This year, cloud investors have been given a dose of reality on how market prices are rising in this category. For Cloudflare, revenue growth is not an issue at the moment. Yet revenue growth is less meaningful in the current macroeconomic environment if growth does not translate into a healthier bottom line.
It is true that the cloud is deflationary, which is why companies in this sector can continue to experience growth in times of inflation. Yet it is also true that cash is becoming more expensive and therefore growth must be balanced with a stronger bottom line.
Cloudflare has a tremendous customer base and holds the predominant content delivery network market share. According to data from W3Techs, 81% of websites that use CDN or reverse proxy rely on Cloudflare with a strong presence in small and medium enterprises (SMEs).
We discussed in a tech stock podcast last year that Cloudflare is strong in the small-to-medium business (SMB) category and offers entry-level free services. The company benefits from converting the free customer base into paid services, and it can also use the free customer base to test new features before they are launched. Cloudflare was able to sell its products with a net dollar retention rate that increased 400 basis points year-over-year to 127% in the last quarter.
Zero Trust Security is gaining prominence due to the increase in security threats because data is not stored in one place. Secure Access Service Edge (SASE) is a cybersecurity concept that uses Zero Trust to identify users and devices to provide secure access to specific applications or data.
Cloudflare One is the company’s flagship Zero Trust Network as a Service. The need for this has increased due to remote teams, as SASE enables policy-based security regardless of user, application, or device location. Zero Trust Security is built on the principle that no one should be trusted inside or outside the network. In traditional security systems, it is difficult to gain access from outside the network when those inside the network were trusted. With Zero Trust, these assumptions of trust are removed with tools such as multi-factor authentication, giving access for a limited time and also allowing to verify, authorize and have continuous control over all the data points to which access is given.
Zero Trust has helped the company grow its total addressable market from $32 billion in 2018 to approximately $100 billion in 2024. The company is playing a major role in transitioning from a traditional hardware-based security approach to modern zero-trust security.
At the end of September, Cloudflare announced its R2 storage product. You can see the dark purple line starting a strong rise after the start of October. R2 storage allows storing unstructured data without egress bandwidth fees, which are charged when developers fetch data from a cloud provider like AWS. The exit fee is essentially a tax with no value. Markups reach 7900% in the US region when calculating fees charged by AWS. This is an 80X bandwidth markup and has been detailed here by Cloudflare management.
Cloudflare primarily hopes to attract developers for its Workers product, which is a serverless compute service allowing developers to build applications and deploy code at the edge. This eliminates the need for developers to maintain spin-up servers or containers. The cloud service provider (in this case, Cloudflare) provisions, scales, and manages the infrastructure required to run the code. Cloudflare wants developers to choose them over the biggest cloud providers because of their edge location.
Cloudflare Q1 Revenue
At the launch of the low-cost R2 cloud storage service, Cloudflare’s CEO said, “We aim to become the fourth major public cloud.” Big Tech has the advantage of high margins and lots of cash on the balance sheet to build cloud infrastructure. For this ambition to materialize, not only does Cloudflare need to build more points of presence (PoPs), but the company also needs to reduce AWS on egress fees, for example, in order to stay competitive.
In the current quarter, network capital expenditure was 9% of revenue. For the full year, network investments should increase by 12% to 14% of turnover. I think this is one of the main reasons Cloudflare’s valuation could be under pressure.
Note: We previously covered Cloudflare for Forbes here: Cloudflare Stock: An Ambitious Company Must Prove Its Valuation
Here’s what the company said on the call:
I think what’s powerful as we build more POPs is that against all odds, because of the design of our network and because of the efficiency of our network that Thomas and I just made hint, it actually drives our costs down over time. rather than pushing it up. It takes a certain number of servers to process a certain number of requests. So your CapEx is actually determined by the amount of usage of your service more than anything else.
What’s powerful is because we’ve worked hard on the network and software side to ensure that any server, anywhere can handle any request, that means at as we continue to expand our network, we are able to interconnect directly with the various ISPs and eye networks around the world and drive down our costs for things like bandwidth, co-location and other variable costs that are part of our activities.
Right now, revenue growth is not an issue for Cloudflare, as it has been quite robust for many quarters. The company reported revenue growth of 54%, beating estimates of 6%, with 49% growth expected in the next quarter. The company raised its full-year revenue forecast to $957 million, halfway through, for growth of 46%.
There is additional supporting evidence that growth won’t be a problem for Cloudflare, including Remaining Performance Obligations (RPOs) up 57% year-over-year and net dollar retention in up 400 bps year-on-year. The number of customers paying over $100,000 increased 63% year over year to 1,537. This exceeded total customer growth of 29%. Notably, the >$100,000 segment saw a deceleration from 71% in the previous two quarters.
Major customers contributed 58% of revenue. There was solid customer growth over $500,000, up 68% year-over-year, and customer base over $1 million grew 72% year over year. year to year.
The company has a gross margin of 77.80% but had a GAAP operating margin of (18.90%) and an adjusted operating margin of 2.30%. The main difference is stock-based compensation, which doubled to $34 million in the first quarter from $18 million in the year-ago quarter.
Similar to the network’s capital spending note, the company says it won’t see an improvement in operating margin in the near term. I think this could put pressure on valuation if cloud peers are able to improve operating margin in the current macro environment.
Here is what management says:
“We intend to increase our operating expenses based on revenue remaining here or at breakeven and reinvest excess profitability back into the business to capture the huge opportunity before us.
Free cash flow was negative $64.4 million (30% of revenue) compared to negative $2.2 million (2% of revenue) in the first quarter of 2021. Of this amount, $30 million were owed a one-time withholding tax payment in the last quarter. This would still show a marked drop in free cash flow compared to last quarter at a time when the market is particularly sensitive to cash flow. The company reported positive free cash flow of $8.6 million in the fourth quarter of 2021, and it was the first positive free cash flow quarter since the company went public. Management said it will have positive cash flow in the second half, while the first half will have negative free cash flow due to the investment in the network and the physical office redesign after Covid-19.
The company had cash and available-for-sale securities of approximately $1.7 billion, including $152 million.
Cloudflare is showing strong customer growth, and its steady revenue growth also helps prove that the cloud is, indeed, deflationary. What is likely weighing on the minds of the market is what the CapEx will be to become the fourth cloud provider. Management confirmed that the operating margin will not improve any time soon as the company plans to reinvest and the company’s recent quarter showed a decline in free cash flow. The I/O fund moved away from stock based to focus on high conviction companies that have a better cash flow margin.
Royston Roche contributed to this article.
Please note: The I/O Fund conducts research and draws conclusions for the company’s portfolio. We then share this information with our readers and offer real-time trading notifications. It is not a guarantee of any stock’s performance and it is not financial advice. Please consult your personal financial adviser before buying shares of the companies mentioned in this analysis. Beth Kindig and the I/O Fund have closed their Cloudflare position and do not own Cloudflare at the time of writing and have no plans to enter the stock in the next 72 hours.