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

Excellent. Thank you, everyone, for joining us. My name is Keith Weiss. I run the U.S. software equity research franchise here at Morgan Stanley. I have our European software analysts in the front row. So I have to qualify that to just the U.S. to get them at it. And very pleased to have with us from Cloudflare, CFO, Thomas Seifert. Thomas, thank you for joining us.

Thanks for having us.

Excellent. So before we get started, a brief disclosure. For important disclosures, please see the Morgan Stanley research disclosure website at www.morganstanley.com/researchdisclosures.

Excellent. So with that out of the way, Thomas again, thank you for joining us. Maybe just to sort of set the bar. Macro has been a kind of top concern for investors for the better part of the last, let's say, 2 years. Can you talk to us a little bit about what you're seeing in the environment today and how Cloudflare has been navigating at sort of, say, a volatile macro backdrop?

Yes. And it's going to keep us busy, I guess, for a couple of more quarters. We saw what we think was a downturn early. We talked about it early in the fourth quarter of -- not last year, the previous year. And we adjusted early in terms of spend and hiring and focus on cash flow. Over the course of last year, into the third quarter, we saw the fundamentals actually starting to improve again. We talked about it on our earnings call. Pipeline in Q3 improved, was even better in Q4. It's pretty stable in Q1. So there are inflection points in the business. However, we see the transitioning from pipeline into ACV into business is still driven by lots of uncertainty. They just -- the behavior we put into Cloudflare, we lowered spending limits. I see more purchase orders at lower levels going out and is reflected in customers too. Sales cycles are moving out. And what we also see is that we have probably more larger deals in the pipeline than ever before, but they take significantly longer. So the impact on how does an improvement in fundamentals and better pipeline translate into ACV. And then ultimately, in revenue is still attached with lots of uncertainty and that has not improved at all in my opinion. So it's a complex picture, I would say.

Right. So if we take those sort of multiple moving pieces like pipeline seems to still be robust. There's a lot of large deals and sort of the expanse of what Cloudflare is going after, is expanding, but the conversion rates and the close rates are still up in the air. The #1 question I get from investors like at the end of every single conference call is the outlook derisked. And when you guys gave your forward outlook, it doesn't look for a lot of deceleration. And I think it's far certain that it's not a derisked outlook. How do you answer that question in terms of the level of conservatism in that outlook?

Well, we tied to, as always, when we give guidance, we try to be prudent and take into account what we know and what we control. So they are, on the one side, the improved fundamentals, but there is the uncertainty of that, how is the pipeline ultimately translating into revenue. I think we thought on the earnings call, we actually feel better about the year than the risk in the short term. And I think that hasn't changed. So we see good traction with the products, especially with the new product, pipeline is healthy and so on, but we deal with the uncertainty of seeing the inflection in the fundamentals really turning into revenue. So I think it's unchanged from what we -- how we talked about it in the earnings call. For the year, we feel we've done our job. Contrary to what people expected, we think there's probably more risk in the short term than there is in over the course of the year, but we'll work our way through it.

Okay. Shifting gears and sort of focusing on the Cloudflare story from a much more high-level perspective. I remember meeting Matt Prince years and years ago, and you met him and asked him about his company and he said, "Well, I'm building a better Internet." This guy -- you've got some major aspirations, but one of the most amazing part of the story is the innovation cycle and how you guys have come out with Act 1, Act 2, Act 3 products and really starting to build out that vision that Matt had, that's a decade ago in terms of building a better and safer Internet. Can you talk to us about sort of that massive expansion of that solution portfolio? How has that sort of expanded the TAM that Cloudflare is going after?

Well, yes. I would go back to when I started, which is now more than 5 years ago, I thought I had some idea on how disruptive Cloudflare could be. And now looking back, I'm surprised of what we are doing and I way underestimated that potential. It comes back. We had a couple of meetings today and where people are new to the story and say, what is the best entrance into understanding us? It's really understanding the architecture of the network and how the offerings, the services really sit on top of that hardware stack and literally every product running on every server in every location. And the bigger we get, the more flywheels are flying. We see so much data now that even just optimizing the utilization of the network is an innovation source. We -- there is unutilized capacity in parts of the network at certain times. And how do we fill that? How we can use excess compute or storage capacity or bandwidth capacity to innovate is huge. And the whole organization is built around it. Our product development organization is unique. We almost have 2 parallel organizations. One is working on products that are GA and one is working -- the team is working on products that we call Wave -- [ T+1 ] Wave, so to speak. So we started as with what we call Wave 1 products. It was a resize that as a $35 billion TAM at the time of the IPO, and it includes the routing and DDoS mitigation application protection services, if you want to say so. And then the second wave of products came very timely you have to say. We launched our first Zero Trust product, our access product, VPN replacement, if you want to say so in the first quarter of 2020, right when COVID started. And that is now a fully fledged product line of gateway, product isolation, e-mails part of that. And now also threat intelligence, we would say that's another $35 billion of TAM. And then there's what we call our Wave 3 products where R2 and S-1, the storage products are in there and Workers is not even size into that market, but we think we are well north now of $100 billion of TAM market that we disrupt. And the live wheel is going strong. We'll have security coming up in 2 weeks. I understand what is in the pipeline. So there's a relentless pace of innovation that will keep us exciting and the markets in TAM, we disrupt expand as we move forward. So exciting. Yes.

So the other really interesting part of the Cloudflare stores on, one side of the equation is this innovation engine, which has been fantastic. The other side of the equation is the network, right? And to me, one of the most difficult things in software is to find durable competitive moats. The technology evolves so quickly. It's so hard to like just use innovation alone to protect your sort of differentiation to predict your competitive moats. But the network is interesting in that way. Can you talk to us about sort of the scale of the network? How that creates differentiation? And you've talked in the past about how you could use some of that gross profit dollars from that network to actually further protect and create a competitive interest?

Yes. As I said before, if you want to understand us in the competitive moats, you really have to look at the architecture of the network. And our CTO would say, JGC would say we can change a lot of things. We cannot change the speed of light. So we have to move as close to the eyeball as close as what wants to connect to the Internet as possible. And that determines the footprint of the network. You have 3 websites and mobile devices and IoT devices as we evolved. So the hardware stack is off the shelf. There's no uniqueness in it. And that is -- that helps in terms of procurement. It helps us in terms of delivering these gigantic network at superior capital efficiency. Our CapEx ratio now is 12% of revenue. Looking at the infrastructure that is there, that's a very competitive number and it's part of why the margins are where they are. And all the offerings we have run in one homogeneous fully integrated software stack on that hardware. The software stack is completely independent from the hardware that is under it. Doesn't matter whether we buy Intel CPUs or AMD CPUs or ARM CPUs or NVIDIA GPUs, the software stack is agnostic to what is under it. And with that, it means that every server we add regardless of where in the world, you increase the surface of this network and you can use the surface in order -- it increases your degrees of freedom and how you manage costs, supply, demand, bandwidth across the surface of the network. And with every server as I said, it gets bigger and bigger. And with the network getting bigger, we see more and more traffic in terms -- it's almost like an eye watch on the Internet in terms of performance, in congestion, security, threats that become an input also in the innovation engine itself. And there's a endless amount of opportunities of what else we can put on this network. And as I said, it drives innovation faster. It's also unique in the cost structure because if you look at the first wave of products, they determined literally the size of the pipe, how data moves through our network. And you pay -- you don't pay for bandwidth by the amount of data that moves through this pipe. You will really pay for it by the size of the diameter. And all the first wave products are determined the size. Now if these traffic coming back that can fill the pipes, and that's why products like Zero Trusted bring traffic back, so to speak, from the eyeballs is literally at hardly zero marginal cost. So you have a second wave of product that is coming at close to 100% gross margin. And you can use then this margin profile, not so much to discount, but to disrupt. We -- when we talk about pricing philosophy, it's never about, okay, let's be 5% cheaper than this competitor or that competitor. The question is always, what is the most disruptive move we can make in the market, unmetering DDoS with such a move. If you are a large customer like the bank that is hosting this event here. If you are an enterprise customer, unmetered DDoS is just part of your package. And we can afford that because it doesn't really matter how big a DDoS attack is. The size of the attack doesn't increase the cost we have mitigating the attack for our customers. So all of a sudden, is the architecture of the network and home products run at it determines a really superior margin structure that we can use to disrupt further and to innovate further into new markets. So it's quite impressive flywheel on its own view, I must say so.

Yes, definitely fascinating. I want to dig into sort of the various product categories and maybe starting with those Wave 1 products, the application services that Cloudflare got started with. And I think the #1 question I get from investors is, how much more runway for growth is there left in these application services?

We think a lot. The first answer when you get a question like that is it's not a static offering, right? We continue to innovate in these base services on threat levels, DDoS mitigation from Layer 4 attacks to Layer 7 attacks, where you defend, how you defend, offering a product for financial service institutions in Europe that offers Layer 7 DDoS medication, that is GDPR compliant. It's not a little feast, and we think we are superior just because the architecture of the network. So you have -- the first wave of products are not static. They get innovated. They disrupt a significant market in terms of installed on-premise infrastructure that needs to get replaced. So we think it's going to drive growth for years to come. In growth rates -- in terms of growth rates, however, what we call our second wave of products, the Zero Trust products will overtake application services from a growth rate perspective already this year in terms of size. So that will come. But in terms of growth rate, Zero Trust-related products will overtake application services already this year.

Got it. And can you remind me, have you given investors any kind of perspective on relative scale of sort of Act 1 versus Act 2 versus Act 3 products?

We have not yet. We are thinking about how we do that. We -- and it's a bit harder for us to do because we're not really selling products, we sell a bundle of products. So when we got started, we described that the revenue structure is literally 50% of our revenue is a security-based product. And even with the start of the Zero Trust Wave, that has not changed much. Revenue has grown significantly. It might be more slightly biased towards security products, but we have not broken out yet of how investors and potential investors can measure us better and new folks can measure us better. We -- well, our analysts -- our Investor Day is coming up in May. I think we'll have some ideas. So we described that. We are referring now if you go back to our earnings calls, we put a lot of focus on describing where the wins are and what verticals are being successful, how big the wins are. So you have some idea where market traction is and how we are doing from a competitiveness perspective. But we understand that we have to become a bit more transparent in showing success in this field because it's going to be a big part of us moving forward. And it is going to determine the growth profile for years to come.

Got it. And if we think about the growth dynamic in application services, in particular, is it still geared mostly towards new customer additions? Or is it more so kind of uplifting those existing customers to become kind of higher ARPU type of...

It's both. So even in customers that have grown with us from the first minute almost from 10 thousands of dollars to multimillion dollars of ACV per year. We still have customers where we have potential to migrate to the second wave product. So there is room in that customer base both from an expansion opportunity as well as from a new logo opportunity. There are quite a lot of more traditional verticals out there that are sitting on significant on-premise infrastructure that needs to be disrupted, where business models are a little bit slower to digitalize and transform. Some of that has accelerated during COVID, but there's still a lot of runway left.

Got it. I want to shift gears to the Act 2. Before we go to Zero Trust, I want to touch on network services. I would describe this as probably the hidden jewel within Cloudflare, probably a part of the equation that a lot of investors don't really fully understand. So maybe you could help us talk a little bit about stuff like the Magic WAN and some of those network services and the value proposition that gives to the end customer?

So are you talking to Zero Trust now or...

The network service.

Well, the -- it's all about sitting behind one control plane in a way. Regardless of you have infrastructure in branch offices or headquarters in subsidiaries, how do you bring all that infrastructure behind one control plane and get the performance and efficiency and cost efficiency and effectiveness and security of on-premise equipment migrated to the cloud. And there -- at one point, you will just take a cable and plug it into a wall. And this infrastructure, that branch office will sit completely behind the Cloudflare network with all the services we offer. So that's a compelling offer. Customers are excited about that. It's probably for all the products we have the most complex onboarding. Because especially with large global customers, you deal with a very heterogeneous corporate networking infrastructure. In some cases, distributed about 15, 18 global ISPs and getting this all migrated is sometimes not a small task. But it's an overwhelming good value proposition. And if you -- I think we launched a product, I talked about it in '19 -- end of '19 the first time. But the buildup of the architecture and the product was almost gearing to that event that literally all you need is a piece of fiber that you plug in a wall and everything else becomes Cloudflare and is delivered by Cloudflare. So it's a huge lift. It's a huge opportunity. We onboarded one of the largest oil and gas companies on this platform in the fourth quarter of last year. So there's traction, but it's also, from a go-to-market motion, a heavier lift than the other products we have.

Got it. But on the reverse side of the equation, I think it's also one of the most sort of well-defined market opportunity because correct me if I'm wrong, this is an MPLS replacement. And last I checked, there's something in the order of like $45 billion spent annually on the MPLS.

In some of the logos we work with, it's still the largest spend category in their IT budgets, this MPLS replacement. It makes for extremely good ROIs. And especially in times like this, where budgets are flat or shrink, the ability to take significant spend out that can be redeployed is a big lever. But it comes at a steeper implementation and high implementation costs, so you have a trade-off that you have to go through.

Got it. One of the areas that's kind of difficult for software investors is there's a lot of different vendors were talking to us about their wide area network products. What's the real competitive environment out there when we're thinking about Magic WAN? And how do you differentiate? Like what makes the Cloudflare solution standout?

Well, there are a couple. Once you are deployed and you just talked about MPLS spend, the ROIs are really superior. And because the products on our side are highly margin efficient, that's normally a win-win on both sides. It's the consolidation of offerings that is becoming a bigger and bigger part, especially in an environment like this. And it's one control plane that becomes more and more important, especially if you look at the very heterogeneous and global fragmented infrastructure of offices, manufacturing facilities, branch offices and you see performance security and perform -- and efficiency all in one control plane across all the offerings you have, whether it's routing firewalling, DDoS mitigation, other secure bot mitigations. And now, of course, also Zero Trust on-ramp.

Got it. Switch gears to Zero Trust because it's been a really hot topic for a while in security, but also a very fragmented market, a lot of different vendors coming out of that space. One, who would you sort of term as your core competitors in that space? And how do you look to differentiate the Cloudflare Zero Trust solution?

Well, similar to what we've seen on the application services, the first set of competitors are on-premise solutions there, top too many names, but the Ciscos and Citrix [indiscernible] world on-premise, VPN infrastructure that needs to be replaced, it has a hard time adjusting to a remote working environment. So that is certainly a big part of where our business comes from, is replacing on-premise infrastructure. And then their names that are probably have been here in the conference, too, and Zscaler falls into that category, Netskope falls into that category that you see -- that we see more and more often. But I would still say today, while that is hyped up a little bit, most of our opportunities are still replacing and displacing on-premise infrastructure.

Got it. And then you guys rolled out Cloudflare One, which has been sort of a bundle of the solutions. What's the recession been thus far? How aggressively do you have to sort of push on pricing in that bundle sort of garner traction?

I think it's big. I mean we've been working on -- one of the problems of opportunities, I think it's a better word to describe this. Once you have such a rate of innovation, once you expand your product portfolio, so aggressively in short periods of time is how do you deal with this in front of the customers? And how do we bundle offerings in a way that they help us get efficiency in our go-to-market, enable our customers to understand better what we do. And so we've been working on this for a while. The reception is, I think, is really good. We looked at companies that we admire that have done this path before Salesforce, Microsoft, that's how you buy Microsoft 365 Office today. You're not trying to figure out how people -- how many people are using PowerPoint and Excel and what's the best distribution license, you just buy the bundle. And this is pretty much what you do with Cloudflare One across the offerings we have. So it has been -- I think it allowed us to get efficiency in our go-to-market. From an enablement perspective, how we structure the account team, so has been rather successful. From a pricing perspective, we don't have to discount our products a lot because we are never the price leader when we enter a new market in the first place. So we -- our prices are competitive because our cost structure allows us to be competitive out the gate and still have superior margins. So pricing pressure is not really one of the biggest topics we have. So we don't go out with high prices that we discount deeply just because the business model allows for a much more differentiated approach, I would say.

Got it. And I want to make sure we touch on workers as well. Probably one of the parts of the solution portfolio that investors get most excited about, and it seems to be almost an open-ended market opportunity in terms of what can be built on top of Workers. But then on the other side of the equation, it's the part of the TAM that you can't quantify yet. And so how do we rectify that? Like what is the unknown that makes it so difficult for you to quantify kind of what that opportunity is?

So for -- workers was -- it's a way of how you deploy code at the edge of our network. That is really what it is. Before a product like Workers code could run in a data center, where it was all about speed of execution. It could run on your endpoint where it was all about latency. Workers now finds this third spot close to the device, so you can execute code the latency almost as if it were on the device, but at the speed as if it were in a data center. And that was not developed in terms of a market opportunity. It was first a means to solve our innovation problem. If you innovate this has put out so many products, we felt that our own structure and tools were hindering our rate of success, and this is how Workers was born. And so today, Workers as a platform is the basis of all the products we have. So if you're the first use case, then if you buy a product from us, like I don't know, load balancer, you attach Workers to it, you can use then Workers to make this the most customized load balance in the planet. So this is where it all started. And the use cases have changed over time. And what we thought would be interesting has also changed over time. There's a really interesting blog post on our website that Matthew wrote, I would say, 3 years ago. And it really talks about Workers and how it works and what the architecture is. And he says, when we launched it, we thought it's all about speed, speed applications. And we had really interesting use cases of automotive manufacturers trying to offload compute capacity in the car, into our network in order to take bill of materials down or we have security companies pushing artificial intelligence and face recognition in front of dumb security cameras. You saw all about this was -- and then it turned out that compliance becomes the more interesting use case in the midterm. Today, we attach it to almost every enterprise contract we signed in Europe or in parts of the world where GDPR or GDPR-like rules are prominent. So Workers allows you to really control data on a very granular level thing. This is Keith's credit card number and Keith is citizen of Switzerland and he cannot leave the country, he cannot leave the canton, and it can only reside in the data center of that security level. So it allows you to run really granular workload. So that has become the big opportunity. Now we cannot finish this call without me mentioning AI 3x. It turns out that combining workers and to our storage product has become a really interesting use case for a place where you train AI models, where you hear at the conference. Yesterday, people talked about how GPU capacity is outpacing, is being outpaced by the demand for training models. You can reside data in our R2 and then really find the cheapest available GPU capacity at whatever hyperscale it is and then optimize and triage for training AI model. So the use cases have evolved. And that is the transition then to dollars. We think we would enable that explosion of use cases and adoption if we push for revenue too fast. So we've been talking about this for a while. Not only is it difficult to size, but we think adoption and getting it in as many hands, especially in hands of developers, is the goal today and probably for the next 2 years before you push that towards revenue. So sizing is difficult, but I think it would be counterproductive. It would -- we don't want any use case being discouraged to run through Cloudflare just because we price it too early, we price it too high. And it's like how Cloudflare was built, right? We want to eliminate any disincentive to not move -- to move a byte of data not for the Cloudflare network. And I think it's the same for workers.

Got it. I'm going to try to sneak one last one. I'd be remiss if I had an interview with the CFO and didn't ask a margin question. You guys did see really nice margin expansion, almost 500 basis points of margin expansion in 2022. Matt has talked about wanting to continue to reinvest in the business. How should we think about that balance between growth and profitability? Are we at a point where both could be going in the same direction?

Well, we are growing up. We are getting the scale. And we understand that there is a trade-off and I think that is what you saw last year, we saw growth slowing down. And we also were able to show the elasticity in the business model that we were able to translate a reduction in growth rate immediately into an increase in operating margin and delivering -- finally, delivering free cash flow than in the second half of the year as we promised. So we understand that, and that is a trade-off we keep in mind. There are minimum hurdle rates we have in terms of how fast we need to grow and what rules we want to follow. And as long as the macro environment is muted and the outlook has uncertainty, we understand that we will deliver more profits accordingly. And it worked out really well last year. We saw the slowdown early, we slowed down hiring and expenses really dramatically. And that prevented us from doing more need of traffic actions like some of our peers. So we managed quite nicely through last year's environment, and hopefully, we'll be able to do the same this year.

Outstanding. Well, thank you so much for the time, Thomas.

Thanks for having us.