Cloudflare, Inc. (NET) Earnings Call Transcript
June 1, 2021
Earnings Call Speaker Segments
Good afternoon, everyone, for those joining us in the East Coast, for those joining us on the West Coast. My name is Shaul Eyal. I cover the cybersecurity universe at Cowen. Last week, we've initiated coverage on Cloudflare with an outperform rating and a $100 price target. We are very pleased to host Thomas Seifert, Cloudflare CFO; as well as Jayson Noland, VP of IR. We will kick things off with a fireside chat, so feel free to send me your questions directly to my e-mail inbox. My e-mail appears at the Zoom window in front of you or through the chat box so we can accommodate as many question as possible. And with that adjunct, thank you so much for joining us. Appreciate it.
Thanks for having us.
Oh, absolutely, absolutely. Maybe for those of us who are slightly less familiar with the story, can you describe what Cloudflare does and how it differs from other market participants such as some of the CDN providers out there?
We have a very lofty mission at Cloudflare. We say we want to help better -- build a better Internet. And with that, anything that wants to connect to the Internet, that connection, we make more secure, faster and more reliable, with a bumper sticker in the very beginning that says you have to think about us almost like Cisco as a service. Anything where you would have bought and acquired hardware on-premise, whether it's firewalls, routers, load balancers, VPNs, we offer this as a service from our network. And this network is masked by now. We have presence in more than 200 cities in more than 100 countries, and we run an enormous amount of traffic by now through this network. We were never designed as a CDN. We had to provide CDN-like functionalities in order to deliver security and performance-based products and services at the edge of our network. But CDN was a means to achieve that, but not the business model in itself. We are pricing our products differently. We have no usage -- or hardly any usage-based pricings. Even today, less than low single digit of our revenue is variable billing-based. And of that, less than 1/3 is really bandwidth-driven. So if you were to ask Matthew, one of our founders, when he got started he said, "The big objection always was you can all -- provide all of the services, but you will add a bump in the wire, and it will slow things down. And that's why it's not going to be successful." So speed and how we deliver our services became an obsession. And that's why we happen to have one of the fastest CDNs in the market, but not in order to deliver content, but to deliver products like security-related and performance-related products at the edge of our network.
Got it. So as we think about the speed, Thomas, how important for you guys in terms of the proximity, and you mentioned about, like, 200 PoPs, give or take, right now with 200, I think, cities as well. How important is that, that you guys are absolutely close? I think probably about 100 maybe 99.8%. I think right now we're talking about 100% proximity to your customers.
Yes, we are -- we are by now less than 100 milliseconds away from 99.-whatever percent of the things that want to connect to the Internet. So that latency has become quite important in terms of performance and speed, IoT devices, websites that want to connect to us. Over the past years now, it has also become another quite important criteria of how localized our traffic can be controlled and can be managed. And if you look at trends that impact data privacy and especially data sovereignty laws where certain information and data needs to reside -- continue to reside within certain jurisdictions, whether that is a country or a region like the European Union, being able to localize traffic, not only getting close to the eyeballs that want to connect, but even being able to keep traffic local has become another really important part and key differentiation feature for us.
Understood. Understood. And as we think about Cloudflare's strategy, and I think the story as a whole going forward, on the one hand, we see a great displacement opportunity; on the other hand, there's so many greenfield opportunities as well. Maybe can you talk to us about what markets could you be displacing some of the legacy incumbents out there? And where do you see, actually, some of the greenfield opportunity?
Yes. I mean we've been started at the core of our products with load balancing, firewalling, DDoS mitigation services. And as recently as when we filed our S1 for when we went public in 2019, we said we would target a TAM of about a $37 billion. Over the last 1.5 years alone, we've added 2 significant TAMs that we are going after that we disrupt. There's what we call Cloudflare for Teams, a product suite that goes after the VPN, the gateways and the browser-isolation products. And then a third TAM that really -- with a product that is called Magic Transit that really disrupts the corporate network and MPLS markets. So 2 really, really large markets we go after. Our traditional competitors are on-premise hardware providers. This is the new business and installed base disruption within the companies, the Ciscos of this worlds and Fortinets and Check Points and Palo Altos and Riverbeds. And as we -- and with the Team products, it's entering now also the VPN space like really would find companies like Cisco again, Citrix primarily.
Understood. And you've mentioned your IPO at 2019. But if we even step back to 2018, I think at that time, you have talked about a TAM opportunity of about $32 billion. Here we are sitting middle of 2021, if I'm not mistaken, you guys are talking about a TAM of $72 billion. So maybe walk us a little bit about that more than doubling of the TAM over the course of the past 2 years. And where are the new adjacencies that we haven't seen over the course of the past 3 years or so coming from?
So the 2 TAMs that I alluded to just a minute ago was at the beginning of last year, we started a product suite that we call Cloudflare for Teams. It consists of 4 products, Cloudflare Access, which is the VPN replacement product. Then the Gateway product. We followed with a browser isolation and a DLP, data loss prevention, product then later this year. So that is a massive TAM that probably the Zscaler business model describes best. So we added that in a relatively short period of time. We offered most of the products, especially the Cloudflare Access products for free last year as our part to help customers and enterprises to manage through the pandemic. We've seen significant momentum in that space in terms of customer sign-on and adoption. We've been winning significantly large customers with tens of thousands of seats. We talked about a very large pharmaceutical company on our earnings call for the fourth quarter and then other big wins already in the first quarter of this year. And then the third TAM we entered is around a product and the bundle of -- around the product called Magic Transit and a bundle that we call Cloudflare One where you really start to offer networking as a service to our customers. And that really goes after the -- in part, also the MPLS spend, which is a significant dollar item in the budgets of our customers. And if you add up now those 3 TAMs, then you get to $72 billion. We think we are not done yet. If there's one thing that is really unique about Cloudflare, it's the rate of innovation, the flywheel of how fast we develop, how many products and features we bring out in a given period of time, that has become quite staggering. So it will allow us and continue to allow us to expand TAM. We launched a product that we call Workers that allows you to deploy code at the edge of our network. So you talk about the significant edge compute opportunity that is not even reflected neither in size nor in any other shape or way in the TAM discussions we just had. And we always said this is -- for us, this is the, what we call, our wave 3 product. So it will not continue to contribute to revenue in a while. We drive adoption. And we want to be the most eminent and prominent edge computing platform moving forward. But that would be a product that is not reflected and an opportunity in the TAM discussions we just had. There's IoT, there's 5G, there are other market opportunities we look at in order to continue to expand the TAM and especially, the TAMs that we want to disrupt.
And I think that maybe just one more word about the expanding TAM, if I'm not mistaken, $100 billion within the next 3 years, is that pretty much what you're addressing in terms of longer-term TAM?
Yes, without taking Workers into consideration, with the products that are existing today and that are being marketed to date. But Workers is not part of that calculation yet. And this, in part, because it's really hard to quantify the edge computing market. The numbers get so big so fast. You tend to become -- lose credibility. And then really, I was serious about saying we are not driving revenue at this point in time. It's much more about developer adoption and making people use Workers for their specific use cases and products.
Understood. When you guys went public the later part of 2019, as you might recall, and again, this is even pre-corona. One of the initial concerns or at least market views on Cloudflare was the fact that it caters initially and mostly to the SMB. And you recall that, Thomas, kind of the way it impacted the business but I think if we look at everything that's happened over the course of the past 5, 6 quarters, I think, actually, what we are beginning to see is absolutely a very nice adoption by enterprise and specifically with the number of clients adopting you that are carrying $100,000 of ARR. So maybe can you talk to us a little bit about some of those metrics? And how has that been evolving over the course of the past 4 quarters, 5 quarters now?
Yes. So when Cloudflare got started, now almost 11 years ago in October, it focused on the long tail of the market. So small and medium-sized businesses, developers, our first go-to-market models were what we call pay-as-you-go models where customers give us a credit card, and we charge them $20 a month and then later $200 a month for the services we offered. And only later came our enterprise go-to-market. Today, this is the majority of our business and our fastest growing business. And if you go more specifically into enterprise and look at what we call our large enterprise customers, and we define those as customers that pay us more than $100,000 a year. This is now 50%, a little bit more than 50% of our revenue. And if you break down the large customers and say, let's look at customers that give us more than $500,000 or even more than $1 million a year, the larger the cohort, the faster the growth. So our largest cohort, so $1 million-plus customers, has been growing north of 70% now consistently over last the 7 quarters. And we will -- we think this will continue that way. We announced our first $10 million ACV customer in the third quarter of last year. By now, you have a -- we have a couple of customers that are in this range of high single-digit million dollars of ACV per year. And if you go back over time, we seem to make a step function change in terms of customer size, from $50,000, to $100,000, to the first $500,000 customer, to the $1 million customer, to the first $10 million customer. So we are right at that brink currently. So enterprise momentum has been extremely strong and has been driving a lot of the growth that we have seen over the, not only in the last 8 quarters, but I would say, the last 4 years.
Got it. And maybe can you talk to us, Thomas, about your 4 product tipping point for customers where customer stickiness improves significantly, because I think it is an important part of the fee percent as we look at long-term growth?
Yes. We -- as you start to add more products to the platform, the -- first of all, the more products we have, the easier expansion becomes. And the uniqueness of the Cloudflare setup is really that installing a product -- or is really it's just a mouse click away in terms of product expansion. And we had this threshold of once we get to 4 customers -- 4 products per customer, then churn rates are coming down really significantly. We were at 75% -- or north of 70% of our customer using 4 products or more at the IPO. That number now has moved far beyond 80%. And now more than 70% of the customers are using 5 products. So with the increase in the product portfolio, we've been able to sell more products to existing customers. And with that, the stickiness of the product and the churn rates come down. Another really important KPI where you see this for us is our DNR, or dollar net retention, which hit north of 120% for the first time in the last quarter. I think it's another good description of the progress we have been making in expansion, cross-sell and upsell with the existing logos.
Got It. As we are beginning to come out of COVID era, the world is reopening for business. We're definitely seeing that in the metrics provided by companies, public and private, by the way. I want to go back for a second, and you mentioned your VPN for Teams product. As I recall correctly, that is a product that you've provided for new users free of charge as a more of a public community service. Talk to us a little bit about the tailwinds that you have been seeing post, if I'm not mistaken, it was September of last year when you've actually started charging again for this product?
Yes. For us, COVID was an interesting period of time because when it all started, we saw more headwinds than tailwinds. Our traffic increased. Everybody was working from home. The internet became this important system for all of us to make it through the pandemic. So since we have a business model that is not charging for use, our costs went up, but we didn't pass that really on. So our revenue didn't spike just because consumption increased. We found other ways to mitigate that. We continued to grow, and we were able to keep our margins. So when we entered this year compared to others, we don't really have those difficult compares. And on top of that, we enter with a lot of momentum because some of the most exciting products we launched, as you said, last year like Cloudflare for Teams and Cloudflare Access, we gave away for free. So we our -- that's why you saw our growth rate for the first quarter of this year continue to be quite impressive, and we leaned in quite a bit in terms of guidance for the year, especially compared to how we talked about the business last year. So we see this momentum continuing. The new product adoptions are looking strong. We said on the earnings call our pipeline is strong, and we continue to win large customers and significant RFPs, especially with the products that we launched during last year. That makes us quite confident for the remainder of this year.
Got it. And even since you've brought up some of those revenue growth metrics of, yes, like 50%, 51% year-over-year growth in the first quarter, yes, then you've upped your guidance a little bit but still, when we look, I think, at the overall 2021 consensus revenue guidance, we're still, if I'm not mistaken, we're still talking about 42% year-over-year growth, correct me if I'm wrong. So am I missing anything? And I think, actually, if I go back and I look at prior year's estimates versus actual, don't know where that landed, but is it kind of just being conservative? Or maybe is it going back to more of a business normal rates? Or this is where you feel mostly comfortable at this point of the year?
Yes. I'm certainly not going to update guidance, but I think we are always -- I wouldn't call it conservative. I think we have been prudent about how we talked about the business prospects and the outlook, and we try to carefully weigh the potential tailwinds, but also the headwinds that might show up. So our prudent guidance has served us well in the past. Will be -- continue to be one of the important yardsticks in how we think about guidance moving forward.
Fair enough. Fair enough. When we think about your gross margins that are indeed very high, very healthy. How much control do you have about this gross margins? It is data usage or what is being baked into those kind of cost of goods?
Yes. Well, it's the cost of revenue. So anything that -- all the costs that operating the network and providing the services to our customers flows into that. I think the gross margins are so impressive because the architecture of the network is so unique. So you talk about competitive moats for the company, the network and its architecture certainly is one. We buy off-the-shelf hardware. There's nothing special about the hardware we buy. There might be more CPU cores in our hardware stack than other networks, especially CDN networks, because we deliver a lot of security products that need encryption and decryption at the edge of our network but it's a completely off-the-shelf hardware stack. And that is one of the reasons why our CapEx is so low, right? We said it's around 12% to 13% in terms of revenue. And on this hardware stack runs a completely integrated, completely homogeneous software stack that allows us to offer every product that we have, every service that we have on every server, in every city, in every location. And with that, the complete surface of the network becomes now degrees of freedom how you manage supply and demand. You can off-shift and offload traffic into parts of the network that are idle because some parts of the world are always asleep and use less of our capacity. So how we are able to move traffic and manage traffic across that network, in conjunction with the unique hardware stack really is the secret sauce around the gross margin. And with every additional server, regardless of where we put it in the world, and with every additional product, the degrees of freedom increase. And with that, the granularity how you can manage traffic, and with that, in the end, also how you can manage cost increases. And as I said before, that is very unique about our network. And I think that's one of the big competitive moats the company has already now and moving forward.
Maybe just one final point longer-term on the model. When we look at companies such as yourselves, 100% SaaS-driven cloud-driven companies, longer-term, as the model fails, how should we be thinking about operating margins and cash flow longer-term?
We gave a long-term model that gets us to margins of 20%. And we said how we think about operating leverage, getting into a target corridor and G&A first, and then R&D will follow and last will be sales and marketing. We also updated at the beginning of this year our breakeven expectations that we are going to expect to breakeven already at the beginning of next fiscal year and not towards the end. Cash flow would have gone a little in conjunction with this. There might be some onetime impacts now because how do we adjust our offices for a post-COVID world will drive a little bit more cash flow this -- CapEx needs this year. But in general, I would say it still holds true. Once we get to breakeven, however, we will pace our time to get to a 20% margin, right? As long as our investment into sales and marketing is driven by superior ROI, by superior growth rates, north of 40%, we'll continue to invest from a go-to-market perspective. On the R&D side, we are already in our target corridor, so plus/minus 1%. And we have seen really good operating leverage on SG&A already in the last 2 years. So that made us confident to talk about the pull in of the breakeven.
As we -- maybe shifting a little bit to your China operations, drive a lot of traffic in China. Maybe for the benefit of our audience that's familiar, can you talk to us about China, your growth strategy going forward in the Chinese market?
Without any doubt, China is an important part of overall go-to-market in our story. It's a big part of Internet and Internet consumption, Internet users. We started very early to develop our footprint in China in the relationship with Baidu that carried us to the current day. We have about -- with Baidu, we have about slightly more than 20 cities in China that's served that had our equipment and provided our services. And that already made us very unique because we are able to offer this as one consistent network, one control plane regardless of whether you're doing business in China, outside of China or into China, one consistent offering, one network. We are evolving our approach there and moving from Baidu into a relationship with JD. We are in this process of transition that will do a couple of things, but it will significantly increase our footprint in China itself. So I said with Baidu, we were in about slightly more than 20 cities in China. With JD, we are going to get to more than 50 cities in China by the end of this year. And an additional 100 cities so -- in the 2 years thereafter. So we'll be in about 150 cities in China. We are today in more than 200 cities worldwide in more than 100 countries. So getting to 150 cities in China will be a really big step. It's important from a varieties perspective. It gets us closer to the eyeballs that wants to connect. As we said before, minimizes latency with anything that wants to connect. But it also allows us to have a much better handle on how granular and how local we can be managing data residency and data sovereignty issues.
And still, I think, important to understand, maybe Tom, just kind of the Chinese contribution because at times, investors kind of tend to freak about it when they hear China, given some of the headline news.
So for us, it has been a rather stable relationship. And in terms of exposure, there is no revenue concentration for us. We are still within normal limits. I would say, 50% of our revenue happens outside of North America. So that's pretty substantial for a company of our size, but it's pretty much 50-50 between Europe and Asia in general. And then China is just a subpart of our Asia business. So it's important from a footprint and from a presence perspective. It has not reached any critical concentration from a dollar perspective at all.
Gentlemen, we're at the hour right now. I want to thank you both. I want to thank the audience for joining us. We'll be in touch. Keep up the good work, and we'll talk soon. Thank you, everybody.
Thanks so much, Shaul. Thanks, everybody, for listening in. Bye.
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