Cloudflare, Inc. (NET) Earnings Call Transcript

We're here with Thomas Seifert, CFO of Cloudflare. He's been CFO since June of 2017. Special thanks to Phil Winslow as well, sitting here as well. Joined the company recently, and thanks for being here and supporting the event. So reach out to -- and I know many of you guys know Phil as well. So the trend of sell-side going to companies continues.

Thomas, yes, just to kick off, I think everyone would love to just hear your perspective on the overall environment, conversations with customers -- and the environment has been obviously -- the wins have been changing, just bring everyone up to speed and your thoughts on what you guys are seeing and hearing?

Yes. Well, first of all, thanks for having us. It's coming up 6 years. I just realized that when you said that, that's the longest I've been in a job for a while. So that tells you something. So, it has been an interesting couple of months. We were -- as I tend to remind people, we're one of the first companies calling a change in macro outlook already early last year, the first quarter of last year. Coming out of the fourth quarter, we saw that headwinds were building up. And at that time, we saw quite a significant deceleration in our pipeline growth, and we talked about that. In the beginning, we were looked at oddly for calling it early. And -- but things started to stabilize towards the end of last year, third quarter, fourth quarter pipeline growth continued to accelerate. Again, stabilized even in the first quarter. And while we had seen some slight uptick in sales cycles over the course of last year. it was nothing dramatic. And it correlated more, to be honest, with our journey up the enterprise stack, larger and larger customers and larger and larger deal sizes with customers. And then the first quarter -- and that story pretty much framed our original thoughts about how this year would play out. And then the first quarter came, and a couple of banking names got in trouble, and that changed at least our business quite significantly after SVB. And then there are a couple of other regional banks, the European banks, more nervousness around macro outlook, really led sales cycles explode. Quite significantly for us, 27%, in general, even more on large customers and expansion deals. And that led to us reframing how we think about the year. So far, being in the second quarter, it hasn't changed much, neither to the worst nor has it improved. I mean a couple of European countries are now officially in recession. So I think that proves the point we try to make. But it frames how we thought about the year and how we try to think through the guidance and how we reframe guidance on our earnings -- on our last earnings call.

We get that question a lot. So what have you put in? What level of conservatism have you put in to give everyone?

Well, we never talk about conservatism. That is a word that changes over time in economics as well as in politics. So we tried to be thoughtful and prudent. Maybe the learnings we took from the first quarter was it was a highly nonlinear quarter. We expect that over the life cycle of the company that we would get more and more nonlinear just because of the deals becoming bigger and bigger. And with that, ACV generation becoming lumpier. But to be honest, I've never seen a nonlinearity like what we experienced in the first quarter, not even during the first quarter of COVID. We literally generated almost most of our ACV in the last week of the quarter and even there in the last day. So we assumed that this would not change. And we -- and the learning from that is that means that you hardly generate any in-quarter revenue from the new ACV. That's just how subscription models work. So we stay true to that. We saw, as I said, an extension, an explosion almost in the elongation of our sales cycles. And we assumed that this would not change much either over the course of the year. And the headwinds are still building up. And I just said a minute ago, as of last week, the first couple of European companies officially in recession territory now. So we built that into our guidance. We didn't put any [plex 1] events in there.

Your top of funnel is strong. What you're saying is that the customers are there, but they're just not...

Pipeline continues to build strongly. That has not changed either. So for us, it's not so much a matter of do we see the business, but when will we see the business? When will we see pipeline turn into ACV? The pipeline development itself was strong in the first quarter, and continues to be strong from what we see so far in the second quarter, too.

And was there any difference in net new deals or cross-sells? it kind of -- it was across both?

I would say, if you look at the first quarter, that it was pretty good from a new ACV business perspective, where we saw most of the challenges was in the expansion business actually. And if you look at a typical land in the expand business, the larger deals usually happen in an expansion fashion. And it became even more difficult, not only expansion but with large customers. So my interpretation of that was that large customers are well organized. They have well run processes, and they just react fast or faster to changes in the macroeconomic sentiment than others. And that's why we saw an explosion or elongation in sales cycles there first. And then, in a way, we are also the victim of our own success. We have extremely short sales cycles, in general. Our implementation times on product is really, really short. So if you decide to put [Atlassian] project on hold, right, you don't really lose a lot of implementation time, if we onboard a large financial institution on the DDoS attack that takes a couple of hours. It's not just week or months or so. That's why I think we are more sensitive to those changes on the way down, hopefully, then also on the way up.

There's a common theme in our work on you guys that you're loved across a lot of different divisions. We have you deployed at Jefferies in a number of different areas. But one of the things that still seems to be missing is just standardization kind of becoming the de facto, maybe consolidating out others. I mean it seems like -- it feels like we're on that pathway. But what do you think is kind of the tipping point for this to happen with some of these larger enterprises where there -- you become the centralized platform.

In a way, it's happening. We showed that on our last Investor Day, a couple of weeks ago in New York, how a Cloudflare customer has changed and evolved over the last couple of years. What it takes now to be a top 10 customer, what it takes to be a top 25 customer, or even what it takes to be a top 100 customer? Now you have to be pretty much at a $1 million annual revenue to be -- to even get to that point. So we are getting there. I think the benefit of this business model in part also explains is an answer to your question. We are not a rip and replace, right? What gives us this durable growth is what we call winning this war of attrition. And what we mean by that is that you have -- especially for our ACT-1 product, you have installed on-premise infrastructure, your firewalls and routers and load balances. And what normally happens is that people put us in front of this on-premise infrastructure. And then over time, upgrade dollars or expansion -- capacity expansion dollars move in our way. And this gives you this durable growth path. But that also means that consolidating spend behind us is a process not a rip in the place, but it's a process. But just looking at how many customers bought how many products from us at the IPO, we measured 4 or more products. 75% of the customers today, this is north of 10, 11, 12 or 13 products. Today, we have about 50 -- north of 50 revenue contributing products and services we offer. So this explosion of products and services will allow us to continue on the path of consolidating more and more spend, becoming the prominent platform behind -- or on which customers consolidate their spend. And this will give us growth moving forward.

The incremental investments, the big investment areas that you're going to be behind in the next 3 years, can you...

From a product perspective or...

Overall, as a company kind of when you think about the three big areas or a couple of big areas? What should we be thinking through?

There's a -- you can answer that question in a couple of ways. What I think makes the business model unique is just the sheer power of innovation, the amount of products and services we put out annually, quarterly 100 products and features on average per quarter. Where when we IPO-ed the market, we addressed for what was around $35 billion now with the ACT-2 and 3. I'll give you more color on that in a minute. We are well north of $130 billion of revenue. So this investment into product and product innovation will continue. So there's a road map in place. We are flexible and agile enough to react. We had [developer week] just 2 weeks ago, which I think was a good demonstration of how fast we can react to changes in the technology landscape. [Developer week], 2 weeks ago was all about AI and how we support that. We ramped out -- we introduced two really cool features, one is called Constellation, that allows developers to run pretrained models, machining learning models and inference tools natively on workers, on our network. And the other one is how we use R2 as a storage. Training models takes a lot of data that can be rather compute and storage-intensive, and R2 is just a way to do this efficiently without egress fees and economically and a scalable way. So reacting fast is one. But the sheer proudness of ramping products is the other one. We are now in what we call our ACT-2 products. It's everything around Zero Trust. We literally had one or two products in 2018. Now it's a complete suite of products, access VPN replacement, gateway, browser isolation, e-mail. Threat intelligence falls into that category. That group of products, plus one more, was already 25% of our ACV at the end of last year. So the way these products will drive the next wave of revenue growth. And then there's what we call our ACT-3 products, our networking products that -- like Magic Transit that will then be the next step in that direction. So investment will go -- will continue to go into -- in the product and product innovation and disrupting new markets. And there's just a lot at [indiscernible]. I always say if you want to really understand Cloudflare, you have to go back, understanding the architecture of the network itself and how the products and services rest on it. This is where the true efficiency comes, from off-the-shelf hardware, a completely integrated -- fully integrated homogenous software cycle that allows you to overrun all the products we have, all the services we have from every server and every location with every new product this flywheel turns faster. And this is where the efficiency of the business model comes from. A long answer.

This little tidal wave coming called AI...

Yes.