Updated: Apr 21, 2021
A deeper dive into Cloudflare and a 2020 recap. This is my top holding, so it only makes sense I do a deeper dive than my brief summaries for my paying members.
Let us remember what NET's mission is, they want to build a better internet. Businesses and people need the internet because it drives businesses productivity and expansion. What used to occur, was the on-premise data centers to deliver VPN, firewall, routing, traffic optimization, load balancing, and various other services. These were complex, costly, technical, and a web of dependencies for businesses. Then in came the cloud.
There has been a huge architectural shift in the network layer. NET has built a global scalable platform to deliver a broader range of network services to businesses of all sizes, in all geographies, to make them secure, accelerate performance, and cut costs and complexity of individual hardware. How could you not want to invest in this business?
Fiducia has been a shareholder of Cloudflare with an average price $39.79. Below are the average share price lots in my long-term Roth IRA account that I label the Fiducia Fund. Fiducia likes to be as transparent as possible in the long-term account, to build that confidence in the names we own for my subscribers. I also own shares of Cloudflare in my trading account as well.
For anyone who is interested, below are some key terms to understanding while evaluating Cloudflare.
Below here will be the estimates that the street has for 2021 2022, and 2023 Fiscal Year for Cloudflare as well, these numbers do get updated through the year. I will updated these in my quarterly reports on Cloudflare for my members given Cloudflare historically beats and raises their guidance.
Let us continue our recap. What a rapid pace of innovation this company has had in 2020. One reason for continued growth in the business is the product innovation by the team creating a larger TAM for themselves, and executing on that product innovation for their current and future customers. Prince knows what he is doing and he is delivering for shareholders and customers at the same time. I think this is a rare once in a time opportunity to really invest capital into a business that takes into account all stakeholder interests. The financials will improve over time. Cloudflare has improved their adjusted operating margin by 1,690bps to -7.9% in 2020 which to me tells me they are on their track to profitability and as an investor in the business, I am expecting it by end of 2023. GAAP operating margin still stands at -24.8%. NET is proving themselves to be very scalable as well.
Understanding what you own is a critical leg of the investment thesis table for Fiducia, if you cannot tell me in 45 seconds why you own what you own then you may not understand it well enough to have a position. A few ways to improve your understanding of the business is the 10-K, 10-Q, and Earnings Calls and analyst notes. These are my favorite places to go to and just read, then after I read I take extensive notes which translate into posts and ideas.
Continuing on Cloudflares business, they have had a rapid pace of innovation during the 2020 year, launching new products for their customers even during a pandemic. With a customer base of 3.5m+, Cloudflare has to rapidly innovate to keep their customers spending, which keeps their DBNR up well over 100%. Cloudflare has 17% of the Fortune 1,000 as paying customers, proving that the land and expand method is working in their favor. Cloudflare Workers is actually one of the largest and widely used edge platforms in the world, with consistent innovation and execution Matthew Prince has put them on the leaderboards. With consistent beats and raises, I see no reason to not continue to hold this excellent business. Hundreds of thousands of developers write tens of millions lines of code that run on NET network (ha ha NET, NETwork).
Matthew Prince developed his own Hierarchy of Developers' Needs:
He originally thought people wanted speed as the biggest feature for edge computing, but he argues that consistency, cost, ease of use and compliance will be far more important. He believes regulatory compliance will be the killer feature of edge computing. I AGREE! Reading this blog post, linked here, felt like he connected all the dots for me. Cloudflare has proved itself to build at scale, growing revenue, customers, reliability, guidance, rapid product innovation, I am trying to find the bear thesis as the one I had dwindles down (not good!).
2020 Annual Report:
As of December 31, 2020, 17% of the Fortune 1,000 were Cloudflare paying customers. Customers are essentially trying to rally behind one global cloud services provider. I wonder who that could be. Cloudflare has developed their network so they can grow it at scale and be flexible, not to mention do both inexpensively. Cloudflare's network is huge, in more than 200 cities in over 175 countries and connecting 9,100 networks globally that include major ISPs, cloud services, and enterprises. This scale is unmatched to Fastly, sorry. We already know the growth strategy with the name, but here is a brief update. Acquire new customers both free, and pay-as-you-go and contracted. The business will then expand relationships with existing customers by upgrading to premium plans and increasing usage of the products. Cloudflare must stay innovative, so they develop new products and solutions for customers, they are building their own TAM. Lastly, extending their serverless platform strategy, storage and compute. The Cloudflare Workers offering is attractive to users because of the architecture coupled with the power of the network.
The business uses multiple sales methods such as web sales, direct sales, and indirect sales to get customers of all sizes. Enterprise customers are the big boys, usually replacing on-premise hardware with cloud network services. Now, Cloudflare obviously is not the only cowboy in town and they do have competitors and some are more broad than others, while others are more focused on Zscaler. I will just post the screenshot from the 10-K because it is pointless for me to type it all!
Take some time to study and write those down if you are a shareholder, because when NET is down 5%, 10%, 15%, we can go look at these businesses and see if they are down as well. Usually some tight correlation because businesses that operate in the same industry, it could be because of a bad earnings report or analyst upgrades/downgrades.
Above we can see that the losses have narrowed over the past 3 years even as they spend to expand. You can see Sales and Marketing are a huge % of the revenue each of the past 3 years, 48.99%, 55.5% and 50.5% in 2018, 2019, 2020 while improving revenue growth. They are spending to land and expand. A pullback on S&M would result in a hefty bottom line increase all else equal and no more share dilution from stock-based comp.
What does this tell you? It tells me there are expansion opportunities in APAC and EMEA. Cloudflare is a global business, scaling fast. I do not care too much about profitability right now I care about the customer land & expand and retention of those customers.
Non-GAAP Loss from Operations and Non-GAAP Operating Margin
We can see the massive improvement on a YoY basis from 2019 to 2020 on Operating Margin, this is really good to see even for a company spending to expand.
How Revenue is Generated
Comparisons for the Year-over-Year
Revenue was up 50%, primarily due to the addition of new paying customers, as they have increased 32%, coupled with expansion within the existing paying customers base (this is where the DBNR comes into play). Cost of revenue increased by $37.6m, 59% YoY, and this was primarily due to a 12.6m expense related to operating in co-location facilities and network and bandwidth costs for the global network. The business also went on a hiring spree and had an increase of $3.7m in employee-related costs due to a 55% increase in headcount in customer support and technical operations organizations.
Sales and Marketing expenses increased by $58.6m or 37% YoY, primarily driven by $48.2m in increased employee-related costs because of the 46% increase in headcount for the sales and marketing organization including a $7.3m stock-based comp expense.
In my eyes, charts tell me stories. Whether they are Gross Margin charts, operating margin charts, technical analysis charts. We can extrapolate data and thoughts on everything. Being an analyst means you read everything and try to us every single data point to your advantage, positive or negative. Below is the full chart of NET since they became public, the first green line is the 150 day moving average and the second green line is the 200 day moving average.
So what can we extrapolate here? Not only do I want to provide all my Fiducia Members with research, but I want you to understand how my brain operates and what I look for so you can utilize it on your own. What I see here is pure strength over the years, people want to own the stock and currently given the broader market pullback, we can see Cloudflare coming off some major highs after a very solid rally. This is OK and it HAPPENS. Stick to your guns, and continue you are reading. We have been following the name for some time now, see the big green bar in the middle? I remember that was when NET released a TON of new products for their customers, and the market loved it! Short-term traders faded the pop, then the real investors bought in and we continued to rally.
I want to look at things from an annual basis on the financial charts, we have public data from December 2019 and December 2020 Fiscal Years, quarterly is too short-term when making "investment decisions". All the charts down below will be taken from Koyfin.com which I have been using, and will start paying for and canceling FinBox once they start charging.
Growth at a rapid pace. Annual revenues have actually accelerated from 2019 to 2020, well deserving of a premium multiple.
We are seeing some major improvement across the board
ROA, ROC, and ROE have all steadily increased on a YoY basis as the business becomes more mature, and capital allocation starts to become priority. I am impressed with the YoY improvement which leads me to believe there will some hefty profitability by 2023.
Short-term liquidity is also in a very strong place
Look, maybe I sound bias, but trust me I am always looking for the bear thesis. Valuation is currently a concern of mine, no doubt it is expensive. Great business will usually sell at a premium, Fiducia believes Cloudflare is a large winner in the internet and security space in the next decade and my money is where my research is. The best thing an investor can do is sit on their hands, monitor, and invest accordingly.
I hope this report finds you all well. Thank you. Please drop comments in the comment section with any questions!