Cloudflare will release its Q3 results on November 07th. Analysts expect revenue to grow 26.4% YoY to $424.12 million and adjusted EPS to grow 14.2% YoY to $0.18.
During Q2 results, management increased the FY revenue guide to $1.658 billion at the mid-point from $1.65 billion, representing YoY growth of 27.9%. The FY2024 adjusted operating margin guide was raised to 11.9% from 9.8%, up from 9.4% in 2023.
There was a survey published by Wells Fargo that stated Cloudflare is taking more market share from cybersecurity vendors. The downside is the report also stated Q3 was the weakest environment they’ve seen in three years. We need an earnings report to confirm the results of the survey, yet it’s encouraging to see NET is stronger than its peers in a spending environment that is largely outside of the company’s control.
Regarding AI, Cloudflare is uniquely positioned to capture inference at the edge. The company has grown developers on the Workers platform from 2 million to 2.4 million, for 20% QoQ growth. Companies with decent sized developer moats (Nvidia, Apple, etc) have a developer following in the 3 to 4 million range. Given the majority of the AI market is focused on training large language models at the moment, inference needs time, but there are early signs of which companies will succeed as AI matures.
Revenue
The company’s revenue is expected to grow steadily at around 26% in the next few quarters. The growth is quite strong for best-of-breed cloud as many >40% revenue growth cloud companies have dipped <20% in recent years in what has been a seismic shift in cloud. Our firm was early to report on this shift for our members. Yet, Cloudflare is one of the very few that have sustained strong growth levels.
- Q2 revenue grew by 30% YoY to $401 million. Management guide for Q3 is $423 million to $424 million, representing a 26.2% year-over-year growth at the midpoint.
- Analysts expect Q3 revenue to grow 26.4% YoY to $424.12 million and 25.8% YoY to $455.80 million in Q4.
- Last quarter, management increased FY2024 revenue guide to $1.658 billion at the midpoint from $1.65 billion, representing 27.9% YoY growth.
- Analysts expect revenue to remain steady over the next three years at 28% growth, 27.1% growth and 27.8% growth YoY through 2027.
Margins
Cloudflare showed strong improvement in operating margin and net margin in Q2. It also significantly increased the full-year adjusted operating margin guide from 9.8% to 11.9%.
- Q2 gross margin was 77.8% compared to 75.6% in the same period last year. Adjusted gross margin was 79% compared to 77.7% in the same period last year.
- Operating margin was (-8.7%) compared to (-18.2%) in the same period last year. Adjusted operating margin also significantly improved to 14.2% from 6.6% in the same period last year. The operating expenses were reduced due to focus on higher productivity and better efficiency in the operations.
- Management’s adjusted operating income guide for next quarter is $50.5 million at the midpoint or 11.9% of revenue compared to $42.5 million or 12.7% of revenue in the same period last year.
- The difference between the GAAP and non-GAAP operating margin is due to stock-based compensation which was $86 million in Q2 or 21.4% of revenue. The high level of stock-based compensation reflects what the competitive cloud industry must do to retain talent.
- During Q2 results, management had increased the FY 2024 adjusted operating income guide from the range $160 million-$164 million or 9.8% of revenue at the mid-point to $196 million-$198 million or 11.9% of revenue at the midpoint. By doing the math, the Q4 adjusted operating income guide comes to $47.1 million or 10.4% of revenue.
- Q2 adjusted net income was $69.5 million or 17.3% of revenue compared to $33.7 million or 10.9% of revenue in the same period last year.
EPS
Analysts have increased adjusted EPS estimates after the company raised the FY 2024 guidance to $0.70 to $0.71 from the earlier guide of $0.60 to $0.61. Management Q3 adjusted EPS guide is $0.18.
- Analysts expect Q3 adjusted EPS to grow 14.2% YoY to $0.18 and 15.4% YoY to $0.17 for Q4.
- Analysts expect strong growth with 2024 adjusted EPS to grow 46.1% YoY, followed by 20.5% in 2025, and 28% in 2026.
Cash Flow and Balance Sheet
The company’s cash flows are improving. Management has reiterated they expect full year free cash flow in the range of $160 million to $164 million. This is a significant improvement from the $119.5 million free cash flow in 2023 and also suggests an acceleration in the second half with estimated free cash flow of $88.1 million.
- Q2 operating cash flow was $74.8 million or 19% of revenue compared to $64.45 million or 21% of revenue in the same period last year.
- Q2 free cash flow was $38.3 million or 10% of revenue compared to $19.97 million or 6% of revenue in the same period last year.
- Network capex was 6% of revenue in Q2. Management expects network capex to reach 10% to 12% of FY 2024 revenue in the 2H of the year as the company is rolling out GPUs in every location. We see setting these expectations while ultimately increasing cash flows as a positive.
- The company had cash and available-for-sale securities of $1.757 billion and debt of $1.285 billion compared to $1.716 billion and $1.284 billion in Q1.
Key Metrics
Remaining Performance Obligations (RPO) Accel’d QoQ
RPO increased 6% sequentially and 37% YoY to $1.42 billion although it was a deceleration from 40% growth in Q1. The current RPO was 69% of total RPO.
Billings
The company primarily focuses on RPO as a more comprehensive measure of its business. We track billings since they are reported for other cybersecurity stocks. Billings grew by 23% YoY and 9% QoQ to $421.7 million, a slight deceleration from 24% growth in Q1.
DBNRR
DBNRR was 112% in Q2, a 3-percentage point deceleration from 115% in Q1. The CEO stated the decline was driven by slower net expansion in the larger customer cohorts and an increase in “pool of funds” contracts. The pool of funds contracts is a transition in billing from annual contracts to pool of funds accounts that are on a monthly basis for three or more years. The pool of funds accounts are unique to the largest customers (for example, 4 of the top 10 customers are this account type) that use many products across the entire Cloudflare platform. These are considered larger platform deals that are paid on a monthly basis in a multi-year contract rather than an annual contract on one product. This is shifting how DBNRR and RPO are reported since revenue is recognized as the customer consumes the service.
Customers and Workers AI platform
Paying customers grew by 21% YoY to 210,166 and accelerated from 17% in Q1. For customers with an ARR of >$100K, Cloudflare reported 30% YoY growth to 3,046. This customer cohort contributed 67% of revenue, flat with Q1 yet up from 64% in the year ago quarter.
Cloudflare Worker Applications grew from 2M developers to 2.4M developers in four months, per the CEO’s opening remarks. The Workers AI Platform developer accounts grew 67% QoQ and inference requests grew 700% QoQ.
Other key point to watch
Customer Wins
Wells Fargo noted that the Q3 security reseller survey was the weakest in the last three years. However, Cloudflare’s survey results showed a strong uptick. “Cloudflare's (NET) results significantly up ticked to +31% net (-9% last qtr), as resellers noted strong overall demand trends for the full suite, including SASE, CDN, and cloud security.” This data point is not meant to make an earnings call, rather we will look for management to confirm the results of Q3.
Management mentioned in the last earnings call that the go-to-market initiatives are reaping rewards. The company also delivered another quarter of double-digit year-over-year increase in sales productivity during the second quarter, and saw an uptick in close rates, and an improved sales cycle.
The management also announced several large customer wins, and the notable one was the land & expand customer, who was a free customer: “A leading Australian technology company expanded their relationship with Cloudflare, signing a two-year $17.5 million contract, $7.2 million of which is expansion. They started with Cloudflare back in 2016 as a free customer and today use nearly all our products spanning use cases as diverse as remote application access, worker serverless development and bot management.”
Another prominent U.S. university signed a five-year $5.7 million contract. With Cloudflare, they were “able to replace multiple legacy vendors with a unified platform and cloud-first architecture.”
Valuation
Cloudflare is trading at a P/S ratio of 20.04 and a fwd P/S ratio of 18.06 and is trading below its five-year average P/S ratio of 32.67. Cloud has seen a re-rating, so the multi-year averages are not reliable in the current macro backdrop.
Conclusion
Given CrowdStrike has stumbled recently, Cloudflare has emerged as the leading best-of-breed cybersecurity stock. Although not GAAP profitable yet, the company saw a slim (3.8%) net margin in the last quarter, which puts GAAP profitability on the horizon. In the meantime, the company is improving its margins and cash flows, putting investor concerns to rest about capex, and is quietly sitting on one of the biggest developer ecosystems in the market with a fairly frictionless path to onboard the Workers AI platform once the inference market takes off.
We continue to watch Cloudflare’s report with anticipation as the company is firing on many cylinders. We are participating in the event Cloudflare beats, and we also have a trading plan in mind should we be able to get shares lower.
Royston Roche, Equity Analyst at the I/O Fund, contributed to this article.
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