Cloudflare, Inc. (NET) Earnings Call Transcript & Summary

Well, thanks, everyone, for joining us. We're going through the Cloudflare fireside chat now. My name is Alex Kurtz. I'm part of the equity research team here at KeyBanc Capital Markets, covering infrastructure software route. I appreciate you guys taking time out of your day to joining us. Before we get into introductions and the fireside chat, we will be taking questions through the conferencing platform. It's very easy to use. The sooner you start populating with questions, I can kind of integrate it into our discussion in the next 25 minutes. For Thomas and Jayson, if there's some really discrete stand-alone questions, we'll kind of throw that on at the end for you guys to work through. But again, thanks for the Cloudflare team for being with us. So today, we have Thomas Seifert, CFO of Cloudflare; and Jayson Noland, Head of the IR team at Cloudflare. Thanks for coming, guys.

Thanks, Alex.

Yes. Thanks for having us.

Yes, much appreciate it. So let's just start with a basic introduction to Cloudflare, kind of the architectural background, the founding of the company, your approach and why you guys are so excited about the TAM. And then we'll get into the more specific questions about the quarter and the near term. But I just wanted to have you guys frame that out for us?

Yes. I think it's fair for us to get started with our mission statement. We say we want to help build a better internet and we mean this literally. The Internet was not built for what it is used today. Our ambition is literally to make anything that wants to connect to it, more secure, more reliable, and cheaper from a cost perspective. The company was founded almost 10 years ago. We have today more than 3 million free and paying customers. We operate a network that is in more than 200 cities today, more than 100 countries. And of this network, we offer to our customers, services like routing, firewall, bot mitigation as a subscription where you would have previously bought on-premise hardware that you needed to install in your data centers. Close to 1,600 employees, I said more than 3 million free and paying customers, more than 16% now of the Fortune 1000 companies are working with us or are customers of ours. And we've been able to do this because of the uniqueness of the architecture of this network. So it's a network that resides in 200 cities, off-the-shelf hardware. And on this hardware, runs a unique fully integrated software stack that allows us literally to offer every product we have, every service that we offer on every server in every city and every country that we operate. And with that, we can lead us to complete network service to manage traffic, demand and supply. And it's one of the reasons why we grow fast, we have lots of customers, but we also have a really interesting margin structure north of 76%. So if there ever is a bumper sticker, it's probably Cisco as a Service.

That's great. And is there a certain use case that you typically spin up first with a customer? Or is it really dependent on the customer segments and their own demand to their network?

Yes. Good question. And we have this unsatisfactory answer, I guess, it depends. It depends who you are and where you come from. If you are a financial service customer out of this vertical, it's very likely that you come to us for security, a DDoS attack, firewall, something that falls into this category. If you're a large e-commerce platform, you are probably looking for one of our performance products, load balancing or -- that's for reliability products. So it -- literally, it depends. But once you are on our platform for one or the other product, it's really easy to expand because literally, every other product, every other service we offer is only a mouse click away. And with that expansion in this business model, it's easy and we pride ourselves that we can expand customers quickly and with the architects on the platform we have.

So there's a lot of new products you bring into market. We can save this for later in the conversation. But obviously, the cybersecurity capabilities is a big part of the story. The serverless marketplace is obviously going to be very important a lot to the business longer term. Maybe quickly frame out why those products are going to be really important drivers to the long-term growth of the business.

Yes. So it's almost like the company is attacking this in building concentric circle. So there -- the first wave of products is what you would call it internally was around protecting the infrastructure, networking infrastructure of our customers. So if you think about the buckets, we think about reliability, performance security. It's about firewalling, bot mitigation. It's about the load balancing. It's about routing. And then we started this year, at the beginning of this year, to talk about this next group of products that we call Cloudflare for Teams. So Cloudflare Access was the first product that's literally the buzzword would be a zero trust platform product. But it's -- if you are a little bit less sophisticated or a little bit less glamorous in terms of buzzwords, it's a VPN replacement product. That is what it is. It will be followed up with the Gateway product, the Gateway product at the end of the third quarter, beginning of the fourth quarter. And then a really exciting technology that we acquired at the end of last year, beginning of this year from a company called S2, it's a browser isolation product where we literally can now offer browsing as a service from our network. So that is a group of product that is -- it had either been launched at the beginning of the year or will come later. It builds the second concentric circle around the TAM that we address. We said it in our S-1 when we get started become a public company last year. There, the first time we disrupt is about $38 billion. The network infrastructure market growing 4% year-over-year that now comes a significant TAM to that with the addition of Cloudflare for Teams products. And then as you already mentioned it once, our edge computing product, Workers, that would be, we call it internally our third wave of product that has -- that we've started now about 2 years ago. But from a revenue contribution perspective, it's more about adoption, maximizing adoption and not so much maximizing revenue. We think about it as a third wave product.

Okay. It's a great place to start. I appreciate that. So again, for the folks that -- and we've got a lot of folks who are logging in here. So we have a Q&A function within the conferencing platform. If you want to start populating with questions, please go right ahead and do that. So Thomas, you saw a very strong growth within larger enterprise this quarter. Are those opportunities generally displacement of legacy on-premise vendors? Or are those more greenfield opportunity? I guess in a broader context of how you go to market, but what really drove large enterprise this quarter for you?

So a lot of answers in answering that question. So from a competitive perspective, where does most of our TAM come from? Our revenue comes from? It's still about disrupting the on-premise-based solutions. And the competitors that would fall in these categories are the names that the F5s and the Riverbeds, and the Ciscos and the Blue Coat appliances and the Palo Alto firewalls, every time where you can take a on-premise solution and move it to the cloud and replace it with one of our service. This is still the majority for us where we disrupt. The second bucket is of competitors that we look at is what we call point solution providers. And we think an Akamai would fall into that, Fastly, a Limelight, also Zscaler. And -- but the majority of our revenue still comes from the disrupting the on-premise hardware solutions. Yes.

One of the things that we've heard through some other presentations today is just how COVID has changed the nature of competition, the nature of adoption and kind of the mix of legacy versus new entrants in the marketplace. So just kind of building on this -- your response to that question. What is COVID meant for your pipeline and kind of how you compete? And what -- how has that changed from like a year ago?

I think we -- it allowed us to play even stronger to the strengths of our business model. And let me give you some color on that. Our -- the majority of our go-to-market before COVID, despite the significant growth that we have seen from a large enterprise local perspective is still our inside sales teams, right? And in a time of COVID, where you cannot visit a customer, where you cannot meet face-to-face, that allowed us really to play to the strengths of our business model. The second topic is we don't have to ship hardware. We don't have to install on-premise. Our services and our products are cloud-based. They are simple to install, whether you are -- come to our website to our -- to us as Alex, protecting your blog post. It takes 5 minutes to be behind our network. If you come to us as KeyBanc, that installation is going to take maybe an hour or two, but it doesn't take weeks. It doesn't need professional services. It doesn't need hardware. So the go-to-market was a big factor that favored us, how our products are sold, installed and "provisioned," makes it really easy for us. And I think the third topic is -- and Matthew mentioned that on our last earnings call. When COVID started, the world seem to take a pause and some of our customers seem to sort the services that they need into a nice to have and must have. And I think we got sorted into the must-have bucket. So business paused for a couple of days in March, but we are now back to our historical sales cycles. And that's another KPI that really reflects the efficiency of the go-to-market. Our sales cycles are well below a quarter. And that, I think, tells you how the business model really can perform and benefits then, of course, in a situation like this.

Do you think sales cycles are benefiting from just generally speaking, more people just in front of their screens and being able to really focus on the projects they want to do and not have to get team meetings together physically sort of benefiting from that efficiency, or at least you're tracking back to more normal levels and that's where it is right now?

Well, I think our sales cycles are short because of how the business model is architectured. And in terms of how we approach customers, how easy it is to install a product. And then also how we do business. We had a customer in the second quarter that was under heavy DDoS attack, all the on-premise products failed. And we brought him behind our network literally within hours. And we didn't talk about contracts and pricing and legal structures, we just solved an acute need of that customer. And once that was solved, we talked about commercial terms. I think that is also something that helps us in our sales cycles that we focus on the help first before we talk about the terms. And this allowed us to build long-lasting and deep customer relationships over time.

Okay. Going into sort of next line of questioning, just about -- and we touched on it a little bit earlier, but can you talk about how your go-to-market is evolving over the last couple of years? And what you're seeing from the channel and integrators in terms of new logos and sort of how they're contributing, if at all, to the model?

Yes. I mean starting maybe the end first and then working backwards. So channel and integrator is still a small part of our business today. Less than 10% of our revenue is partner-based. It's a big opportunity for us moving forward but in part, it's also a result of what we have been discussing so far, right? If you go to us and we are able to help you within literally minutes if you are a developer or maybe within hours if you are one of the largest financial institutions. The ease of installing our products doesn't or has not left traditionally a lot of value-add for integrators and partners. This is changing now as we move to Teams and Gateways and especially the opportunities that Workers is giving for partners to invest and provide vertical-specific solutions or problem compliance-specific solutions. So lots of us from an improvement perspective. Also, as we internationalize our footprint from a field sales organization perspective, room to grow the partner revenue. We've come from a freemium model. That's where we started, and then it became a pay-as-you-go segment where customers literally gave us a credit card, and we charged them $20 or $200 a month. And what you would call enterprise business or a contracted businesses, it started really late but it's now more than 80% of our revenue. So -- and that was built with inside sales teams first, and that is still, if you were to look at our sales headcount, that is still the majority of where our go-to-market sits. And only over the last 2 years have we started to build our field sales organization. And today, most of our headcount investment and buildup goes into our sales infrastructure.

So we're going to come back to that sales infrastructure question in a second, Thomas. But Jayson, we're not going to let you get out of here without taking some questions, too. The serverless marketplace, Workers, where you see Cloudflare fitting into that competitively? And why the opportunity is pretty exciting for the top line? So just kind of where you see Workers playing into the model over the longer term.

I can start and I'll have Thomas come in behind me. I mean, we -- the most common use case that we see today is a customer that wants to modify one of our subscriptions. So they like our firewall or our bot management solution or distributed denial-of-services solution, but they wanted to do X, Y and Z for their vertical and their geography, for their use case. And so they can write that code on our platform to customize our subscription. It saves our engineering department a lot of time and trouble, building features for corner cases. It helps us close deals faster because we get the customers what they want sooner. And then it just makes the relationship more sticky because they've customized our solution with their own codes. So that's where it starts. And if it was just that, it would be really good. But there's a lot more that has to do with compliance and multi-cloud and the fancy 5G IoT applications that we started to see. But I know Thomas has opinions on this, too, so I'll turn it to him.

No, no, it's good. Let me go back one step because we are really excited about Workers. It's today one of the largest and probably most widely used edge computing platforms. We launched it almost 3 years ago, now it has been in GA more than 2 years. And over this time line, we have seen hundreds of thousands of developers build product on it, hundreds of millions of lines of codes have been written on Workers. And Matthew had talked about it on our earnings call. He also wrote a really good blog on our blog post site. So if you want to have more details, just go there. But it describes also how our thoughts about edge computing have evolved over this time period, where we thought speed was really there, he called it the killer feature. We understand today that it's still important, but it's probably the niche case of applications. And what Jayson just mentioned, compliance in the world where data sovereignty, privacy laws have become so complex and difficult. A network that resides in 200 cities in more than 100 countries and offers you now a product that deploy code at the edge of this network and really allow you to run compliance-based use cases across all the products and services we have is really, really unique. And then comes ease of use. I think that is something that is also very special about Workers that you don't have to come to us and learn a programming language or something a new skill in order to use Workers. Literally, any programming language you learn down to as far back as COBOL, allows you to write code for Workers. And then the cost of that allows us to offer Workers at a really competitive pricing and still be marginally accretive to us. And then the architecture on isolates and 0 spin up times that allow us to be really competitive. What you also have to keep in mind, I think this is what Jayson alluded to, all of our products are built on Workers. So if you buy that as a subscription and use Workers, you can make that the most customized service for your needs, the most customized load balance or the most customized firewall, the most customized Cloudflare for Teams application. So we are excited about that. And as I said in the beginning of our chat here, we think in terms of waves of revenue generation, that would be a wave 3 product for us.

Okay. I'm sure we could spend all day talking about the other serverless products and how you're competing with them in the marketplace. We'll save that for another day. We are starting to get some questions here, and we have about 8 or 9 minutes left. So I just wanted to, Thomas and Jayson, integrate some of those, if you don't mind.

Certainly.

Just what's the proportion of your revenue base that kind of gets split between SMB, mid-market and enterprise today? And how do you see that trending over the next couple of years?

Yes. On our last earnings calls, we said that's slightly more than 80% of our revenue. It's what we call contracted, what others would call enterprise. And with that, less than 20% is now pay-as-you-go or SMB. Our enterprise business grows really, really fast. Our large enterprise footprint or our large enterprise segment, so customers that spend more than $100,000 a year with us, grew 65% last quarter, 65% the quarter before. It's between 65% and 70% in the quarters before that. So the contracted business, the enterprise business is going to get bigger and bigger, not because the other businesses are shrinking, it's growing too and growing nicely, but it's outgrowing the rest of the business.

Okay. Question here. Could you talk about how the Teams' trial is trending on -- end September 1. Any stats you could share here around just sort of adoption of that product through the trial period?

Yes. That was -- I mean, when we launched in January, we couldn't know that COVID was in front of us. We added thousands of customers in the first quarter. We continue to add hundreds of customers in the second quarter. And -- but we also have to be honest, there is, from cats and dogs and small to very, very large. So there's a wide variety of sizes and logos in there. We offered that for free because we thought it was the right thing to do in a situation like this where we all had to switch from on-premise to work from home. We originally said that the trial would last until first of September. We are still thinking through how we best manage the transition because the last thing we want to do is a minute past midnight on the first wave contracts in front of those customers. We want to be really diligent and helpful, especially to those that still might be in trouble or in need. We have been very conservative forecasting revenue. So we said, we gave guidance for the remainder of this fiscal year but it really -- it literally doesn't include any revenue from that free to paid transition. We'll have more color to share on our next earnings call. But of course, we are pleased. I mean what product allows you to launch in January and then literally add thousands of customers within 3 months. I mean it's just another good data point to show how efficient the architecture of their network in terms of hardware and software stack is.

Okay. And kind of a question around churn. I want to kind of expand your view of churn through COVID. And have you seen anything of the SMB versus mid-market versus enterprise, strategic versus nonstrategic accounts or maybe churn across different regions? Just sort of your overall thoughts there.

Yes. That was one of the pleasant surprises was the resilience of our pay-as-you-go business where we and probably others outside of the company expected higher amounts of churns. And -- but to be honest, the first and second quarter, from a new logo addition perspective, were probably the strongest quarters we have seen in years. And I think it goes back to what we said earlier, if you're a small- or medium-sized business, you don't have a web presence yet and this is the time where do you need to build it. And I think that is similar to what companies like Shopify saw, too. Literally, a strength in that segment. From a churn perspective, we are doing extremely well. We saw some large -- some accounts churn off in Asia, -- non -- we call them nonstrategic customers that joined us for other reasons and we try to optimize our margin going forward. But other than that, I think we are really happy where we are. We have seen good DNR's development, especially in Europe and in North America. 9 of our large -- 10 largest new ACV deals in the second quarter were expansion deals. So that I think gives you also an idea of how good we are when it comes to customer retention and expansion. Yes.

Okay. So just to finish up on a final topic here, which is the investment you've made in ramping up new account reps over the last year or 2. And what is the typical ramp period for a Cloudflare rep and when do you expect them to start being productive? And how does that all kind of factor into '21, right, as far as the timing of the trends that you saw play out this summer and the timing of different cohorts as they work through their development?

Yes. So we always prided ourselves that our sales product is not only high, but it stayed high consistently over the last quarters. And then last quarter, second quarter, especially, we saw a significant increase even in sales productivity. We said on the earnings call about 7% from a quota retiring capability perspective. So we've been able to add sales resources and sales capacity in the majority quota-carrying reps. And we've been able to onboard and ramp up this capacity, rather consistency -- rather -- in a rather consistent way, let's put it this way. And even now in the last quarter and the quarter before, where we -- everything is even for us virtual onboarding, we've been able to keep that productivity. We said on the earnings call, the second quarter was the highest ever in terms of number of our employees we added to the sales team. And we thought it was really important for us to keep that pace building up capacity for -- before we enter '21. Normally, it takes us about 3 months to ramp sales capacity or sales rep from starting to more or less full capacity, 3 to 6 months.

Okay. I think that would be a good place to stop. I want to keep everyone on time. I know everyone has kind of a packed schedule today. So really appreciate, Thomas and Jayson, taking some time with us today. Thank you very much.

Alex, a pleasure, as always. Talk to you soon.

Yes, that's great. And enjoy the rest of your time talking to investors at our conference, and have a great rest of your week. So thanks, everyone, for joining, and we'll talk down the line. Thank you.

Thank you.

Thanks.