Cloudflare will report its results on August 1st. Management guided revenue in the range of $393.5 million to $394.5 million, representing YoY growth of 27.7% at the midpoint. Despite the Q1 revenue beat of 1.4%, management did not raise the FY guidance due to the mixed macroeconomic environment and geopolitical uncertainty. They remained cautious and said that the short term is uncertain, and the long term is bright.
Cloudflare is at an advantage as the company has visibility into many industries and had rightly given early warning of the slowdown in 2022. They reassured investors in the last earnings call during the Q&A that the level of concern is not the same as in Q1 2022 but remains prudent.
We see pockets of weakness (Tesla, for example, continues to face the effects of high interest rates), yet we will need to look to more commentary from Cloudflare to understand if the situation has grown worse or better as it’s not clear from our vantage point what spooked the CEO last quarter.
Revenue
The analysts expect Q2 revenue to grow 27.9% YoY to $394.5 million. Revenue growth will decelerate from 30.5% YoY to $378.6 million in Q1. It will further decelerate to 26.1% YoY growth in Q3 and 25.9% in Q4 and then accelerate to 26.2% growth in Q1 FY 2025. This is actually quite strong for best-of-breed cloud as many >40% revenue growth cloud companies have dipped <20% in recent years.
Margins
The Q1 gross margin improved 180 bps YoY and 50 bps sequentially to 77.5%. The adjusted gross margin improved 170 bps YoY and 60 bps sequentially to 79.5%. This was higher than the management’s long-term target of 75% to 77%.
The operating margin was (-14.4%) compared to (-16.3%) in the same period last year and (-11.8%) in the previous quarter. The adjusted operating margin improved 450 bps YoY and 20 bps sequentially to 11.2%. The operating expenses as a percentage of revenue were reduced by 300 bps YoY due to the focus on higher productivity and greater efficiency in the operations. Sales and marketing expenses as a percentage of revenue reduced by 100 bps, R&D expenses reduced by 200 bps and general & administrative expenses reduced by 100 bps YoY. The adjusted operating margin guide for the next quarter is 9%, up 240 bps YoY and down 220 bps sequentially.
The net loss was (-$35.5) million or (-$0.10) per share compared to (-$38.1) million or (-$0.12) per share in the same period last year. The adjusted net income was $58.2 million or $0.16 per share compared to $27.2 million or $0.08 per share in the same period last year and beat estimates by 22.6%. The guide for the next quarter is $0.14.
The analysts expect adjusted EPS to grow 40.7% YoY to $0.14 in Q2 and decline by (-6.3%) YoY to $0.15 in Q3.
Cash Flow and Balance Sheet
- Q1 operating cash flow was $73.6 million or 19% of revenue compared to $36.41 million or 13% of revenue in the same period last year.
- Free cash flow was $35.6 million or 9% of revenue compared to $13.9 million or 5% of revenue in the same period last year as it benefited from an uptick in collections on accounts receivable. Network capex was 8% in the recent quarter. Management expects network capex to be 10% to 12% of revenue in 2024, including the rollout of GPU capacity to every location.
- The company has cash and available-for-sale securities of $1.72 billion and debt of $1.28 billion compared to $1.67 billion and $1.28 billion in the December quarter.
Key Metrics
RPO
RPO increased 8% QoQ and 40% YoY to $1.343 billion. This is an acceleration from growth of 37% YoY in the previous quarter.
Billings
The company’s primary focus is on RPO as a more comprehensive measure of its business. We track billings since they are reported for other cybersecurity stocks. Billings grew by 24% YoY and declined by (-7%) sequentially to $387.6 million and a deceleration from 28% YoY growth and 15% sequentially in the previous quarter.
DBNRR
The dollar-based net retention rate was 115% in Q1, flat QoQ but down from 117% in the year-ago quarter. Management expects the decelerating trend to stabilize around the current levels.
Customers
Customers with greater than $100,000 annualized revenue grew by 33% YoY to 2,878. The number of customers has been trending higher sequentially even though the growth decelerated from 35% in the previous quarter.
Matthew Prince, CEO and co-founder, said in the earnings call, “We added 122 new large customers, those that pay us more than $100,000 per year, and now have 2,878 large customers, up 33% year-over-year. Revenue contribution from our large customers during the quarter increased to 67%, up from 62% in the first quarter last year. Digging into our largest customers, we added a record number of net new customers year-over-year spending more than $100,000, $500,000 and $1 million on an annualized basis. We are successfully moving upmarket and becoming a larger and more strategic vendor to more and more of our customers.”
Paying customers grew by 17% YoY to 197,138 and have been growing at a similar rate in the last three quarters.
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.”
Other key points to watch
FY Outlook
Cloudflare has good visibility in various industries since the company is a leading CDN player. Management has been cautious due to macroeconomic uncertainty and geopolitical tension, maintaining the FY 2024 guide of $1.648 billion to $1.652 billion, representing a YoY growth of 27.3% at the midpoint. However, the market expected a rise in the FY 2024 guide, particularly after the strong Q1.
Matthew Prince said in the earnings call, “I feel extremely confident and clear in the long-term opportunity that Cloudflare has in front of us. 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. Even without that visibility, if you've been watching the news at all, it's clear that the near-term outlook for the world is uncertain, increasing tensions in the Middle East, no end in sight from the Russia-Ukraine war and potential signs of instability in Asia. It's not at all certain on anything we see that things will get worse, but we do know from even recent history that macro factors can impact short-term sales trends.”
During the Q&A, Matthew Prince clarified that they didn’t see a clear signal of a slowdown that they saw in 2022. He described the crystal ball as cloudy. “We see things that worry us, but we also see things that give us some level of optimism. And so, I think describing the crystal ball as cloudy is the right thing.”
Customer wins
The management highlighted strong customer wins during the Q1 earnings. Some of the notable include:
“The National Cyber Security Centre, the UK's technical authority for cyber threats, signed a three-year contract with Cloudflare to deliver its protective domain name service. PDNS protects over 1,400 UK organizations in central government, local government, healthcare and emergency services from malware and cyber threats.”
“A leading technology company expanded their relationship with Cloudflare, signing a three-year, $40 million pool of funds contract, $8.5 million of which are expansion.”
“A large international energy company signed a five-year, $4.5 million contract. This new customer is going all-in with Cloudflare's SASE platform with 6,000 Zero Trust seats along with CASB, DLP, browser isolation, Magic WAN and Magic Firewall.”
Network capex
The company has been efficiently managing capex despite the GPU rollout and benefitting from the uniqueness of its platform to onboard new workloads. Management mentioned that they don’t need capex like the hyperscalers. Matthew Prince highlighted in the earnings call that they sell more high-margin products like Zero Trust and SASE that require lesser capex. They also made the right decision to reserve space, sensing the AI opportunity. The company now only needs to plug the GPU cards into the servers, freeing up the capex to invest in other areas. Also, they note that the inference tasks do not require cutting-edge GPUs that are in short demand, so the company has more flexibility in choosing between different GPU vendors.
Network capex was 8% of the total revenue in Q1 and has been at the same level in the last three quarters. Management expects network capex to be 10% to 12% of revenue in 2024, including the rollout of GPU capacity to every location.
Valuation
The company trades at a P/S ratio of 18.9 and a forward P/S ratio of 16. The average P/S ratio since the company’s listing in September 2019 is 33. We continue to monitor the 20x forward P/S level that ‘best-of-breed’ cloud stocks struggle to maintain, particularly when the macroeconomic conditions worsen.
Conclusion
The company sits in an enviable position for AI inference at the Edge. The developer growth of Workers to 2 million was the highlight in the last earnings report. We continue to monitor the key metrics and the outlook for the year. We liked the management’s response on network capex as it shows they have a strategy. It’s showing up today with cash flows remaining at an acceptable percentage of revenue – although, notably, we want to stay neutral here regarding what the network capex reports in the future and continue to scrutinize cash flow margins.
Royston Roche, Equity Analyst at the I/O Fund, contributed to this article.
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