Cloudflare reported a razor-thin beat in Q1, with revenues increasing 30.5% YoY to $378.6 million, marginally ahead of the company’s guide for $373 million by $5.6 million. The guide next quarter is for $394 million at the midpoint. Analysts were expecting $393.5 million. The stock is selling off because although Cloudflare beat for two quarters, management is not raising full year guidance.
If you do the math, the current guide implies a growth rate in the second half of 26.5%. The growth rate for H1 was:
- Q1 actual of $373M
- Q2 guide for $394M
- H1 of $767M compared to H1 revenue last year of $598.7 for H1 2024 growth of 28.1%
- H2 will be revenue of $883M compared to H2 revenue last year of $698M for H2 2024 growth of 26.5%. Notably, H1 2023 had higher comps (53% both qtrs) than H2 2023 (47% and 41%) so that doesn’t help explain the deceleration, in fact, it would make the decel stand out more.
The interesting part is that Cloudflare’s key metrics are not throwing any major flags as to what is causing the deceleration. Paying customers accelerated by 20 basis points from 17% to 17.2%. Customers above $100K were up 33.5% compared to 35% in the prior quarter. RPO increased 8% QoQ from $1.245 billion to $1.343 billion for growth of 40% YoY. This is an acceleration from growth of 37% YoY in the previous quarter.
When asked why management didn’t raise full year guidance, the answer was macro concerns. Essentially, what this earnings report is communicating is that Cloudflare is quite strong, but the macro environment is not, per signals Cloudflare is seeing from their vantage point as a company that has visibility into many industries.
Revenue and EPS:
Management said Q1’s results were “fueled by a record number of net-new customers year-over-year spending more than $100,000, $500,000, and $1 million with Cloudflare on an annualized basis.”
Although adjusted EPS increased 100% to $0.16 and beat estimates by 23%, Cloudflare struggled to make improvements down the line on a GAAP basis, with GAAP operating loss widening YoY and GAAP net loss showing little improvement. Cloudflare has stubbornly high SBC expense, at $69.7 million in Q1. This is about 18.4% of revenue, meaning that Cloudflare’s path to GAAP profitability will rely on continual improvements in gross profit growth and minimizing SBC growth.
- For Q1, Cloudflare reported revenue of $378.6 million, increasing 30% YoY and beating estimates by 1.4%.
- Adjusted EPS of $0.16 increased by 100% YoY, and beat estimates by 23.1%. GAAP EPS was ($0.10), an increase of 16.6% YoY.
- For Q2, Cloudflare guided revenue of $393.5 million to $394.5 million, representing YoY growth of 27.7%.
- For Q2, Cloudflare guided adjusted EPS to be $0.14, a slight sequential decline but a YoY increase of 40%.
- For FY24, Cloudflare maintained its revenue guidance for $1.648 to $1.652 billion, for YoY growth of 27.3%. Management increased its adjusted EPS forecast by $0.02, now seeing full-year adjusted EPS of $0.60 to $0.61.
Margins:
A higher mix of Zero Trust and SASE revenue contributes to the gross margin expansion. Zero Trust and SASE are discussed in more detail here.
A closer look at Cloudflare’s report shows that as revenues increased $88 million YoY, operating expenses increased $81 million, more than offsetting improvements in gross margin. However, Cloudflare reported a one-time sales & marketing compensation expense of $15 million, which was likely the primary reason for a ~41.6% YoY increase in sales & marketing spend. Stripping out this one-time expense would see GAAP operating loss improve by nearly $8 million YoY, from ($47.3 million) in Q1 of last year to ($39.5 million), instead of slipping deeper into the red at ($54.6 million).
- GAAP gross margin in Q1 was 77.5% for profit of $293.6 million, a 180 bp YoY and 50 bp QoQ expansion.
- Adjusted gross margin was 79.5%, a 170 bp YoY and 60 bp QoQ expansion for $301.1 million.
- GAAP operating margin was (14.4%), a 190 bp YoY improvement but a 260 bp QoQ contraction from (11.8%) in Q4 2023 for operating losses of (-$54.6) million. As stated, stock-based compensation is $69.7 million which drags down GAAP profits into the red.
- Adjusted operating margin was 11.2%, a 450 bp YoY and 20 bp QoQ expansion for adjusted operating income of $42.4 million.
- GAAP net margin was (9.4%), a 370 bp YoY improvement but a 170 bp QoQ contraction to ($35.5) million.
- Adjusted net margin was 15.4%, a 500 bp YoY and 80 bp QoQ improvement for $58.2 million.
- For Q2, based on management’s guidance, adjusted operating margin is expected to be ~9%, a 220 bp QoQ contraction. They expect FY adjusted operating margin of 9.8%.
Cash and Debt:
Free cash flow decelerated from 14% last quarter to 9% this quarter for a total of $35.6 million. Operating cash flow of $73.6 million had a margin of 19.4% down from 24% last quarter. On a YoY basis, Cloudflare is trending up on cash flows but the market is sensitive right now on this line item. Despite the QoQ deceleration, the CFO stated on the call that cash would increase in H2: “We expect free cash flow to be relatively consistent with operating profit for the full year 2024 with the first half lower and the second half higher compared with operating profit.”
Network capex is expected was 8% this quarter and is expected to be 10% to 12% for FY2024, which is in line with prior comments, yet will be up from FY2023 by 200 basis points, at the midpoint.
Essentially, the 10,000-foot view is that Cloudflare is competing with hyperscalers who have very large capex budgets. The concern is that Cloudflare may not be able to keep up — where will the cash come from to build a larger footprint given the cash flow margins are fairly thin with $1.7 billion on the balance sheet although net cash is $432 million when you consider the $1.28B in debt.
The CFO pointed out why capex should remain reasonable: “We were at 8% to 9% of revenue with network CapEx in the first quarter. We said the year will be close in the range of 10 to 12, and this includes the rollout of GPU capacity pretty much to every server and every location we have.”
The CEO said something similar later in the call – that capex will remain reasonable as a percentage of revenue: “If we have to — we — so it may be that we — on a just pure dollars basis, end up spending more on GPUs. But as a percentage of revenue, we feel very comfortable that we can service these applications very well at the percentage of revenues that it is in our forecast going forward.”But as a percentage of revenue, we feel very comfortable that we can service these applications very well at the percentage of revenues that it is in our forecast going forward.” There was additional discussion from the CEO on the call quoted below.
- Operating cash flow was $73.6 million in Q1, or 19% of revenue, compared to $85.4 million or 24% of revenue in Q4.
- Free cash flow was $35.6 million, or 9% of revenue, compared to $50.7 million or 14% of revenue in Q4.
- Cash and equivalents totaled $1.72 billion.
- Debt totaled $1.28 billion.
Key Metrics:
RPO increased 8% QoQ from $1.245 billion to $1.343 billion for growth of 40% YoY. This is an acceleration from growth of 37% YoY in the previous quarter.
DBNRR was 115% in Q1, flat QoQ but down from 117% in the year ago quarter.
- Customers with ARR of >$100K grew 33.5% YoY to 2,878. This customer cohort accounted for 67% of revenue in Q1, compared to 66% in Q4 and 62% a year ago.
- This is down from last quarter with 35% YoY growth.
- This is down from the year ago quarter with 40% YoY growth.
- Paying customers of 197,138 accelerated both YoY and QoQ
- This is up 20 basis points from 17% growth last quarter
- This is up from 13% growth in the year ago quarter
Cloudflare is reporting 2 million developers on their Workers platform. This is up from “more than a million” in a press release in November of 2023 and is up from 450K developers in May of 2022 per a corporate blog. Per the opening remarks: “The last few months were incredible for the entire workers' ecosystem. First, we crossed over 2 million active developers building applications on Cloudflare Workers. Second, in April, we GA-ed a number of key products like DY, our serverless SQL database; hyperdrive, which makes any traditional database perform like it's globally distributed; and Workers AI, which allows developers to run and tune AI models across our global network.”
Earnings Call:
The earnings call can be boiled down into two key discussions. The first was on capex, which was a very important discussion for the longer-term thesis of AI inference at the Edge and the Workers Platform, which we discussed here.
The second important discussion was analysts grilling management on why they didn’t raise guidance for the back half of the year. The brief answer is macro reasons, but the discussion addresses the primary reason the stock is down after hours.
Network Capex:
Today, for this report, network capex is not an issue. However, we did recently note that Super Micro has a fundamental problem where the company must raise cash to grow. Investors should pencil-in that Cloudflare could be in a similar issue someday. The management team is pulling a lot of levers to make sure this isn’t a serious concern, and ultimately if they can time their need to scale to when cash is cheap, then all will be well.
Here is what management said regarding why their approach is different from the hefty cash approach the hyperscalers take.
Answer
Matthew Prince (Executives)
[…] the thing which is really magical about Cloudflare's business, which is really elegant is that it all fits together so well. So for instance, as we sell more of our Zero Trust and SASE products, those are extremely high-margin products, and they don't require a significant additional amount of CapEx. That then frees up our ability to invest that CapEx in other areas, including in the AI space.
[…] That means that as we deploy CapEx, it's literally not shipping an entire server to support AI, but shipping just the GPU cards that go into existing servers that are in the field. That reduces the amount of CapEx that has to be deployed. And again, it works because it is all running on 1 unified network. The fact that every server across Cloudflare's entire platform is capable of performing any function that we need. That has allowed us an enormous amount of flexibility in how we can deploy things and has helped us.
[…] But in the average hyperscaler, if they're getting maybe 20% utilization out of a CPU or GPU resources that they've deployed, we can often be many times that in terms of the utilization where in CPUs we're seeing almost 80% utilization. So that efficiency allows us to get more out of every CapEx dollar. Finally, I would say that inference is different than training. And so you need different resources for that. You don't mean necessarily the most cutting-edge GPUs in order to do inference tasks. And so that has meant that we haven't had to chase down what is a — GPUs that have limited quantity. It's also meant that we can be much smarter about picking and choosing between different GPU vendors and matching workloads to whoever it is that can provide the best service. And I think over time, that gives us a significant advantage over people who are just trying to rent 1 particular type of GPU or rent that and let their customers figure out how to be as efficient as possible.
–End Quote
Workers Platform:
As we likely face some turbulence in the near-term (defined as next couple quarters) due to cloud valuations being quite high, it’s important to remember the medium-term thesis (next 1-2 years). When asked what was special about the Workers Platform, the CEO stated the following, some of which we described in detail in the October deep dive.
Answer
Matthew Prince (Executive)
In terms of why, what is it about Cloudflare that's unique? I think there are sort of 3 things that stand out to me about it. The first is just the performance of Cloudflare Workers AI because we are distributed around the world and today, over 150 locations globally, as we serve customers that serve a global audience, we can just give them a much better experience in having to ship all of your code back to some central location.
The second is that we can actually be significantly more cost effective. If you're using one of the big hyperscale cloud in order to do any sort of AI task, it's up to you to manage efficiency. You have to make sure that you're getting the most out of the GPU that you're renting whereas what we do is much more of a serverless AI model where you only pay for the task that you actually run. So especially in a lot of the start-ups, they're finding that they can just get significant better efficiency, significant better cost if they use our platform in order to deliver that AI experience. And then the third thing is that because we got it distributed globally and because of the fact that we have such a rich ecosystem that we've built, where you can get a AI experience that's allowing people to actually fine-tune their models […] We can actually correspond all of the local and regional differences all around the world. That's something that you don't get anywhere else.
—End Quote
Macro Concerns:
The tone on this particular call was that macro is providing early signals of a H2 slowdown. This was not your typical “oh, macro is hard to predict” discussion. When they discussed the H2 slowdown, it was not Cloudflare specific at all, rather that Cloudflare would have better visibility than other companies due to where they sit in terms of the internet.
This was a sample of the opening remarks:
“In the short term, however, my crystal ball is less clear. We see a lot of signals based on our privileged position running a good chunk of the Internet […] The short term is uncertain, the long term is bright, and so in the medium term, we're going to keep our hands firmly on the levers of our business […]”
Here’s an additional glimpse into the tone on the call, at times:
Question
Jonathan Ho (Analysts)
Excellent. And just a quick follow-up. Is there something specific in the macro that's maybe causing you a little bit of pause? Anything that you can sort of point to in terms of that additional concern on the outlook.
Answer
Matthew Prince (Executives)
I think that we we get a lot of signal based on where we sit on the Internet. And what I would say right now is that it's not any one thing pointing in any one clear direction. But there's a lot of noise pointing in a number of different directions that give us, I think, reason to be cautious and I think that, that is in our very nature is always taking as much signal being data-driven and making sure that we're making investments in a responsible way. And so I think the obvious thing is the geopolitical uncertainty around the world. That absolutely causes changes in buying behavior. On the other hand, some of that — those changes in buying behavior have been positive for us as we're seeing, especially in our government business, pick up because of that uncertainty.
So there are puts and takes that are out there. What we want to do is just make sure that we are being prudent and responsible and thoughtful as we make investments and as we think through how to handle the responsibility that we have with investors capital and that they've trusted us with.
–End Quote
Additional discussions on macro had a similar tone, such as this one from the CEO: “We can make investments and we can think through what that future looks like in part because we just get much more signal than I think the average enterprise SaaS company gets. And I think that, that has served us well. And I think we try not to be surprising in any way. And so as we see — I would say that there is certainly an uptick in uncertainty and sort of potential downside this quarter over last quarter.”I would say that there is certainly an uptick in uncertainty and sort of potential downside this quarter over last quarter.”
Here is more along those lines: “I think my level of concern is not at the same level that it was in Q1 of 2022, but it is definitely heightened over a lot of what we've seen in more recent quarters.”
However, one analyst didn’t let them off the hook so easily, and so to really drive home the tone of the call, I’m quoting in full one of the last questions where the analyst pushed for management to be crystal clear.
Question
Alex Henderson (Analysts)
So if nothing is really spooking you here, I'm still struggling with the guidance and the outlook for the back half of the year. You've given guidance that — or commentary that you're seeing significant strengthening of your pipeline, you're saying you're duration stable. You're seeing solid closure rates. You're adding more sales capacity, you're winning large customer deals at an accelerating rate. You’re spending more on hiring people and productivity in your sales force is significantly improving. Yet your guidance implies with the first quarter beat and the second quarter are above the Street, the back half is much more conservative. So I guess the question is, is that a function of specific weakness in a particular geography or due to political issues? Or is it just trying to feather in more opportunity for the sales organization to be realigned as Mark comes on and drives things because ultimately, it sounds like the mechanics imply an acceleration, not a deceleration.
Answer
Matthew Prince (Executives)
Yes. Alex, I'll start and then Thomas can give a little bit more color. I would push back on your initial statement, which was that nothing spooks me, a lot spooks me right now. So just because just — and I want to make it clear, we are in a much more uncertain environment and the signal that we're seeing is that uncertainty is up. In addition to that, I think you're correct that whenever you have a sales leadership change, there is risk that comes with it. And so there's a bit of that. But the primary factor here is that as we look at the signals in the overall macro economy, it is — it feels like a much more — it feels like there's much more reason to worry in Q1 than there was in Q4. But that doesn't mean that it was the same, just sound the alarm bells that we were seeing back in Q1 of 2022.
–End Quote
Conclusion:
Cloudflare’s valuation at 18x forward sales is hovering at the 20x forward PS level that ‘best-of-breed’ cloud stocks struggle to maintain. If macro does weaken, cloud stocks will get slammed for their thin FCF margins (far majority have negative FCF) and lack of GAAP profitability. Remember, I’m simply the messenger here. The reality is that cloud gets hit hard. We trimmed the position over the past quarter or so because cloud simply doesn’t sustain well at certain valuations. Had we not already trimmed Cloudflare, we would be doing so today – primarily based on valuation, secondly due to this management team being better than most at giving investors a heads-up when something is off. Meaning, management stated their crystal ball was “cloudy,” but in reality, if you’re listening, they’re being crystal clear.
With that said, Cloudflare is one of our favorite choices for the medium-term. The company sits in an enviable position for AI inference at the Edge. The key metrics are strong incl an acceleration in RPO, and I suspect that won’t be the case with most cloud peers this quarter. The developer growth on Workers to 2M is fire. I liked management’s response on network capex as it shows they have a strategy, and it’s showing up today with cash flows remaining at an acceptable percentage of revenue – although, notably, we do want to stay neutral here in terms of what the network capex reports in the future and also continue to scrutinize cash flow margins.
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