Cloudflare

Updated: Sep 25, 2020

My single largest holding, Cloudflare ($NET), is one of my highest conviction holdings over the course of the next 3-5 years. First, let's understand the business and what they do. This is critical to me when assessing a company, if I do not know what they do, how can I invest in them? Cloudflare is a cloud platform that provides numerous network services to businesses globally. The company as stated in their 10-k, says that their mission is "to help build a better internet". What can we take away from this? We can dive further into the services they provide, which range from providing Content Delivery Network (CDN), Distributed Denial of Service (DDoS), Infrastructure Protection, IoT, and much more. Matthew Prince, who is CEO and Co-Founder is brilliant. I admire management who is always asking for feedback.


As we look at the most recent quarter, revenue was up 48% YoY, and large customers (those who have $100k< annualized) grew by 65%. This is quite an impressive feat in the face of COVID-19. New paying customers were 7,000, bringing the total paying customer count to over 90,000. Annual revenue for Cloudflare has had a 50% CAGR from 2016-2019 and 48% from 1H 2019 to 1H 2020. I do expect revenue to accelerated above 48% into 2021, on the back of COVID-19 slowly dying out. Cloudflare has 16% of the Fortune 1,000 as paying customers. 51% of their revenue is derived from outside of the United States, so they have a relatively strong global footprint operating in 100+ countries and 200+ cities. In the Q2 presentation, which will be linked below, they have a slide highlighting the competitive position and limitations of On-Premise, Point Solutions, and Public cloud on slide 15. I recommend reviewing the slide. The comany estimates that their 2018 Total Addressable Market (TAM), is $32b, and by 2022 estimated to by $47b. Sitting at a market cap of $10.27b today with revenue estimates of $406.49m for this fiscal year, I would say there is much room for growth acceleration. While the company is not profitable on a GAAP basis, I would like to point out the breakdown of how they are spending. Cost of revenue is primarily due to increase of expenses related to operating in co-location facilities and bandwidth costs for operating a global cloud platform (OK), amortization of capitalized internal use software costs (OK), employee related costs and headcount (OK). What I am not fond of is stock comp. Cloud names always seem to have rather higher stock based comp especially for the sales people, considering thats how the business is driven. I would not like to get diluted too much.


The company is not cheap. Price-to-sales is currently at 19x next year, and 14.7x next year. I do expect the company to beat every quarter on top line (bottom line is not too relevant for me at the moment, as I want to see them spend to gain share), so those P/S ratios will probably come down slightly as we move toward each quarter.


One last highlight before we end this simple blogpost on why I like Cloudflare is simply their GAAP Gross Margins sitting at 76%. Their Dollar-Based Net Retention or DBNE is consistently at or above 115% for thee last 9 quarters. DBNE is essentially a Key Metric that software companies use, it measures retention and adding new products or cross selling to current customers. With various growth vectors on fire, I expect the company to continue plowing away. I love the longer-term guidance they provided on the Q2 report. Gross margins to be 75-77%, Sales & Market as a % of revenue to be 27-29%, (48% in Q2), R&D to be 18-20% (21% in Q2), G&A to be 8-10% (17% in Q2) and lastly, Operating Margin to be at 20%+ (-10% in Q2 2020).


Fast growth, large TAM, excellent management. Here are a few key quotes from the earnings transcript that I found to make them even more compelling of a buy. The quotes are from a document, so words may be slightly different.


"Today, much more so than on our last earnings call, we feel, we have clear visibility into the effects of the pandemic on our business that has given us the confidence as Thomas will detail to raise both our Q3 and our annual guidance."


"We’re worried sales productivity made slow as our team adapted to working remotely. Instead, sales productivity per ramped rep hit a new record high. Deeper into the weeds, we watch our receivable collection period closely"


"We had nearly 47,000 applicants up 750% year-over-year. If you do the math, that means we extended offers to less than 0.6% of applicants. We had a 96% offer acceptance rate company-wide and then 99% rate in our sales organization. The talent we’re seeing is incredible. My parents were proud when I got into HBS, turns out the odds of getting a job at Cloudflare these days are much harder."


"A leading identity and access management provider signed a two-year deal worth a $0.5 million per year. They’ve moved workloads away from Amazon Web Services due to better speed and flexibility of our platform."



https://cloudflare.net/files/doc_downloads/Presentations/2020/q2/Cloudflare-Q2-2020-Investor-Presentation_FINAL.pdf

https://seekingalpha.com/article/4365592-cloudflares-net-ceo-matthew-prince-on-q2-2020-results-earnings-call-transcript



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