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

Welcome, everyone, to the Jefferies CyberSecurity Summit. This is Brent Thill. I run the software team. I'm joined by my partner, Cyber Joe or Joe Gallo. We appreciate your time. We have both Thomas and Jayson from Cloudflare with us. Obviously, an incredible year for the company. Great to see the momentum, gentlemen. Thomas runs all the finance functions. Jayson's in IR and does a number of other things for the company and made the right move from the sell side to a company. So congratulations on that move, too.

Maybe just to kick off, gentlemen, I mean, accelerating growth in Q3, architecturally in the right spot. You've got -- obviously, you don't want to bet on the pandemic to help the business. But kind of everywhere you look, the wins seem like they're at your back. Give us a sense of kind of what you're seeing from your perspective at a high level in the momentum of the business. And as you look into next year, kind of what are the things that are -- you're most excited by at a high level that you see as we look out into '21?

Well, first of all, thanks for having us on your conference. So happy to be here and talk about Cloudflare. It's -- as you said there, it's always not a good thing to start about profiting or getting tailwinds out of a pandemic. But certainly, when COVID started in March, markets took a pause. We saw that in -- for 1 or 2 weeks, the world seemed to come to a still, a stand. And then customers saw that companies, I think, in 1 of 2 pockets: are you essential or are you not? Are you essential for us to continue doing business? And we were sorted in this must-have category. And I think this has been driving and -- as a tailwind, you might want to say, for sure, the performance of the last quarters. But it's not like that tailwind is going to disappear into next year. So -- like a vaccine is rolling back time, and customers are rolling back digital transformation. If at all, the pandemic has shown us that different business models are workable. We just have to look at us. We were a company that was very skeptical towards remote employees and not coming towards the office. We thought that would be an essential part of Cloudflare culture. And now we all work remotely. So at the very least, we are going to tolerate it and -- if not encouraging it. And all of a sudden, that means -- what does that mean for your security posture for the tools you need in order to enable that. So we think the trends we have seen this year, to a certain extent, will continue moving into next year. And some things will even be -- like COVID, would thrust almost like a time machine. I'm not sure you saw that we announced a feature today that our customers, in conjunction with our Cloudflare for Teams products, Access and Gateway, you can collect information where your employees are working, where they're logging in from. And that can automatically feed into your HR systems, and so you're -- and payroll systems. So you're tax-compliant in a world where location and your workplace has become rather mobile and remote. So we're excited by the products that are coming out, and we are looking optimistically into next year, I guess.

Great. Now you're going to tax me more for living in California. Thanks, Thomas. Cloudflare One, some exciting packaging combination of a lot of the products, can you just give us a sense of the reception, or what it means to you? And any kind of sense, just how you think about pricing for Cloudflare One?

Yes. We announced Cloudflare One a couple of weeks ago now. And it's -- literally, it's the culmination of a lot of engineering and technical development that was guided by hundreds, if not thousands of customer engagements and discussions of what the future of the corporate network is going to look like and what it means that now things are transitioning to the cloud, that employees are working remotely, that your network infrastructure has become rather, rather complex, and you need new ways to secure them. So it is bringing together a comprehensive, in part, new features, in part, existing products, bringing together a comprehensive cloud-based network as a service solution. And it's designed to make you secure and fast and reliable. And in a way, it defines -- it has to define what we think the future of the corporate network is going to look like and how it replaces all those patchworks of appliances and technologies you had in place. So it brings -- for us, it brings together how users connect, how you on-ramp branch offices, how you secure connectivity for applications and how you control access to SaaS into one single platform. And we think that this reflects what their complex nature of their corporate network looks like today and how we can move it into their -- into a secure environment moving forward. So we are excited by it. And the feedback from the customers has been really, really strong. In a way, it's going to be a seat-based product. So we will sell it by dollars per seat per month moving forward. So it also moves us from a bundling and from a pricing perspective in the new category. What I think -- a few folks have realized that it also increases our TAM, especially when it comes to how you onboard your branch offices. And we now can clearly say we are also going after ISP spend in the budgets of our customers.

A lot of attention around Cloudflare Workers, Thomas, as the channel checks indicate that the serverless area is an area to move. If you're a developer, this is a game changer, where you can focus on the application and let Cloudflare handle all the back-end pieces that you don't really have to worry about. I think a lot of excitement, a lot of questions from investors. Maybe you could just kind of level set where you're at today, where you think this could be going forward and anything you think is important to add around this solution.

Well, first of all, we think edge computing is the future, and we are excited about the product we have that literally allows us to deploy code at the edge of our network. I -- and it's not a beta. It's not an announcement. We talk about 10,000s of new developers on -- that have joined the platform and that are deploying real code at the edge of the network. I think we learned also a lot over the last 2 years. And Matthew wrote this really interesting blog on our web page that said the edge computing opportunity might not be what you think it is. When we got started, we thought that it is a platform and a product that is all about speed and minimizing latency to -- between anything that wants to connect to our network. But we've realized that we have to look at it almost like a pyramid of needs from a developer perspective. And today, in the near term -- in the midterm, we think that the biggest use case and application for Workers and our edge computing platform will be compliance needs. And then in the world of data sovereignty and more privacy laws in different regions of the world, putting heavy regulations on how data should be handled and where it could flow, we actually truly think that the biggest opportunity is -- in the midterm is our compliance-related applications. The architecture of the product itself is also very unique. It runs on a very slim architecture. We call it isolates. That allows it for that technology to run -- an extremely cost-efficient, so we can price it aggressively and still be highly margin-accretive. It has incredible performance because it's such a light architecture, the spin-up times are close to 0. It's 5,000x faster from a spin-up time performance than Amazon Lambda. And it's also -- it caters very much to the developers from an ease-of-use perspective. You don't have to learn a language. We come to you. We literally enable everything from Python to COBOL in order to capture a large universe of developers. So super excited. From a revenue perspective, we are always shying away from pushing revenue too fast. So we always call that Workers, a wave 3 products for us. So at the moment, it's not priced for revenue. It's literally priced for adoption. We want to get it in as many hands -- developer hands and customers as possible and really make it the edge computing platform that is on the market.

And in doing that, this can serve as a halo for your other products?

Well, not only is it a halo -- you have to keep in mind that all Cloudflare products are built on Workers. So the simplest use case is that you buy a product for us, and if you attach Workers to it, you can make it the most customized product in the market. You could buy our load balancer and attach Workers to it and use Workers to make it their most customized load balancer that is out there. So it's not only a halo. It's a tool to customize our products through your specific needs, and that's one of the other reasons why I think the attach rate that we have -- we said we are attaching Workers about 20% of our enterprise contracts, is so high.

Shifting to Cloudflare for Teams, the Access and Gateway solution. You were kind during the pandemic to kind of give away Access for free, and you onboarded thousands of customers. Maybe talk to how you think this translates to monetization into the next year?

Yes. Cloudflare Access, it is a VPN replacement product. So it goes after VPN installments. And we launched it in January, shortly before COVID hit us. And we decided in a world where companies were struggling, especially small companies who are struggling to all of a sudden accommodate a remote workforce that it would be well served for us to run a program where we make that available for free. We got later requests by -- especially from governments to extend the program and also cover larger enterprises from a footprint perspective, and we did. You have to keep in mind that for us, Cloudflare Access is 1 product out of 4 that summarizes -- is summarized under this Cloudflare for Teams approach. So for us, before COVID, it was a really important step forward to increase our TAM that we attack, move from protecting networks to protecting individuals and teams, that was the idea behind it. Access was the first step. There are 2 more products that followed this year: our Gateway product that I mentioned shortly in the beginning and then our browser isolation product that literally allows you to offer browsing as a service and were followed by a DLP product in the first quarter of next year. So Access was this first step. It was a free program until end of September. And we are careful how we transition from free to paid, keeping in mind that there is a bigger bundle possible. So the last thing we want to do is -- was showing up at a customer's foot -- doorsteps at the -- on the 1st of October waving a big contract. So we wanted to be diligent. A lot of companies out there that are still suffering. And also not push short-term revenue and forgiving -- forgoing a bigger opportunity with a bigger bundle once all 4 products are ready. So we've seen good adoption out from free into paying across very small customers but also very large customers. And you asked earlier, what am I excited about for next year, Cloudflare for Team, and the opportunity and the TAM it addresses certainly is something that falls into the category of excitement for next year.

I think Matthew highlighted on one of the calls recently that it's harder to get into Cloudflare than Harvard Business School. Are you still seeing this flow of resumes and the demand load? I mean when you think about onboarding direct sales quota capacity and the type of engineering talent you need in this environment, just talk to us about your ability to onboard enough capacity to keep up with what the demand you're seeing.

Yes. We talked about how many applications we've seen in the second quarter, what happened in the third quarter. It's not slowing down, let's put it this way. And that is good news, it makes us excited and it gets us excited about the talent we're able to attract, of course, makes recruiting processes rather long. We are, meanwhile, famous for the number of interviews you have to go through in order to become a part of Cloudflare. And even to this day, at the very end, will be an interview with the founders, even at this size. And there are hundreds of employees we hire. And that, I think, is a good transition into how do you hire and keep your culture. We were very nervous what would happen if we literally onboard now hundreds of new employees. They've never seen a Cloudflare office from the inside, have not met their hiring manager in person like so many other companies are experiencing it right now. And we have tried to counter that. We've tried to adjust our onboarding processes, how big an onboarding class can be. It's now limited by the amount of individual windows you can put on a Zoom calls, so to speak. We've tried to put tools in place that allow for random interaction of new employees. So you find a platform to build cross-functional and -- relationships within the company. So we've been quite conscious that this is something we need to manage very carefully. And so far, it has been working well. If at all -- you mentioned sales and onboarding, if at all, sales productivity has gone up in the second and third quarter and was not impacted by the pandemic.

Yes. One of the big questions that you get, and we get is this kind of migration from helping the upstarts, the mid-tier companies to now the large enterprise companies. Last quarter, you recorded your first $10 million ARR customer, with paying large customers up 63% year-on-year. For a real high level, can you talk through the company's move upmarket in enterprise and how you think this evolves into '21?

There are a lot of things that we're proud of, how enterprise developed over the last 24 months certainly falls into that category. And you mentioned the large customer cohorts or large customers are redefined as customers that we make more than $100,000 a year in terms of revenue. What is the strongest growing cohort? It has now -- you mentioned 63% in the third quarter. But I think even more impressive is that cohort has been growing north of 60% consistently since the first quarter of 2018. But there is a lot of momentum there. Growth is 50% new logos, 50% is the expansion. So we -- that, I think, gives you an idea that we've been able -- despite there walking our way up in terms of larger and larger accounts and larger and larger ARRs per account, we've been able to keep the efficiency of our broker market. The customer that you mentioned that plus the $10 million ARR threshold started out at the $60,000 a year customer 4 years ago. So significant expansion. I think the efficiency of the onboarding, how you buy our products, so to speak, and how you implement our products is a part of that. Even if you're on our platform for 1 or 2 products, there's complete visibility of the traffic that hits your infrastructure. And every new service, every additional product from Cloudflare, literally, is only a mouse click away, so that we do not have -- that we don't need any professional services. The Cloudflare doesn't need to send employees to your location to onboard or do something, certainly help, especially during COVID, to keep this momentum. But the efficiency of the go-to-market that we're able to invest behind a demand curve that we do not have to build up capacity, and then this sales capacity has to find business, has been rather elastic from a capacity-profiling perspective. And so far, we are confident that's going to hold up in '21, too.

40% top line growth has been pretty -- really impressive, obviously. When you think about -- as you go out the next couple of years and you look at product mix, how do you think about the primary engines of growth? And then what are the engines that are kind of coming up? As a pilot, you have confidence in you're going to be able to kind of turn those engines on to kind of help sustain if there's any type of issue with the primary engines. How do you think about the new engines that are coming on as well?

No. I think what has made Cloudflare special from the very beginning is that it's not a one-trick pony. And that growth has multiple growth vectors and drivers. There is, for sure, product and the amount of product that we -- and features we have been launching. And there, if you look at the pipeline is on is one of those factors that is, I think, very, very strong. And not only is it new products and features, we have been able to constantly increase our TAM over time, too. The core of products for us, very much networking as a service. In the S1, when we went public last year, we sized that at about $38 billion, growing 4% every year. We launched now Cloudflare for Teams at the beginning of the year. So that is another concentric ring on around this TAM. So it's TAM increasing. And we talked briefly about Workers, which we call a wave 3 product, that would add on top of the 2 TAMs that we just talked about. So very strong core product and development and feature pipeline. I think in Q3, it was north of 120 products and features alone that is driving that. You have the growth vector of the go-to-market. We just talked about our -- the accounts that we lend are getting bigger and bigger, and the ACV per account gets bigger and bigger. So you have the expansion vector and the logo vector. We were at 10% of the Fortune 1000 companies. And last year, we had 16% now. So big improvement, but there's also a lot of whitespace for us still to cover. And then one more vector to point out is our international footprint. We were always in a good situation that 50% of our revenue happened outside of North America, but that revenue in the beginning was pay-as-you-go business. And we are building -- as we move up the enterprise stack and get to bigger accounts, we are increasing our local footprint offices in Germany. We just opened Paris a couple of weeks ago, Tokyo, Sydney. And we have 3 more international locations coming up in the first and second quarter next year. So multiple growth vectors that would support this moving forward, I think, it's rather unique and gives us the confidence to look ahead.

Just on international, Thomas. You are partnering with the JD Cloud in China. Do you think that there -- unlike the rest of tech that we cover, very few can have a big presence in China. Do you feel that there's an opportunity to tap the China market?

Yes. For sure. And we think about the China market literally in 3 buckets. There is international businesses that I want to do business in China. You have large now Chinese international companies that want to do business outside of China. And then you have the domestic economic activity that needs to get covered. And that is potentially a lot of market. 25% of whatever wants to connect to the Internet, whether it's individuals or IoT devices, is sitting in China. So it's, for sure, an important market for us. We are present today with about 25 PoPs, 25 locations in cities. The partnership with JD, that is ramping up as we speak, will get us to 150 locations in China over the next 3 years, pretty much 15 new locations every year consistently for the next 3 years. So it's an important platform for us. Today, we -- it's still less than 5% of our revenue. So there's opportunity.

You're a rare opportunity there, that doesn't happen. So should feel good about that. The -- in terms of kind of -- when you think about organic versus M&A, how do you approach that? How do you think about opportunities? Given what's happened with the stock now and your presence, do you think differently about M&A or not?

We constantly look and scan for technology and things that are interesting. But we have a really high hurdle for inorganic growth. And the high hurdle comes from the architecture of our business model and where the efficiency in the architecture comes from. We always talk about this off-the-shelf hardware stack. And on that hardware stack runs a fully integrated software stack that allows us to run every product and every service we offer on every server in every city. And this is the secret sauce behind the margin. It's the secret sauce behind the low CapEx -- network CapEx intensity that we have. And we do not want to endanger that. So when we look at technology, the first question always is how easy is it to integrate for us that technology into our existing software stack. That's why S2, the browser isolation company we acquired at the end of last year, beginning of this year, because we saw that it would make a lot of sense for us and we will be able to integrate it in our software stack. And because of us being able to run every product on every server, we can use the complete network service to manage demand, supply and cost for our customers. And every new location we offer, increases those degrees of freedom. So that puts a very high hurdle on M&A from an integration-capability perspective. That doesn't mean it's not going to happen. It doesn't mean that we are looking around. But that's why I think there's this natural bias towards organic development and tuck-ins, for sure. But we don't want to end up with a Frankenstein network that is cobbled together, that breaks this one control plane that we are currently able to offer across all products, across all regions, including China. So does that make sense?

Right. Maybe, Jayson, to bring you in quick on the conversation. Anything that you're hearing from investors that needs to be addressed or something that may be a misperception that you think is important to kind of clear up or not really anything from your side? I'm curious if there's anything that you would want to add.

One thing that comes up are companies that you and I have covered through the years that are best-of-breed winners with really narrow TAMs that have a day in the sun, and then they become a feature of a firewall or another platform over time. So that's -- it's a common question, and I think some investors have been burned by traditional cybersecurity companies that are feature-rich but too narrow. And I think Cloudflare has a chance to turn a lot of products into features. But it's a question that comes up from people that have looked at security and -- for years and haven't had as much success as they had hoped.

That's great. We're out of time, but congrats on all the momentum. Thanks for joining our conference today. And looking forward to what you guys can do in '21. So have a great end of the year. And we look forward to staying in touch. Thanks again.

Thanks, Brent. Thanks, Joe, for having us. Bye.