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

Excellent. Thank you, everyone, for joining us this afternoon. My name is Keith Weiss. I run the U.S. software equity research effort here at Morgan Stanley. And I'm very pleased to have with us this afternoon Thomas Seifert, CFO of Cloudflare.

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Excellent. Before we get started, I do have to read a brief research disclosure. For important research disclosures, please see the Morgan Stanley Research Disclosure website at www.morganstanley.com/research disclosures. If you have any questions, please shoot to your Mortgage Stanley representatives.

So with that out of the way, Thomas, thank you so much for coming back to the Morgan Stanley TMT Conference. Cloudflare is coming off of really an outstanding quarter and an outstanding year. You saw accelerating revenue growth to the mid-50s in the most recent quarter, net dollar expansion rate expanding even further [indiscernible] growth at 70% plus growth in the large customer cohort. Can you talk to us about -- is this -- the top question from investors is the durability of this on a go-forward basis? And really coming down to sort of the crux of it is, is there some aspect of this great 2021 that is your COVID beneficiary? Or is this really just the summation of -- you guys have been putting in layers and layers of sort of new solutions, new go-to-market and into the company, and now you're seeing the fruition of that investment?

Yes. [Technical Difficulty]

I think the mic is not on here.

So I think it's a misconception to a certain part that COVID was a significant tailwind to the business. It actually started out as a significant headwind. And that is part on how our business model is structured. When COVID happened and traffic spiked, we all depended more than ever on the Internet. Traffic went up by 60% with a subscription business model. So we are not able to pass on those explosion in costs in our prices. So we were able to digest these headwinds, both from a margin perspective, but also from a growth perspective. So when we entered '21, they were not easy compares or difficult compares. It was really basic organic growth. I think COVID might have accelerated enterprises digitalizing their business models, that certainly helped. But I think if you look at our growth, and this has been growing. Last year was the first year in a row where we grew north of or at 50%. I think it's primarily the result of -- and even for me, after 4 years at Cloudflare more than 4 years, an incredible growth engine that is driving that. When we went public 2 years ago, we treat -- the elevator speech was we described ourselves as a Cisco as a service. Every time you go to a Cisco, or a Cisco-like competitor and you buy a load balancer, or firewall, or router, we offer this as a service from our network. And we sized the TAM at that time at around $38 billion. And then we added Cloudflare for Teams protecting infrastructure, VPN replacement, gateway, browser isolation, e-mail. Now that added probably another $20 billion of TAM. And then we launched a suite of projects called Magic Transit, Magic WAN, Magic Firewall, where you take that protection that we offered on an application layer down to Layer 3. That adds another $30 billion. And then there's Workers. So I think a big part of what is driving growth or has driven growth in the past is our ability to just out innovate and keep that TAM that we disrupt increasing.

Yes. To me, one of the most exciting parts of watching Cloudflare over the past couple of years is that innovation engine. And we talk about it in terms of like Act 1, Act 2, Act 3 type solutions. There's other companies that I followed before, it takes 20 years to get to Act 3. You guys have done it in basically 5. Can you give us some kind of sense -- when we see the mid-50s growth? What are the relative contributors? Like how much of that is Act 1? How much of it is Act 2? Is Act 3 still on the comp? Or is that a major contributor today? With that one being more of the sort of traditional CDN, WAN, DDoS, Act 2 of being more of the Zero Trust security and the Layer 3 and Act 3 being the edge compute?

The easy answer would be the good news is still to come. I think this year is a lot about taking our Zero Trust solutions to market and continuing to expand. In your words, on your description that would be a Wave 2 product. We see significant traction with our infrastructure, networking as a service product, but that is just picking up. And there's Workers, which is our platform to take computing and code to the edge of our network. And we always said that it's a way for product. So we think primarily about adoption in the developer community penetration and less about dollars and revenue at this point in time. So we think that is still good news to come.

Got it. As we're thinking about entering 2022, obviously, dominating the news flow is the Ukraine crisis. I wanted to ask you about this from kind of 2 sides of the equation. On one side of the equation, can you talk to us about the potential exposures that, that Cloudflare has? On the second, perhaps more constructive side equation, on Monday you guys announced a critical infrastructure defense project, working with other vendors like a CrowdStrike and a Ping to help protect critical infrastructure. Could this be more of a tailwind for you guys as people understand the threat vectors out here?

So our revenue exposure in that part of the world, whether it's Ukraine or Russia, is neglectable. So there's no dollar exposure. We see a lot of traffic. The teams have been incredibly busy over the last 2 weeks to onboard the Ukrainian infrastructure on our network in order to help them protect and stand up with north of 30 Ukrainian government sites now on our network and a significant part of their financial infrastructure. And this is not about money, this is about doing the right thing from a moral and from a business ethics perspective. So that is all -- we cover those customers to a program that we call Galileo that is offering free service enterprise-grade services to customers like that. And of course, as part of a larger community, we are participating in cybersecurity discussions on a national level. And we saw that there was a significant concern that the invasion in the Ukraine would spill over into the cyber world and make our critical infrastructure vulnerable and become a target. So we will look for a way to step up defense in a meaningful way and in a short period of time. So together with the 2 companies you mentioned, CrowdStrike and Ping, we offered a program that we -- the 3 of us call critical infrastructure, defense project that offers for enterprises in power, in water and in hospitals free service for the next months. And it was all about our ability to onboard a significant amount of customers in that field without a lot of work. And this is where Cloudflare really excels. This is the easy installation of our products. So we are not thinking about monetization this point in time, this is just the right thing to do in a situation like this. And the good news is in the intent and not whether that carries any dollar values down the road.

Got it. That makes tons of sense. I want to switch gears and talk a little bit about products and kind of like step through the product portfolio starting with the applications services. This is where the Cloudflare story started. How much more runway for growth is there? We continue to see kind of good customer growth within the overall business. Is that an indication of kind of the growth opportunity expanding there? And how much room is there to kind of push customers of the value chain when it comes to sort of the core application services?

I would say we think there is a huge amount of runway still left in the segment for 2 reasons. First of all, the market, itself, is still growing. And then you have a gigantic amount of installed on-premise infrastructure that can be replaced and disrupted. So a typical customer journey could be that a large retail platform comes to us in front of a holiday business. And so we put Cloudflare load balancing in front of our infrastructure, in front of our on-premise infrastructure, in order to protect ourselves against the spikes that we see are coming. And then over time, dollar spend moves towards to us, budget-wise because on-premise infrastructure doesn't get upgraded anymore, capacity expansion happens in our product portfolio. So it's not only about new business and new installations, it's really disrupting the installed infrastructure and there is, in our opinion, significant runway still ahead of us.

Got it. Got it. One of the sort of really fascinating, I think, uncovered gems, if you will, of Cloudflare is the MPLS replacement opportunity with Magic WAN. Have read MPLS is still like a $45 billion market. Can you talk to us about the value proposition of Magic WAN? And how have you -- how well have you guys been able to sort of execute on that replacement opportunity?

So it's a product like we call it Magic Transit, Magic Firewall, Magic WAN that literally takes services that we offered on an application layer now down to Level 3. And it helps you to protect physical offices in that case. And you are able now to offer a service that has been previously offered by -- in a regional way by ISPs and are able to offer that on a global scale. So we have significant traction in verticals that would be normally further away from a cloud business model that don't have a big web presence but might be large oil and gas companies that have a highly heterogeneous complex global footprint of offices and manufacturing facilities that need to be protected. And they have a hard time enforcing a global consistent Zero Trust platform because of all the heterogeneous ISPs and regional networks. So that has become a significant advantage to us in our offering. It's a bit more complicated go-to-market. Onboarding customers like that is more difficult. And we've been we've been a business model that's hardly dependent on partners because the products are so easy to install. So now we also have a product that allows us to open up a new go-to-market channel and open up a partnership go-to-market approach for these offerings.

Got it. How does that impact your relationships with the ISPs? I mean that -- one of the interesting parts of the Cloudflare story is you guys [ solved ] that chicken egg problem and how do you get into these ISPs networks, and you did it by paying them at first, but now giving them kind of good value proposition of enabling more traffic on their networks, when you start trying to take some of their core business, that might create some testing relationships.

So far, so good because the value that we provide to local ISPs or regional ISP is still the same. We help them to save substantial amounts of cost. They don't have to backhaul traffic because we are local in cash, a lot of traffic locally. We -- in a lot of cases, we help them increase revenue. Other than the United States and other parts of the world Internet consumption is not flat fee and all you can eat; you pay for it as a consumer by consumption. We make the Internet faster -- conversion rates higher. So that's a unique opportunity for them to increase revenue. So that is a big benefit. And in with some ISPs, we enter into a go-to-market partnership. So we are a way for us for them selling our products into their -- especially their small- and medium-sized footprint. So far, so good. And ISPs is a large and complex organizations too that need to show a path forward.

Got it. So you give them some skin in the game as well, got it. I want to go to a Cloudflare for Teams, when you think about the customers that have come onto Teams thus far, is this primarily a greenfield opportunity of where you guys are the first kind of cloud access solution? Or are you winning them from other vendors?

It could be both. We talked about a very significant win on our fourth quarter earnings call, north of 100,000 seats, a very large European telecommunication company. They ripped out their installed VPN provider, and it was a competitive bid with 2 other Zero based -- Zero Trust cloud-based providers and we won. So that is one way. We have wins where we start with protecting small teams that work remote. We had a lot of wind stream in the pharmaceutical industry, just covering distributed research networks. So it could be either or, but we are more and more also leading with our Zero Trust product in bids where you -- where there's no on-premise provider anymore, where you just have cloud-based solutions in the mix.

Got it. So in something like that large telco win going against. What are 2 pretty -- assuming pretty large Zero Trust, I'm not going to name names, but vendors out there, what's the value proposition? What was the differentiation that enables Cloudflare win in those situations?

Right, there are a couple. One for sure is the ease of implementation that is becoming a bigger and bigger effort. That's why we talked about their infrastructure defense project. It's just -- you don't need hundreds of hours of professional services to implement a Cloudflare solution. So that for sure is one. I think we see more and more importance, especially with large clients, to have one gateway that solves a lot of problems and not a gateway for Zero Trust and the gateway for Firewall. And so 1 gateway that routes all traffic, 1 dashboard, consistent threat intelligence across the products we buy that becomes a more important part. And then especially from a Zero Trust perspective, in a world that is more and more remote, our ability to be present not only in large cities, but literally now in close to 250s in the world in more than 100 countries is just allowing for better performance from a latency perspective when it comes to a large and distributed workforce.

Got it. If you think about Cloudflare for Team and the Zero Trust Services, is there the same kind of demand profile amongst the small, midsized business customers that you have, is there isn't large enterprises? Or is it sort of focused on one side of the equation versus the other?

Small and medium size is where we always start with the product when we launch. And then we call this journey up into the right on the Gartner Quadrant. So I would say it's highly successful also with small- and medium-sized businesses because it's low effort and low cost from a support and from a maintenance perspective.

Got it. Can you talk a little bit about the Cloudflare One bundle, sort of what's the solutions that you're putting into that bundle? Is it a discounted bundle? Or is it just sort of the products work well together? And what's the traction you've been seeing with that offering?

So Cloudflare One was making a bagger, especially including the network as a service products that we just talked about. Cloudflare One was actually a push from customers, and this is what we need, this is what you should offer. We are normally highly flexible in how we bundle. There is not you have to buy those 5 products and whether you need the first product or not doesn't matter. So we are able to highly customize the offering. And with that, our ability to price accordingly is also super flexible. This gives us a unique ability, I think, to turn products into features of our network, and that is an important competitive advantage, especially in situations where others are working with a significantly smaller product portfolio. But -- so early interest is good. We're really happy with the traction that we see in the market with our accounts. It's a slightly more difficult go-to-market. But on the other side, it opens up the opportunity for us to get a partner -- organization and partner channel open, and that's a huge benefit.

Right. That's an interesting point. So traditionally, Cloudflare has been a very direct organization, a very kind of efficient hybrid model, a lot of self-service bringing customers in the door and then adding sales intensity as the customers grow and get bigger. But you haven't traditionally had a very big partner side of the equation, these solutions now that you have in network services and Cloudflare Teams and the bundles, does that make the partner channel more attractive for you guys?

Well, I think it makes us more attractive for the partners, right? Because we didn't leave a lot of value on the table with our first and second wave of products. So there was not really a significant opportunity for a partner to make money in onboarding a complex global customer with a very heterogeneous footprint that might be served by 10, 15, 20 different local regional ISPs is quite an undertaking. It allows now also partners to specialize onboarding verticals and develop a specific vertical competence. And with that, we are interesting for them because we give them now an opportunity to earn money. So I think it's very much mutual.

Got it. Got it. On the Workers product, a huge potential opportunity, right? A new kind of surface area which to build, deploy and run applications on a go-forward basis. But in our opening comments, when you were talking about the TAM expansion, we talked about going from $38 billion to I calculated $88 billion but you stop short before you added Workers, right? So how do you guys think about how big that market opportunity can be? Or is it just too early to kind of understand what the core usages will do there?

We've been struggling for a while now how we model that market because depending on what assumptions you make, the numbers are becoming awfully big, awfully fast. And you have to make sure something I was always afraid of is that you lose credibility because the numbers are just getting out of control. And the first question is how many of the workloads that we today centrally compute moving to the network? Is that 20%, 30%, 40%? Are we increasing the market? Are we enabling business models -- new business models with the ability to compute at the edge of our network? We think we do. If we look at our use cases, there are so many interesting things. So how do you now get those 2 things together? Is not easy without getting -- making the numbers too big too fast. And what I think is helping us out that we said monetization is not really our first priority. We want to get adoption out. We want to be in this many hands of developers as we can. We want to get diversity of interesting use cases and make it the eminent and prominent edge computing platform. So we can punch the way on how big is the market because that is not really first priority at this point in time. We appreciate help from you guys, sizing that market. So any input is welcome.

Okay. Matt, mark that down to do from next week. Can you talk us about the most -- like is there any commonality or any sort of -- are you seeing any use cases or very popular use cases emerge for Workers yet?

Very diverse. I think the most obvious use case is you have to keep in mind that Workers is the platform on which most by now, if not all Cloudflare products are built. So when you buy a Cloudflare product and you use Workers, you can make that the most customized product that is in the market. We have customers buying our load balancer and then using Workers to customize it to their needs. That is a very common use case. But it goes to the extreme of Workers being used as a stand-alone application. We have one of the largest retail platforms in the world building an e-tail servicing model, where the use case scales up to 200,000 requests per second, which is enormous. I mean Google, I think is digesting 50,000 search request per second. So 200,000 request is quite enormous. And then anything in between what I think is exciting currently are all the use cases where Workers serves as a means to be data sovereignty or data privacy compliant. So we see a lot of use cases in countries like the European Union and others where data privacy becomes prominent and now, we've developed in -- based on Workers a product that we call data localization suite that really allows you to control the flow and the storage of data on a very granular level down to -- you have a European citizen on holiday in Mexico, trying to lock in into his bank account, making sure that this individual, you have to decrypt the package. If you do that in Mexico, you violate, the bank is violating GPDR rules in Europe. So how do you solve for that problem? So very interesting use cases around data sovereignty and data privacy where we see already significant momentum in the market. And then you have the more edgy cases, you want to say, so where people use our network to offload bill of material of devices that connect to the Internet and offload compute -- non-latency compute-intensive path into the network and make the device cheaper, whether it's a car or drone or the other way around where you use our network to push artificial intelligence or facial recognition in front of devices that are done so far, some standard security camera that all of a sudden becomes -- has facial recognition capability because it's at our network and then whatever, 5 milliseconds away from it. So it's a wide variety of use cases, some really close to our products, some very far away stand-alone and anything in between.

Got it. Got it. 27 minutes in the conversation. We haven't mentioned margins yet and their election of duty when you're talking to the CFO. And see there was R2, right? So R2 is an offering that I think investors got pretty excited about a big market opportunity to be able to do storage on that network. But as an analyst, I worry about gross margin, right? You guys have been able to sustain high 70s gross margins. And I think about a commodity storage business, and it doesn't feel high gross margin to me. Can you talk to us about: one, kind of early customer interest in R2? And two, as the CFO how do you see the margin impact there, both from a gross margin standpoint and also sort of CapEx intensity for the business?

Maybe the good news upfront. We don't see it's going to change our long-term business model from a margin perspective. And we think it's also not going to impact the CapEx efficiency of the business model for a variety of reasons. The traction -- I'll get to that in a second. The traction so far is overwhelming. We are in what we call still private beta, and we had more than 9,000 customers signing up and really large logos. And we are already moving hundreds of petabytes through our network or store through our network. And it's really hard to aim for becoming the edge computing platform and that's not solving the storage part of it. So this goes together. So it was really important for us to get that done. One of the key features I think of our business model is, whether that is go-to-market, whether that is network capacity is that we have always been able to invest behind the demand curve, right? And this is also true here. We don't have to push significant CapEx that is going to sit idle until demand picks up. How the network is structured and built? How their devices and the boxes today are already configured? They have significant storage capacity already today as they have significant CPU capacity because we started with security and not pushing media, that gives us a lot of flexibility. So we increased guidance for GAAP CapEx slightly, 1 percentage point at the midpoint for this year, and we think that covers us well. And we think the efficiency of the business model. I mean maybe it makes sense to say that here. We have one standardized hardware stack. So no matter where you go in the world, the equipment will always look the same. It's off-the-shelf hardware. And on that hardware runs what we call a homogeneous unified, fully integrated software stack that allows us to literally offer every product and every service we have on every server in every city and every country. And when you do that, your complete network surface becomes decrease of freedom how we manage demand and supply from a compute, from a storage and from a bandwidth perspective. And every server we add, whether it's in Pakistan or in San Francisco, adds to our capability. So the bigger the network becomes from a footprint perspective, the more decrease of freedom we have. The more products we have the bigger that opportunity becomes. So we already moved 1 byte of data from point A to point B with 1 product. So when we sell more products, we just wrap more value add around that byte of data and it hardly causes any marginal additional cost. So the flywheel becomes faster, the bigger we get. And this gives us confidence so far that not only will we be able to hold up our margins and stay in this really nice zone, but that the CapEx efficiency is also going to be impacted by what we have in mind.

Got it. And maybe just one last question on the margin side of the equation. On the last conference call, Matt Prince made an interesting comment. You guys have been operating above your target range for -- long-term target of 75% gross margin, been operating ahead of that. And Matt, talked about using that excess gross margin as a competitive tool. Can you talk about how that transpires?

We've done this in the past. So when we talk about competitive, it's not like, oh, let's discount this product. We have 1 percentage point of margin left. It's like what is the most disruptive move we can make in a given competitive situation. The best example I always have is when we thought about how do we market DDoS mitigation. We said, "Well, let's not look at our competitors and offer that as a 20% discount. Our network architecture allows us to digest any DDoS attack as long as it is not bigger than our network capacity at 0 additional cost, regardless of how big the attack is, so that the most disruptive move is to unmeet a DDoS, right? When we launched Cloudflare for Teams, in January, before COVID, nobody knew that COVID would come, but the most disruptive move was to give it away for free and help companies out. We didn't know when we gave guidance that the Ukraine would be invaded. But giving away now these products for free, I think, is the right move to make. So -- when we think about using margin, it's about -- not so much about discounting a certain product. It's what is the most disruptive move we can make for a product or for a specific situation and then we go with that.

Well, Cloudflare has definitely been a very disruptive force within overall software. And very successful disruptive for us. So congratulations on the success, and thanks for joining us.

Thank you. Thanks for having us.