end solution across all environments is a strength. The company is seen as a leader in RPA across many reports: Gartner, Forrester, Everest Group, MarketScape, etcetera. You’d be hard pressed to find any product analysis on RPA that doesn’t thoroughly assess UiPath’s product as the leading product across both cloud and on-premise. This is important because RPA may become a winner-takes-all due to scaling complexity.
Below is a chart that shows the percentage of interest in RPA as of 2017 compared to the number of companies that had deployed it:
The most recent survey from Deloitte stated that 73% of organizations have looked into automation, up from 58% in 2019. The issue is that very few have reached automation at scale with the far majority in the piloting stage. We think this will resolve over time and this is the primary reason we are invested in UiPath – real demand with high anticipated penetration being consistently reported across analyst firms, yet many companies are stalling out due to the complexity of the solutions, and UiPath leads the category. We also think that as organizations chose UiPath over other vendors, that the high switching costs will be nearly insurmountable.
Financials:
I agree with the forum comment that the earnings report was unremarkable. The company did beat on both top line and bottom line and increased the forward, yet the market is still trying to factor in the slowdown in growth from previous years which was roughly 127% in fiscal 2019 and 80% in fiscal 2020. Will the slowdown stabilize or continue to meaningfully erode? That’s why the company hasn’t quite won the confidence of Wall Street yet.
Regarding my comment on the fact that high switching costs are nearly insurmountable, I can’t give you a clear reason as to why UiPath did not discuss their net retention rate in the most recent earnings reports. In the past, it’s been an industry-leading number of 145%+ and my hope is that it continues to be above minimum the 130% range for the next few years.
As stated, the company emphasizes ARR, yet this is declining although still above 50% on the forward guide. The YoY growth in ARR was at 64% in fiscal Q1, 60% in Q2, 58% in Q3 and is expected to decelerate again to 55% in Q4. Despite the beat, the company’s deceleration is being penalized as are nearly all decelerations in cloud from the Q3 reports.
If we read between the lines, we see that Covid had a negative upfront effect on UiPath although Deloitte believes in the long-term, digital transformation will be a tailwind for UiPath. Cost could be one factor as to why we are seeing slowing growth and the other could be that organizations had to prioritize cloud migrations. Regardless, the $3 billion market size is communicating that RPA is early and the slowing growth is not because demand is slowing; rather it may have been paused or de-prioritized. It’s true that investing in Path is a bet that it’ll resume stronger growth in the future.
The key metric that is most exciting from the recent report is that customers with $1 million plus ARR was up 82% year-over-year. The customer category above $100K was up 52% year-over-year. UiPath also plans to be profitable next quarter but this could be lumpy depending on how many investments the company makes. Nonetheless, gross margins remained robust as consolidated gross margin was 85% and software gross margin was 93%.
Remaining performance obligations (RPO) increased 80% to $579.5 million, while RPO to be completed in the next twelve months (NTM RPO) increased 11% QoQ to $359 million. Looking forward, NTM RPO represents 33.0% of the NTM revenue estimate, an improvement of 70 bps QoQ. The improvement in NTM RPO relative to forward sales expectations provides a ‘floor’ for future sales, improving the quality of forward estimates.
However, it should be noted that cash support for future sales has declined. For instance, current deferred revenue relative to NTM RPO declined QoQ from 73% to 70%, which lowers the quality of recently reported RPO. However, the billing cycle discussed above may be temporarily skewing this metric, as management is prioritizing one-year deals over multi-year deals. We will be watching this metric going forward and anticipate an improvement as the trend annualizes. Furthermore, current deferred revenue has increased relative to subscription sales for the past two quarters, highlighting that one-year deals appear to be healthy and suggesting the lower cash support is due to the drawdown in multi-year deals.
Moving down to cashflows, quarterly cashflows from operations declined from $7 million down to an outflow of -$25 million. The steep drawdown in cashflows is likely a result of the company’s billing cycle change mentioned above, as the upfront cash payments from multi-year deals is being replaced with relatively smaller amounts of upfront cash payments from one-year deals. We should expect cashflows to improve going forward as this trend fully annualizes. Management has discussed that it does not have to sacrifice as much margin (and cashflows) with one-years relative to multi-year deals, so in the long run this change should improve cashflow generation, all else equal.
Conclusion:
I’ve heard UiPath called a story stock and I agree. The story here is quite compelling in terms of the percentage of organizations that are pursuing automation (70%+) compared to the number that have scaled RPA solutions (low single digits). I believe there is enough evidence that UiPath is the leader and will continue to lead. I tend to not counter invest in product leadership. The ongoing integrations and partner network also certainly doesn’t hurt which we covered in our original analysis here.
I/O Fund is keeping tabs on cloud security company Zscaler because of its surging sales and strong growth over multiple quarters. Zscaler's success is evident in the most recent earnings results.
Sales History
Zscaler's growth is impressive, because sales have grown over 50%+ for five consecutive quarters.
In fact, as you can see in the chart below, Zscaler has grown 40%+ or more in every quarter, except one, as a public company.
Growth Factors
Zscaler's notably high growth is due to a few secular tailwinds propelling the company forward:
Rise of the cloud environment
Obsolescence of firewalls used to secure networks in the cloud
Network effects, as Zscaler collects massive amounts of data, over 300 trillion signals everyday
Upward Trending Sales and Persistent Demand
Market demand for Zscaler's products and solutions is demonstrated in customers' willingness to pay for multi-year contracts upfront, allowing for a constant stream of revenue and capital to go back into Zscaler's operations.
Current cashflow trends are indicative of Zscaler's ability to deliver high quality results.
We can see upfront cash payments by looking at deferred revenue, which increased 74% YoY. It is also worth pointing out that long-term deferred revenue (DR) increased 99% YoY to $63 million. Deferred revenue turns into sales in the future and an outsized growth in DR highlights that there is ample balance sheet support for future sales.
Deferred revenue actually represented 281% of Q1 sales, the highest seasonal value in the firm's history.
Thoughts from Zscaler's Management
Management has raised its sales guide, and expects FY2022 sales to grow 50% YoY to $1 billion. Management also expects billings to increase 40% YoY to $1.3 billion, which further underscores recent topline growth.
I/O Fund's Potential Position on Zscaler
I/O Fund is watching Zscaler closely but we do have reservations about the company’s elevated valuation. Zscaler trades at over 50x fwd sales which is a premium multiple in the cloud category.
We will be tracking cloud earnings to better understand whether Zscaler is positioned to continue to grow strongly going forward.
But there's more to Zscaler and this analysis –
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This article was originally published on Forbes on Dec 10, 2020,11:25pm ESTForbes on Dec 10, 2020,11:25pm EST
In this analysis, we review the recent earnings reports from Zoom Video, Okta, Snowflake, Crowdstrike, ZScaler and Elastic.
Zoom Video Q3 Earnings
Zoom Video provided a nearly flawless earnings report for the first full quarter that followed initial work-from-home orders. The company reported lower-than-expected churn and market-leading growth on both an annual and quarterly basis. Notably, margins were thinner on both a YoY and QoQ basis due to free accounts. Regardless, it's hard to find fault with Zoom Video's current level of profitability in relation to other tech growth stocks (outlined below).
Strong forward guidance also provides a glimpse into Zoom's traction as the company expects revenue growth to continue at a similar rate year-over-year and also quarter-over-quarter. Revenue grew 367% in Q3 with customers that have more than 10 employees growing 485% year-over-year.
Quarterly revenue is at $777 million or a $3 billion run rate – or 500% growth from FY2019 revenue. Quarterly revenue beat the top-end of guidance at $690 million with the company reporting "lower-than-expected" churn. Customers generating more than $100,000 in trailing 12-months revenue grew 136% year-over-year for an increase of more than 300 customers compared to Q2.
The blend of Zoom Video having virality across consumers from its freemium model combined with enterprise is the company's strength strategically as the competitors do not have the virality component. In Q3, customers with more than 10 employees represented 62% of revenue with net dollar expansion rate of 130%. Globally, Zoom exhibits strong growth, as well, with revenue from APAC and EMEA growing 629% year-over-year.
Gross margins were a weakness in the report at 68.2% compared to 82.9% last year and 72.3% last quarter. The company is providing the service for free to many users including K-12 schools during the pandemic. From my perspective, the temporary margin hit in exchange for virality and establishing consumer behavior is a good trade-off.
Adjusted operating margins improved year-over-year but were slightly down quarter-over-quarter at 37.4%. Adjusted EPS was $0.99 which exceeded guidance by $0.25. RPO totaled $1.6 billion, up 215%, from $517 million year-over-year which is a strong sign the growth will continue. The company ended Q3 with $1.9 billion in cash (nearly unheard of for a tech growth company at this stage).
Guidance for the next quarter is in the range of $806 million to $811 million with adjusted earnings of $0.77 to $0.79 EPS. Fiscal year guidance is for revenue of $2.57 billion to $2.58 billion, representing 314% year-over-year growth (currently company is in Fiscal Year Q3 2021 and the fiscal year ends next quarter). The adjusted operating income for FY2021 is forecast to be $865 million to $870 million for nearly 900% growth and equal to $2.85 to $2.87 EPS.
The Gartner report that Zoom Video references canbe found here. The bigger revelation is not that Zoom Video is listed as a leader but that Gartner forecasts only 25% of enterprise meetings will take place in-person compared to 60% today. The analyst firm also predicts that 74% of companies plan to shift to more remote work — (keyword here is more – not entirely shift)
Source: Gartner (2020)
The interesting piece about the chart above is that Zoom Video leads enterprise players Microsoft and Cisco but is also in a wide lead for consumer. The consumer traction may be Zoom's biggest tailwind as consumer behavior will be hard for a competitor to change.
The strengths that Gartner sees include zoom's user-centric design, service reliability and flexible consumption model. Zoom is also moving into verticals, such as healthcare and financial services, to add to its popularity in education.
The primary risk for Zoom Video is security. As I've stated a few times, it's common for an enterprise to not offer end-to-end encryption as the employer prefers to access the data on their employees. In response to the criticism, Zoom Video offers end-to-end encryption for accounts with more than 200 users.
In another Gartner report for Unified Communications-as-a-Service, Zoom appears for the first time due to the recent launch of Zoom Phone and receives a leadership position with its first mention in the UCaaS report. That's a significant entry. Zoom Video offers Zoom Phone at no additional charge and has secured a partnership with ServiceNow. The company is also partnered with Pinterest on hobbyist classes. Despite the Zoom Phone service being relatively new, it offers a 99.999% availability SLA target.
Source: Gartner (2020)
Visionary CEOs tend to better than competitors who lag because they have a vision for what the space will need next. We see many products rolling out of Zoom that challenge the way video conferencing is done today. As pointed out in the earnings call, Rakuten has partnered with Zoom for the broader UCaaS offering of Rooms and Phone. This is a leader in internet services with 1.4 billion members globally.
OnZoom is a product in beta that will help creators monetize fitness classes, concerts and music lessons. There is also an event discovery feature. Recently, Pinterest has announced a partnership to help creators on their platform reach a larger audience with Zoom.
Analysts on the recent earnings call seemed especially excited about Zoom's ability to sell into the Global 2K with international expansion being a large focus. From Rakuten's recent partnership, plus Lumen/Centurylink and Deutsche Telecom, these larger partnerships with tech providers are my favorite catalyst moving into next year. Essentially, they see Zoom as the best product available (and least threatening) to integrate for unified communications and voice. This is the best evidence that Zoom Video is not a fleeting pandemic stock as large telecommunications providers shift towards cloud.
Zoom Rooms is a software-defined video conferencing system. Eric Yuan is likely tapping into his experience at Cisco as this will be one of the main competitors he takes on with this move to eradicate conference hardware.
The software-defined solution also extends to kiosks for virtual receptionists, will allow for voice control including an Alexa integration and advanced AWS console. The Smart Gallery will use AI to create a gallery-view of participants for hybrid workforces to where the viewpoint of the camera creates the best imaging possible and other whiteboard features are coming in 2021.
Okta
According to most standards, Okta's earnings report was solid and resulted in an uptick in the stock price. However, the growth has been flat for most of this year.
Revenue rose 42% to $217.4 million ahead of estimates for $202.7 million. Bookings (remaining performance obligations) are growing faster than revenue at 53% to $1.58 billion. Calculated billings were up 44% year-over-year. This was a re-acceleration of calculated billings from the previous quarters in FY2021 where the pandemic weighed on budgets.
The company is profitable on an adjusted basis with EPS of $0.04 and free cash flow of $41.6 million, up from $9 million a year ago. Highlights include a growing number of customers in the financial services sector and government.
The guidance was conservative at $221 million to $222 million, representing a growth rate of 32% to 33% year-over-year. The company is also guiding for an adjusted loss of $0.02 to $0.01 EPS. The fiscal year 2021 offered stronger guidance of 40% growth year-over-year for $822 million in revenue with adjusted EPS of $0.04 to $0.05.
According to the investors deck, the company has a combined addressable market of $55 billion across Workforce Identity and Customer Identity. The contribution margins at 70% for fiscal 2017 cohort analysis on page 14 was impressive. The net retention rate is 123% with adjusted gross margins of 78% and adjusted operating margins of 2.5% and free cash flow margins of 19%. The net retention rate saw a re-acceleration to its highest level in two years. Typical NRR is in the 119-121% range. Free cash flow margin was also its highest in two years.
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Total customer count was up 27% and annual contract value was up 34%. The current outlook for the company is 30-35% CAGR through FY 2024 and free cash flow margins in FY 2024 of 20-25%. The total number of $100,000 plus customers stands at 1780, an increase of 34%. The base of customers with annual contract value of greater than $500,000 grew 50%.
Okta's management pointed to three trends in driving business: Cloud and Hybrid IT, Digital Transformation and Zero Trust security. There is a partnership across Proofpoint, Netskope and CrowdStrike which is classified as a deep product integration for an enhanced product stack.
Okta was also recently introduced to the AWS marketplace and is the only identity vendor in the products for Control Tower, which allows for the management of more complicated AWS environments.
Notably, Okta was given a lower-ranking spot in the leader category of the 2020 Gartner Magic Quadrant for Identity and Access Management. One could argue too much attention is given to Gartner at times as Okta has been through a challenging and anomalous year. However, it should be noted that Okta was in a wide lead on the leader quadrant for 2019 and has been bumped down to equal standing with Microsoft and Ping Identity.
Snowflake
Snowflake grew 119% year-over-year to $159.6 million with remaining performance obligations of $927.9 million, or 240% year-over-year growth. Product revenue grew 115% year-over-year. The net revenue retention rate of 162% is impressive although other companies have exceeded this in their 6th year (Snowflake was founded in 2012 but was in stealth mode until 2014 when it began to work with customers).
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Gross margins are between 58% to 63%, which it's normal for a cloud company to be lower than a SaaS company on margins. However, operating margins were negative (30%) with FCF margins of negative (23%). Probably the biggest issue that Snowflake faces are the sales and marketing costs. In the previous two quarters, they were near or exceeded total revenue and in this quarter they were about 90% of revenue at $134 million compared to the $159 million in revenue.
The issue here is the rapid growth is being paid for in sales and marketing dollars and could slow when the bottom line becomes prioritized. Growth marketing tactics like this can often skew the true growth rate of a company at the expense of the bottom line. When equilibrium is sought, the top line suffers (or the alternative is that profitability is a long way off). Oddly enough, the bleeding operating and FCF margins weren't mentioned by the analysts in the Q&A on the earnings call.
The bigger product announcements on the earnings call include Snowflake expanding from semi-structured to unstructured data (which will be helpful for machine learning), SnowPark which enables users to query in their language of choice (Java, Python, etc). The overarching goal is to consolidate workloads and meet the demand for data governance purposes.
The company issued forward guidance for FY 2021 of revenues between $538 million and $543 million for YoY growth of 113% to 115%. Margin will be decent for adjusted gross at 68% compared to negative (40%) operating margin and negative (18%) adjusted FCF margin.
Snowflake is a strong company. In my opinion, the valuation is a major risk and continues to be considering the high sales and marketing costs that are causing an imbalance between the top line and bottom-line growth. Net retention rate of 169% is impressive although is a consumption model and cannot be compared to SaaS.
CrowdStrike
CrowdStrike beat consensus estimates on both the top and bottom lines and raised Q4 guidance. Revenue grew 86% YoY, representing an 8% beat above Wall Street estimates. Subscription revenue increased 87% YoY while annual recurring revenue advanced 81% compared to a year ago. The company also achieved its most impressive quarter ever in terms of profitability, earning $0.08 per share on the bottom line. This was CrowdStrike's third consecutive quarter of positive EPS and its highest total yet. Free-cash-flow margin increased to 33% and gross margin improved to 76%.
Here is how CrowdStrike's FCF margin compared last quarter:
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In the quarter, CrowdStrike added 1,186 net new subscription customers, representing growth of 85% YoY. CrowdStrike also continues to drive new module adoption in existing customers, as 44% of the company's subscription customers have adopted five or more modules versus 39% in the previous quarter. Management guided for $248M in revenue for Q4 (+63% YoY), representing a 7% raise above expectations.
This was an impressive quarter for CrowdStrike both in terms of increased usage of existing customers and the addition of new customers. As previously mentioned, CrowdStrike continues to excel in its ability to drive new module adoption with 61% of the company's customers adopting 4 or more modules versus 52% in the same period a year ago.
In the quarter, CrowdStrike announced the addition of three new modules to the Falcon Platform, covering cloud security posture, dark web threats, and incident response investigations. The Falcon Platform now encompasses 16 modules in total.
CEO George Kurtz highlighted new module adoption as a key to the company's growth strategy in its Q3 Earnings Call: "I'm pleased to announce that in Q3 we reached a new milestone with 22% of our subscription customers having adopted six or more modules. Driving adoption of our expanding module lineup is a keystone to our growth strategy as it increases the strategic value we provide to customers, which also translates to higher retention rates."
This quarter indicates CrowdStrike is successfully executing on this growth strategy.
The second key to CrowdStrike's growth hinges on its ability to add new customers, a metric that increased 85% YoY in Q3. One key customer win in the quarter was signing Target, which displaced Symantec and deployed Falcon completely across its footprint in less than 10 days.
CEO George Kurtz discussed the marquee win in its earnings call: "a win with Target that highlights how our single agent cloud-native architecture, intuitive console, and rapid re-bootless deployment capabilities continue to be significant differentiators for us. Target Corporation was looking to rapidly move away from Symantec and transition to a single agent cloud solution that could be deployed in days, not months or years."
Zscaler
ZScaler announced Fiscal Q1 2021 results that easily cleared analysts' expectations. Revenue growth accelerated to 52% YoY, which represents the company's third consecutive quarter of growth acceleration.
Adjusted billings growth increased 64% YoY, far surpassing the consensus expectation calling for 39% growth. This beat was driven in part by a record quarter of seven-figure deals. The company's net retention rate of 122% advanced from 120% last quarter and 119% the quarter before. Non-GAAP EPS of $0.14 was 8 cents better than expectations while the company also announced an impressive 30% FCF margin. Non-GAAP operating margin of 14% far exceeds the consensus of 2.9%.
CREDIT SUISSE
The acceleration in growth coupled with the record quarter of operating profits and free cash flows makes this one of the best quarters ZScaler has announced.
CEO Jay Chaudry discussed the three main factors that allowed his company to outperform this quarter: "One, building on our growing traction with large enterprises. We closed a record number of seven-figure ACV deals… two, our optimized go-to-market engine is driving significant velocity… Last year, we doubled down on our investment in our sales organization. These efforts are also bearing fruit in two big ways. One, our newly hired sales reps are contributing at a faster pace. And two, our sales productivity is higher than a year ago, despite a high percentage of ramping sales reps… Three, the power of our Zero Trust Exchange platform is resonating with CxOs."
Looking ahead, ZScaler believes that the strong business momentum they have exhibited in the last several quarters will continue. Management raised guidance over 5% for FQ2, now expecting $147M of revenue at the midpoint (+45% YoY). Management attributed the strong FQ1 in part to stronger than expected deal activity and expects these trends to continue into the next quarter.
In its FQ1 Earnings Call, CEO Jay Chaudry touted the company's position amongst a growing opportunity: "I believe in the current challenging environment and in the post-COVID economy, Zscaler will be the go-to-platform for vendor consolidation, cost-saving, increased user productivity, and better cyber protection.."
Elastic
Elastic announced strong FQ2 earnings on 12/2. Total revenue increased 43% YoY, representing an 11% beat above consensus. Total billings grew 42% YoY while SaaS revenue increased 81% versus the same period a year ago. The company's losses also improved significantly, with non-GAAP EPS of -$0.03 coming in 17 cents better than expected. Non-GAAP operating loss improved to -$1.9 million, representing a -1% operating margin versus -10% projected. Gross margins also came in better than expected with 77% versus a consensus of 75%. FCF margin was -13% for the quarter.
Subscription revenue totaled 93% of Elastic's total revenue in the quarter, with 45% of total revenue coming from outside the US. Management views this geographical distribution as a strength in the company's business model. Elastic's net retention rate ticked down several points from last quarter but still remained modestly above 130%. Elastic now has a total of 12,900 subscription customers with 650 of those (5%) having annual contract values exceeding $100K.
At the start of its fiscal year, Elastic's management discussed how COVID-19 would likely create headwinds to calculated billings for a couple of quarters and that they would then see gradual improvement beyond that.
In its FQ2 Earnings Call, management confirmed that the first half of fiscal 2021 played out as expected. The company has observed longer sales cycles and many customers are looking to conserve cash as spending patterns have not recovered to pre-COVID levels. Management updates its outlook for the second half of the year, noting that they expect the trends they observed in the last two quarters to continue in the next two: "given the global situation with the pandemic, our current assumption is that the mixed demand environment that we experienced in the first half will continue for the rest of the fiscal year. Previously we were expecting the environment to gradually improve during the second half." Still, Elastic's strong execution in the first half of its fiscal year gave management the confidence to increase its guidance for the next quarter. Management raised guidance 4% for FQ3, now expecting $146M of revenue (+29%). However, the company expects EPS to decline to -$0.15 on a -7% operating margin for FQ3.
Elastic's management ultimately expects the demand environment to return to pre-COVID levels in fiscal 2022, which would align with the summer of 2021. While the company is certainly facing some headwinds due to the pandemic, the digital transformation has provided tailwinds that have allowed growth to remain strong. Management expects these tailwinds to continue beyond the rest of their fiscal year: "the tailwinds of cloud and our solutions adoption position us well for the rest of this fiscal year and beyond."
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.
This article was originally published on Forbes on Oct 8, 2020,11:23pm EDT
Rebound numbers from Q3 will look spectacular following the paralyzing effects of strict shelter-in-place orders in Q2. The economy is officially in a recession after posting two negative quarters of GDP growth at (5%) in Q1 and (32%) GDP in Q2. The latest estimate from Atlanta’s Fed GDPNow for Q3 2020 is showing a record rebound of 35.3%.
This represents an increase of 7.9% quarter-over-quarter and 3.1% below the pre-recession high. For comparison purposes, the Financial Crisis of 2008 bottomed at 4.0% below its pre-recession during the third and fourth quarters of its recession.
The chart above shows the projected Q3 rebound of 35.3% from the Atlanta Fed’s GDP Now released on October 6th, 2020.
Cloud and IT Budgets: Staying Objective
Some will argue the market is not the economy (which is true), however, cloud software can’t stop the spiraling effects of lower IT/cloud spending and tighter budgets that follow a weaker economy. One area that companies might reduce costs is to trim down on the number of cloud software and tools they use. Unemployment could exacerbate this if the subscriptions are paid per employee.
Spiceworks recently released a survey that shows 80% of IT-decision makers expect IT budgets to grow or stay steady over the next 12 months. This supports the notion that even during periods of uncertainty, IT and cloud are central and critical to operations.
With that said, the decision-makers polled stated the primary drivers in IT budgets are noted to decrease year-over-year except covid-related budget allocations. In the past, drivers such as employee growth, security concerns, and the need to upgrade IT infrastructure were expanding to support higher budgets.
Perhaps more indicative is the decrease in revenue that is being forecast across the 1,000 IT-decision makers that were polled. One-third of businesses expect revenues to increase from 2020 to 2021 which is down from 58%. One-third also expects revenues to decrease YoY which is up significantly from the previous two years when only 7% expected a decline in revenue.
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As the survey illustrates, cloud software will be more resilient than many other categories. However, there will be some cloud software companies that see an impact on one side of the equation or both sides of the equation – this means either fewer new customers or more churn or downgrades in existing customers or both. There are three points where weakness can occur (fewer sign-ups, churn, and downgrades). Notably, companies that have annual recurring revenue will be more protected.
In this article, we go back through earnings calls to see what management is saying in each respective company:
These companies had positive things to say about budgets …
Twilio:
“Our customers in nearly every industry have had to identify new ways to communicate with their customers and stakeholders, from patients to students to shoppers and even employees essentially overnight… Twilio was built for this. The things we've always brought to our customers, digital engagement software agility and cloud scale are enabling organizations to innovate now even faster than ever. Messaging, email voice and video are allowing companies to engage with their customers safely while reimagining their digital engagement strategies in ways that will be resilient for years to come…And now we're seeing the strength of that diversification really play out during COVID, as we've seen new industries, new use cases offset some of the more negatively impacted areas.” – CEO Jeff Lawson Q2 Earnings Transcript (8/4/20)
Fastly:
“The need for a trustworthy and modern edge platform has never been greater. Developers and security operators are at the center of the transformation and they can only drive transformation effectively if they can build quickly and securely…Fastly is in this unique position to be a usage-based model with the most innovative companies in the world. And so when you stack on, the most — the largest innovators and you look just at their results, whether it be Pinterest or Shopify, the list goes on and on.” CEO Joshua Q2 Earnings Transcript (8/5/20)
Crowdstrike:
…. “even in this challenging macroeconomic backdrop, cybersecurity is mission-critical and more important now than ever, as the threat environment escalates and the attack surface continues to grow…as organizations rapidly adapt to the new distributed workforce paradigm and move more workloads to the cloud, it has become clear that the endpoint is the new security perimeter, and the inadequacies of the complex brittle patchwork of legacy solutions continues to be exposed.” — CEO George Kurtz Q2 Earnings Transcript (9/2/20)
Bandwidth:
“The second factor driving our outperformance was the increased usage driven by COVID-19-related remote work requirements which peaked in April and thereafter dissipated throughout the quarter, but remained at elevated levels as compared to pre-pandemic period…While it is becoming increasingly difficult to differentiate COVID-19-related usage from organic usage growth, we estimate that COVID-19 revenue impact in the second quarter to be in the range of $4.5 to $5 million.” — CFO Jeff Hoffman Source: Q2 Earnings Transcript (8/2/20)
Price-to-sales change for the stocks covered in this analysis since the start of cloud software earnings reports on August 1st, 2020.
These companies were more some headwinds and some tailwinds cancel each other out for a neutral outlook …
Dynatrace:
“Despite the global pandemic continuing to delay some new sales cycles…Customers tell us that they consider Dynatrace an essential element of executing a successful digital transformation as they drive towards greater agility, efficiency, and business effectiveness…what we’re seeing is that as digital transformation accelerates, the need for a Dynatrace class solution even goes up. And that’s what we saw the beginnings of it in our fiscal Q1 and we continue to see it as we look out into Q2 and beyond with the sales cycles we’re now in.” – CEO John Van Siclen Q1 Earnings Transcript (7/29/20)
Cloudflare:
“We believe the pandemic forced companies [to] distort their vendors into two buckets, nice to have and must have. All indications from the quantitative metrics we’re watching as well as the qualitative conversations we’re having with customers are that Cloudflare is squarely in the must have bucket…COVID-related concession requests peaked in early April and had been tailed off. We came in well below what we forecast for potential downside…our sales cycle has kicked up by a few days in Q1 and trended back down in Q2 and remains well under a quarter and at the low end of our historic range.” – CEO Matthew Prince Q2 Earnings Transcript (8/7/20)
Okta:
“So we're obviously pleased with the results of the quarter and the strength in the quarter. We did see those mild pandemic headwinds. Frankly, they were not as strong as we thought they would be. And so I think what the movement of companies to decentralizing how they're working with the fact that companies are seeing with their customers, they're transitioning to more of an online relationship with those customers are both just big impacts for us, big tailwinds for us that are just accelerating some of the overall mega tailwinds we've talked about before, and that's really what's happening.” -Bill Losch, CFO Q2 Earnings Call (8/27/20)
Change in price for the stocks covered in this analysis since the start of cloud software earnings on August 1st, 2020.
These companies were more conservative in their comments about budgets …
Datadog:
“The macro environment did have some impact on our top line results, and in particular on growth of existing customers. Our customers continue to grow usage of our platform in Q2, but the rate of this growth was below the trends we saw before the pandemic. This dynamic was primarily seen in our larger customers, who already had sizable cloud environment. Given macro uncertainty, we saw these customers look to conserve cash where they still could and therefore, optimize the consumption of cloud infrastructure…To put it plainly, customers with large cloud deals from AWS, Azure or GCP look for short-term savings. Note that this is not a new motion, as we see many enterprises go through these optimization exercises on a regular basis. What was unusual this quarter was to see a large number of companies going through it at the same time.” -CEO Olivier Pomel Q2 Earnings Transcript (8/7/20)
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Alteryx:
“The global dislocation experienced as a result of the COVID pandemic followed by shelter in place orders, altered our customers buying behaviors in Q2. We observed notable changes such as higher levels of scrutiny on spending across all sectors resulting in longer sales cycles, smaller deal sizes and less favorable linearity in the quarter…Based on what we see today, we do not anticipate a material improvement in business conditions during 2020.” – Former CEO Dean Stoecker Q2 Earnings Transcript (8/7/20)
UPDATE (10/5): Alteryx currently expects that total revenue for the third quarter ended September 30, 2020 will be in the range of $126.0 million to $128.0 million, representing 22% to 24% year-over-year growth, ahead of the previously issued guidance of $111.0 million to $115.0 million
Slack:
“In Q2, calculated billings were impacted by approximately $4 million of COVID-related concessions and contract duration related headwinds. This brings the total concessions-related billings headwind in the first half to approximately $11 million.
Although we’ve seen a slowdown in concession requests over the past couple of months, it’s still not possible to forecast the effects of the pandemic on our customer base over the next few quarters. We plan to continue to help customers manage through this unique time and expect calculated billings to be negatively impacted and less useful as a measure of underlying growth during the COVID-19 crisis.” -Allen Shim, CFO Q2 Earnings Call (09/09/20)
New Relic:
“On the other side of the equation of customers are reducing their spend. So in the quarter, that number was also – we had $5 million to $6 million of downgrades that were COVID or macro related.” – CFO Mark Sachleban Q1 Earnings Transcript (8/5/20)
Conclusion:
We think it’s important to remain objective when evaluating cloud stocks. They have already proven to be affected by budgets per second quarter earnings calls and this could extend into Q3 for cloud software business models that are dependent on (1) number of employees, (2) new customers, (3) low churn, or dependent on (4) upgrades.
IDG released a survey stating that 81% of survey respondents were using cloud infrastructure compared to 73% in 2018. Even more bullish than the universal acceptance of cloud is that only 9% of environments are cloud-only with the large majority having a mix of cloud and on-premise at 83%. This will grow to 16% cloud-only over the next eighteen months.
Therefore, regardless of any temporary setbacks, cloud as a category still has quite a bit of runway.
