Cloudflare Q2 2023 Earnings Call Transcript

Quartr
Provided by Quartr
August 3, 2023

There are 11 speakers on the call.

Operator

Thanks for joining us today to discuss Cloudflare's financial results for the Q2 of 2023. With me on the call, we have Matthew Prince, Co Founder and CEO Michelle Zatlan, Co Founder, President and COO and Thomas Seifert, CFO. By now, everyone should have access to our earnings announcement. This announcement as well as our supplemental financial information may be found on our Investor Relations website. As a reminder, we will be making forward looking statements during today's discussion, including but not limited to our customers, vendors and partners, operations and future financial performance, our anticipated product launches and timing and market potential of those products, our anticipated future financial and operating performance, and our expectations regarding future macroeconomic conditions.

Operator

These statements and other comments are not guarantees of future performance and are subject to risks and uncertainties, much of which is beyond our control. Our actual results may differ significantly from those projected or suggested in any of our forward looking statements. These forward looking statements apply as of today, and you should not rely on them as representing our views in the future. We undertake no obligation to update these statements after this call. For a more complete discussion of the risks and uncertainties that could impact our future operating results and financial condition.

Operator

Please see our filings with the SEC as well as in today's earnings press release. Unless otherwise noted, all numbers we talk about today other than revenue will be on an adjusted non GAAP basis. You You may find a reconciliation of GAAP to non GAAP financial measures that are included in our earnings release on our Investor Relations website. For historical periods, a GAAP to non GAAP reconciliation can be found in the supplemental financial information referenced a few moments ago. We would also like to inform you that we will be participating in Stifel's Tech Executive Summit on August 29th and the Goldman Sachs Communitytopia and Technology Conference on September 6.

Operator

Now, I'd like to turn the call over to Matthew.

Speaker 1

Thank you, Phil. We had a Strong quarter in spite of continued macroeconomic uncertainty. In Q2, we achieved revenue of $308,500,000 up 32% year over year. We added 196 new large customers, those that pay us more than $100,000 per year and now have 2,352 large customers, up 34% year over year. Our focus on go to market improvements is already paying off.

Speaker 1

After we saw sales cycles increase 20% in Q1, Discipline around deals had them return to levels closer to what we saw last year. While our customers and prospects continue to be very careful around their IT spend, Our improved execution led to a record quarter in new ACV booking. My sense talking to customers is that while the macro environment is Still challenging, it has stabilized. And for the first time in several quarters, sentiment among IT buyers does not appear to be getting worse. Our dollar based net retention ticked down to 115%, down 2% quarter over quarter.

Speaker 1

Dollar based net retention is a lagging indicator, So it will be slower to reflect the go to market improvements we are seeing. It's also important to note that we did not see any new competitive pressure or churn throughout quarter. Instead, the lower dollar based net retention is due to slower expansion from some of our existing customers. We expect that our focus on go to market operational excellence will improve this metric over time. Our gross margin held stable at 77.7%, still above our long term target of 75% to 77% and in line with 77.8% last quarter.

Speaker 1

We delivered an operating profit of $20,300,000 our 4th consecutive quarter with a record operating profit. We also meaningfully outperformed on free cash flow, generating $20,000,000 during the quarter, which represents a free cash flow margin of 6.5%. I'm proud that our team has proven we can not only execute in good times, but also be disciplined and deliver operational improvements while we're in more challenging times. We continue to see very strong pipeline growth. Q2 was another record for new pipeline generation.

Speaker 1

As we discussed last quarter, we made significant changes in our sales team to proactively address underperformance. That went very well, both qualitatively and quantitatively. Our top performers are invigorated. We saw a marked improvement in the average account executive productivity. At the same time, we've implemented robust onboarding, enablement and training programs.

Speaker 1

Combined with the record number of applicants we're seeing for sales roles, This makes for the right formula to build a world class sales organization. And our team is armed with great products to sell. Last quarter alone, Forrester recognized AreaOne, our email security product, as a leader. IDC recognized us as the leader for 2 reports in 0 Trust and Network Edge Security as a Service, and we were the only new vendor recognized by Gartner for Secure Service Edge. Our developer platform, Cloudflare Workers, continues its explosive growth.

Speaker 1

We reached 10,000,000 active workers applications in Q2, up 2 50% since December and 4 90% year over year. R2 continues to grow and now stores over 13 petabytes of customer data, up 85% quarter over quarter. We have 44,000 distinct paying customers with R2 subscriptions and brand name customers are beginning to adopt it as their primary object storage solution. That seems like a good segue into some other customer wins in the quarter. One of the fastest growing generative AI companies expanded their relationship with Cloudflare, signing a 1 year $1,700,000 contract less than a year after first starting to use our platform.

Speaker 1

Like many AI companies in the space, this customer relies on a multi cloud architecture for training and processing requests. R2 lets them unlock the best prices and performance across multiple cloud providers. In their words, We see Cloudflare as a strategic foundational glue across all our services. Cloudflare continues to be our best strategic partner of all partners. That's great to hear from many customers, but it's especially fun coming from a company that's doing such cutting edge work.

Speaker 1

These days feel like membership in the CEO Club is predicated on saying AI as many times as possible in your earnings call script. I have to confess, I still find it a bit awkward. When we first pitched Cloudflare to venture capitalists back in 2010, at one point I described it as the first AI powered security company for the cloud. The eye rolls around the table were so intense that I'm still a bit scarred. But more than a decade later, here we are.

Speaker 1

And by our estimates, Cloudflare is the most commonly used cloud provider across the leading AI startups. They're using R2 to help arbitrage the lowest GPU cost to train their models. They're using our security tool themselves powered by AI or what our team would prefer to call machine learning to protect their own AI systems and increasingly they're using the edge of our network to perform inference. We are continuing to And believe that we are uniquely positioned to win the inference market, which we believe will be substantially larger than the AI training market. In Q2, we hosted our developer week, highlighting 10 major announcements and features to extend Cloudflare Workers as the preeminent developer platform for the leading AI company.

Speaker 1

Q3 will feature our annual birthday week, and we have a lot more in store to provide the picks and shovels to enable AI companies to build the future. Beyond AI, Cloudflare's 0 Trust solutions were another big winner in Q2. A Fortune 500 technology services company Expanded their relationship with Cloudflare, signing a 3 year $7,200,000 contract for 25,000 0 Trustees. That brought their annual spend with us to over $5,000,000 They first became a customer in Q3 last year using our application security products. 6 months into the deployment, one of their senior executives said, Cloudflare is like magic and brought us into an ongoing competitive 0 Trust proof of concept.

Speaker 1

Butler's Access and Gateway products were chosen over 1st generation Zero Trust competitors due to our rate of innovation and ability to consolidate all their security onto a single pane of glass. 1 of the largest online recruiting platforms expanded their relationship with Cloudflare, signing a 25 month, dollars 2,400,000 contract and bringing their annual spend over $5,000,000 With more than 90% of their employees remote, They were looking for a comprehensive Zero Trust solution and evaluated us against every leading vendor in the market. They decided to go all in on Cloudflare with 15,000 seats for access, gateway, CASB, data loss prevention, browser isolation and Area 1 email security. I'm especially proud of how quickly we were able to onboard them, less than a month to fully replace their 1st generation Zero Trust vendor. That's awesome.

Speaker 1

An Australian technology company expanded their relationship with Cloudflare, signing a 1 year $2,200,000 contract, bringing their total spend with us to over $5,000,000 This customer started out on our pay as you go plan in 2016. This quarter, they signed a 0 Trust deal to protect their expanding workforce. They're also broadening their use of Cloudflare's developer platform with both R2 and Durable Objects. Sticking Down Under, a leading Australian healthcare provider, expanded their relationship with us, signing a 3 year $2,800,000 contract. We are replacing their hodgepodge of 1st generation 0 Trust vendors with 12,000 seats of access, gateway, browser isolation, CASB, data loss protection and AreaOne email security.

Speaker 1

This is another example of a customer looking to consolidate vendors and choosing Cloudflare for their holistic network security solution. Here's another cool one. A Fortune 500 social network expanded their relationship with Cloudflare, signing a 3 year $2,400,000 contract. They initially became a customer a year ago, building on top of workers and using our global network to authenticate the security of one of their messaging products. They approached us again looking to add increased privacy onto another product with our privacy gateway solution.

Speaker 1

They view Cloudflare as a leader in privacy based on our co development of the oblivious HTTP DB Standard. And they admire us as one of the only other companies that truly understands scale. As privacy is increasingly top of mind, We believe there will be more and more of these sort of strategically beneficial relationships. I think I've only said AI 11 times so far, putting me way behind Satya. So let me end with one more AI customer win.

Speaker 1

Another generative AI company expanded their relationship with us, signing a 3 year $1,300,000 contract. They came to us for our developer platform signing up as a pay as you go customer. Because their developers loved us, they approached us about a security need and signed a deal to use our application security and 0 Trust products. They're only 100 seats, but they're growing like crazy and building Cloudflare deep into their whole stack. Whether you're a Fortune 500 industrial company that used us for application security and are now hiring AI developers to use our workers platform to drive innovation across your business Or you're a 100 person AI startup that started using our developer platform and then realized you can get the same security as the biggest Fortune 500 companies.

Speaker 1

That's what's really unique about Cloudflare. We've built the cloud that connects the world securely, reliably and efficiently. With that, I'll turn it over to Thomas. Thomas, take it away.

Speaker 2

Thank you, Matthew, and thank you to everyone for joining us. During the Q2, I'm pleased to share that we've seen improvements in terms of the impact from the external challenges that we highlighted last quarter. Specifically, also still somewhat elevated from historical levels, sales cycles shortened in Thank you to the implementation of more efficient processes and tactics. Our pipeline growth rates have also shown improvement as we continue to Fine, our go to market strategies and operations. Furthermore, we observed a notable uptick in collections in our accounts receivable, which we believe reflects a rebound in customer confidence and financial stability.

Speaker 2

We also continue to maintain our strong commitment to being fiscally responsible and act as good stewards of Investors Capital. We delivered our 4th consecutive quarter of record operating profit. We also prudently allocated capital with a focus on maximizing shareholder value by taking action to retire our 2025 convertible notes during the Q2. Turning to revenue. Total revenue for the Q2 increased 32% year over year to $308,500,000 From a geographic perspective, the U.

Speaker 2

S. Represented 53% of revenue and increased 30% year over year. EMEA represented 27% of revenue and increased 38% year over year. APAC represented 13 And of revenue and increased 23% year over year. We were pleased to see notable performance in the EMEA and APAC regions with both achieving record new ACV bookings in the Q2.

Speaker 2

The strength in APAC was primarily driven by large customer deals, and we are seeing security become an even higher priority in EMEA given the geopolitical situation in the region. Turning to our customer metrics. In the Q2, we had 174,129 paying customers, representing an increase of 15% year over year. We ended the quarter with 2,352 large customers, representing an increase of 34% year over year and an addition of 196 large customers in the quarter. In fact, we added a record number of customers spending more than $500,000 on an annualized basis with Cloudflare, And the Q2 was also one of our highest quarterly additions of customers spending more than $1,000,000 annually, including our largest hero trust contract to date.

Speaker 2

Our dollar based net retention rate was 115% during the Q2, representing a decrease of 200 basis points sequentially. Importantly, renewal rates in the Q2 were consistent with a quarterly average in 2022, which was an all time high for the company. Instead, Similar to the last two quarters, the decline in DNR was again primarily driven by slower expansion in our larger customer cohorts. We calculate DNR by comparing the annualized revenue from paying customers 4 quarters prior to the annualized revenue from the same set of customers in the most recent quarter. As a result, this will be a lagging indicator Cloudflare's underlying business trends.

Speaker 2

Based on our visibility, we believe the deceleration in DNR is nearing a bottom. Moving to gross margin. 2nd quarter gross margin was 77.7%, representing a decrease of 10 basis points sequentially and a decrease of 120 basis points year over year. Network CapEx represented 11% of revenue in the 2nd quarter. For fiscal 2023, we now Expect network CapEx to be 10% to 12% of revenue, underscoring the scalability and efficiency of our network even as we onboard new workloads, including AI.

Speaker 2

Turning to the operating expenses. 2nd quarter operating expenses as a percentage Revenue remained consistent sequentially and decreased by 8% year over year to 71%. Our total number of employees increased 11% year over year, bringing our total headcount to 3,389 at the end of the quarter. During the Q2, we addressed consistently low performing sales capacity with a focus on upgrading our customer facing talent to improve Growth, increase productivity and drive long term success. We will continue to pace hiring for the year based on market conditions and remain committed to raising the bar on new hire additions given talent opportunities available in the market.

Speaker 2

Sales and marketing expenses were $125,400,000 for the quarter. Sales and marketing as a percentage of revenue decreased by 1% sequentially, a decrease of 41% from 44% in the same quarter last year. Research and development Expenses were $53,000,000 in the quarter. R and D as a percentage of revenue decreased by 1% sequentially and decreased to 17 Percent from 20% in the same quarter last year. G and A expenses were $41,000,000 for the quarter.

Speaker 2

G and A as a percentage of revenue increased 1% sequentially and decreased to 13% from 15% in the same quarter last year. Operating income was $20,300,000 compared to an operating loss of $891,000 in the same period last year. 2nd quarter operating margin was 6.6%, an increase of 700 basis points year over year. These results highlight our continued focus on becoming more efficient and more productive, not just during the currently uncertain macroeconomic backdrop, but also because operational efficiency is a long term competitive advantage. Turning to net income and the balance sheet.

Speaker 2

Our net income in the quarter was $33,700,000 or a dilutive net income per share of $0.10 We ended the Q2 with $1,600,000,000 in cash, cash equivalents and available for sale securities. Free cash flow was $20,000,000 in the 2nd quarter or 6% of revenue compared to negative $4,400,000 or 2% of revenue in the same period last year. Remaining performance applications or RPO came in at $1,000,000,000 representing an increase of 8% sequentially and 36% year over year. Current RPO was 75% of total RPO. Before moving to guidance for the Q3 and full year, I would like to begin with our Prince.

Speaker 2

And the provisions we have factored into this outlook. Despite being encouraged by the forward progress we delivered during the 2nd quarter in terms of shortening sales cycles and improving close rates, mixed macroeconomic data points serve as a reminder that we are operating in a business environment that so showing signs of stabilization continues to be challenging to predict. As a result, we remain prudent and cautious in our outlook for the second half of the year, and we are fully committed to continuing to adapt our tactics and strategies in response to these external variables. Now turning to guidance. For the Q3, we expect revenue in the range of $330,000,000 to $331,000,000 representing an increase of 30% year over year.

Speaker 2

We expect operating income in the range of $20,000,000 to $21,000,000 and we expect diluted net income per share of $0.10 assuming approximately 347,000,000 shares outstanding. We expect an effective tax rate of 11%. For the full year 2023, we expect revenue in the range of $1,283,000,000 to $1,287,000,000 representing an increase of 32% year over year. We expect operating income for the full year in the range of $81,000,000 to $85,000,000 And we expect diluted net income per share over that period to be $0.37 assuming approximately 345,000,000 shares outstanding. We expect an effective tax rate of 9% for 2023.

Speaker 2

After having achieved positive free cash flow in the second half of last year And again, during both the 1st and second quarters of this year, we anticipate generating significant free cash flow for the full year 2023. For modeling purposes, we continue to expect free cash flow to trend upward on an ongoing basis, but anticipate variability in our free cash In closing, our team remains committed to driving operational excellence, ensuring long term growth Delivering significant shareholder value. I'd like to thank our employees for their continued dedication to our mission, customers and partners. And to our shareholders, we greatly value your continued support. And with that, I'd like to open it up for questions.

Speaker 2

Operator, please poll for questions. Thank

Speaker 3

and one follow-up question. And we will take our first question from Shaul Eyal with TD Cowen. Your line is open.

Speaker 1

Thank you. Good afternoon, guys. Congrats on the results and the outlook. Matthew, can you talk about some of your displacement activity this quarter? And maybe my second part of the question will be, Do you see AI as accelerating your displacements and win rates?

Speaker 1

Thank you. Yes, Shaul. I really appreciate the question. We've got a lot of noise on the line from the operator, so hopefully we can get things muted. Apologies for that.

Speaker 1

So I think that when we look at displacement, it really is across 3 different Parts of our business. So the first area is our traditional application security business. And in that space, we continue to displace a number of Traditional hardware vendors, the people who are providing web application firewalls, load balancers, finding various services that people had in those areas. We also see point cloud solutions that are doing just one of those things, getting displaced by us where we can very much pick up a significant amount of their business. And that's been the case for quite some time.

Speaker 1

In our the second part of our business, which is our 0 trust Business. The first is sort of the front door of your business. The second is kind of the back door of your business. The Zero Trust business is about protecting employees and data. In that case, we're more and more going head to head with the other 1st generation 0 Trust providers, so the Zscaler's, Palo Alto Networks, Cisco Umbrellas of the world.

Speaker 1

And again, we really like our win rates in this space. And in a number of the examples that I cited, We were specifically either in competitive solutions there or in some cases where we were actually doing takeouts people who have made bets on the 1st generation of Zero Trust Providers and wanted to upgrade to us for better ROI, a much better user experience, much Faster, more performant network. And I think that that's one of the areas that I'm the most excited about. The third area is really our workers business, Which is our developer platform. And in that space, it really depends on what's going on.

Speaker 1

Increasingly, we're doing takeouts from object store where people are moving data off of more traditional object stores onto R2, which is our object store. But a lot of times, we're also just moving Individual applications or individual functions to us. And so it's not a complete displacement. Oftentimes, people will use us alongside a more traditional hyperscale public cloud, but we can see that working together. In the AI space, in particular, I think that, again, it's such a new space that I don't know that we're displacing people as much as we're just Helping AI companies get what they need.

Speaker 1

And the 2 big areas around that are first around training, where GPU scarcity is significant And the cost with the traditional hyperscale public clouds of moving data to wherever there's cheap GPU capacity or even available GPU capacity, makes it cost prohibitive. And so R2, because we don't charge for egress, has been just a real boon For a lot of AI companies to be able to adopt wherever they can find the cheapest GPU at any moment in time. And that again is An area where a lot of that growth has come from. And then increasingly, we think that the inference market is really going to be fought between 2 Arias, one is going to be on your device itself. If you have a driverless car, you don't want when a ball is bouncing down the street and the kid He's chasing after it for that decision on whether or not to put on the brakes to have to go out to the network or not.

Speaker 1

You want that to live in the car itself. And so a lot of inference and models we run on devices. But we think if they're not a run on devices, if they have, if they're too large, if they need Too much capacity from either a GPU or memory or network access space. In those cases, it's going to make sense to run it in the network itself. And in that sense, Cloudflare is uniquely positioned to win in that inference market for those models that make sense not to run on the device themselves, the more complicated model that makes sense to run-in out at the edge of the network.

Speaker 1

And that's exactly what we're starting to see from more and more of these really innovative AI Startups. Got it. Thank you so much. Good job. And

Speaker 3

And we will take our next question from Matt Hedberg with RBC Capital Markets. Your line is open.

Speaker 4

Great. Thanks for taking my question, guys. Thomas, I had a question for you. Obviously, good results this quarter and there was a lot of optimism in your portion of the prepared remarks. You talked about sort of like better win rates, shorter deal cycles, etcetera.

Speaker 4

When I look though at sort of the sequential growth for Q3 and Q4, it's a bit higher than what we saw in the first half. I just what are some of those main Factors that are giving you sort of increased optimism for the second half? And does guidance assume that macro stay constant or maybe even improve a little bit?

Speaker 2

Well, thank you, Matt. We saw the first data points that what you call To make me be a bit more optimistic, we think we still think we need to apply a good portion of cautionness To our outlook, one data point doesn't really make a trend. At this point, we do not assume that the macroeconomic environment It's improving significantly. We still see significant mixed macroeconomic data points that we factored into our guidance. And then therefore, as that state, as we said, prudent and cautious, not over interpreting just on one data point.

Speaker 5

Got it. That's helpful. Maybe just

Speaker 4

a quick follow-up. Sort of double clicking on the strength that you saw this quarter, there was a lot of conversations about shorter sales cycles, better win rates. Have you noticed any quantifiable benefit from your new CRO, Mark, as he's come on board and maybe improved sort of the sales focus.

Speaker 2

We are making good progress, both in terms of restructuring our In terms of adapting our tactics and strategies, how we move up market. But you have to remind a member that bringing on new people takes ramp time, a little bit shorter in the mid market, a little bit longer in the Enterprise segment. We have not seen most of those improvements yet, and we do not expect to see them over the course of the remainder of this year. So we are making really good progress, but we have been cautious in terms of what we factored in, in the guidance We've given for the second half.

Speaker 1

Thanks, guys.

Speaker 3

And we will take our next question from Trevor Walsh with JMP Securities. Your line is open.

Speaker 6

Great. Thanks, Steve, for taking my question. Maybe Matthew, just for you first. A lot of the comments around AI seems to focus more around the developer piece and workers specifically, which you kind

Speaker 1

of have as your Part

Speaker 6

of your Act III. Does that become more something accelerated into more of an Act II for that part of the platform? Can you just maybe talk a little bit about kind of the changing of the game from that perspective.

Speaker 1

Sure. Thanks, Trevor. I think that I mean, I think that the order of the acts is pretty I would still say Act 1 is application security, Act 2 is zero trust and Act 3 is workers. But I would say that we have been very pleasantly surprised at how quickly the workers platform is taking off. But we are not at this time optimizing that platform for how can we bring as many dollars out of it as possible.

Speaker 1

We think that Studying developer platforms across history, what we've seen is what you really need is adoption. And so, what I'm encouraged by is that Every single day when new companies are starting, when new trends take off like AI has that people are turning to this. And I think it's I don't think that this is a flash in the pan. This isn't a polyester kind of new wardrobe that is going to look good for a little while, but quickly fade. This is something that's real and we're seeing that more and more companies, more and more experienced developers Are turning to the workers platform in order to be able to deliver something that they can't get from the traditional hyperscale public clouds.

Speaker 1

And I think that any great work of fiction or Otherwise, some of the excitement often comes in the later chapters. And so I don't want to diminish it by saying that it's Act 3, but I and I think there's Huge opportunity there. But I also don't want to lose the fact that we had many customers this year really dive into our ACT II products and we're making Incredible gains in that space as well. So I think we've got a really exciting second and third act.

Speaker 6

Awesome. Thanks, Matthew. Appreciate the color. Maybe just a quick follow-up for Thomas. Of the 196 large customers that you added in the quarter, could you Maybe provide a little bit of color around are those current customers crossing into that threshold?

Speaker 6

Or is there a preponderance or even like an even split of new customers kind of just landing of that size? Could you just give us maybe a general sense of Kind of where that pool of customers is coming from.

Speaker 2

In the past, it was Pretty even fifty-fifty between new customer sign ons on the dependor expansions. I would say In the last quarter specifically, we had probably a larger share of new customers signing up right beyond the $1,000,000 range. So it shifted slightly away from expansion into a new logo sign on.

Speaker 6

Awesome. Great. Thanks again for taking the questions.

Speaker 3

And we will take our next question Jim from Jonathan Ho with William Blair. Your line is open.

Speaker 7

Good afternoon. This is John Widenberg for Jonathan. Thanks for taking my question. I'd like to get some clarification, if I could, on and better understand your net retention rate, if I understood you correctly, You had indicated in your prepared remarks that the retention rate is a lagging indicator that should benefit from your go to market and sales replacement initiatives and such. But then I believe you also said That was impacted by large by the largest customer cohorts.

Speaker 7

I wouldn't expect large customers to be quite as impacted. I wouldn't think that large customers would be impacted so much by your sales or go to market because they're Could you help me understand how that would impact Retention rate and what kind of some of the moving parts are there?

Speaker 2

All right. Well, just to make sure, the expansion rates stayed high. Expansion in the large customer cohort was a little bit lagging. That is what we already saw in the prior quarter. It's also one of the reasons for my previous answer that the large customer growth was pretty much coming more biased towards new logos than it was coming from expansion.

Speaker 2

Expansion, as I said in my prepared remarks as far as the lagging indicator because it's pretty much a look back to the 4 prior quarters. That is what you compare Good to see you sign on. So any movement we see in an existing quarter will take time to show up in DNR. We see we think we are seeing bottoming of the DNR development. So we are quite hopeful we'll move that upwards to where and beyond where we came from.

Speaker 2

But because we are so conservative in how we measure DNR, it's an all in across all customer cohorts, It's very much a lagging indicator. So it will take a while before all the improvement that we are initiating and And getting expansion going again will show up in DNR.

Speaker 7

Okay. Thank you. And if I could just ask for, you mentioned that Some of these initiatives you wouldn't expect to see the new sales folks and whatnot being fully productive through the end of the year. That makes sense. Can you talk about your progress on the implementation of the sales processes?

Speaker 7

Kind of when where you might Think you're like halfway done, fully done at what point in time? And have you identified further process improvements Since our last talk a quarter ago. Thank

Speaker 1

you. Yes. So I'll take that. I think that Mark is doing a really great job looking across the organization. I think one of the things that we really highlighted last quarter was that we had some underperformance across the org and we addressed that.

Speaker 1

What I was that's I over the course of the last 3 months have kept very careful sort of my fingers on the pulse of the organization, met with a ton of our team. And what I'm hearing from the team is that they're super invigorated. They appreciate the additional training and enablement that we've implemented and that we're seeing our sales team get the tools that they need in order to make sure that they can close great deals. And we again still have very strong pipeline. And I think that what you'll see is that that gets reflected as we have those new reps that are coming on as we do more enablement with our existing reps.

Speaker 1

And that I think is something that's very bullish for what we have going forward.

Speaker 4

Thank you.

Speaker 3

We will take our next question from Brent Thill with Jefferies. Your line is open.

Speaker 1

Good afternoon. Matthew, if you take your crystal ball out in the second half of the year, I'm just curious if you feel Things are starting to slowly improve. It seems like a lot of your security peers are starting to see some decay and perhaps you're Gaining to share here relative to your architecture and the platform. I'm curious if you can kind of maybe stitch the back half together In how you see it at a 40,000 foot view. Yes.

Speaker 1

I don't know how accurate my crystal ball is, but I think that I want to say that it feels like things are improving. It feels like things are plateauing. Q1 was really hard. The fact that we had in 1 quarter sales cycles increase 20% was a very big and frightening occurrence. And I think that We were pretty early in earning seasons call that there was a real concern across IT buyers, but that got reflected by many companies that came after us.

Speaker 1

What we saw in Q2 was that sales cycles returned back to be more in line with what we were seeing last year in 2022. 2022 was still elevated in the several years prior to that. So what it feels like to me is that we're in for a grind. And not Cloudflare in particular, but across the entire economy. And that that grind is going to be hard, But I think it is actually serving us quite well because it's forcing us towards operational excellence.

Speaker 1

And across our entire team, people are digging in, they're working hard, and they're making sure that every process is as efficient as possible. I think that you're right. One of the things that is unique about us versus a number of others is as we look at our products that we've been able to achieve very high gross margins. I think that's the best one of the best indicators that we have a really differentiated platform. And as customers are looking for ways to consolidate their vendors to find how to get more ROI out of everything they're doing.

Speaker 1

They are turning to us and our team is ready and we have the right products. And so I think the grind that's ahead is actually something that it's going to be hard, but it's something that I think I'm looking forward to and we're going to become a better company as a result of it. Thank you.

Speaker 2

And we

Speaker 3

will take our next question from Keith Weiss with Morgan Stanley. Your line is open.

Speaker 8

Excellent. Thank you guys for taking the question and definitely glad to hear things are stabilizing. Matt, I wanted to dig into the comment that you made, both in the press release and on the conference call about Workers and Cloudflare being a really good platform for inference. Can you talk to us about sort of the underlying technical why of why you think it's still pretty early days with these technologies and we're all trying to figure out kind of how inference plays out over time. So I think your view would be helpful to the overall kind of industry conversation as well as the CloudFair conversation on why you guys are well positioned.

Speaker 8

And then the follow-up is for Thomas. Whenever we hear inference, we're thinking that this GPU intensive and compute intensive type stuff, and typically lower gross margin. It sounds like you're pretty comfortable that this isn't impacting the gross margins in the near term. Is that just because it's still relatively early days and relatively small volumes? Or should we be thinking that this could as this ramps, this could potentially have a bigger gross margin impact over time.

Speaker 8

Thank you.

Speaker 1

Yes. So, Keith, I appreciate both questions. I think they're really, really important to understand the advantages that we have in the space. So, first of all, what are the challenges with inference? And I think there are really 2.

Speaker 1

One seems like a bigger deal and it's probably actually not as big a deal and the other, doesn't seem like it's a bigger deal, but it is a really big deal. And in both, I think that they shape how we think the inference market is going to work out. So the one that kind of feels like it's a bigger deal is around performance, Which is that if you're playing with the various generative AI companies, if you're trying to do something, That wait time between when you submit a query and when you get back to response, that's going to become a bigger and bigger And so anything that you can do in order to make that performance as fast as possible He is advantageous and one of the ways to do that is to move the actual inference as close as possible to the person who is requesting it. And so again, we think that Inference will primarily be done on device or very close to where the end user is inside the network. We won't get again, if the ball is bouncing across the street, you want that inference to be done on the device, on the driverless car itself.

Speaker 1

So we won't win every inference task, but there will be a lot that makes sense to be running in the network, where we have, again, almost infinite network capacity, almost infinite storage and memory and very, very significant CPU and GPU resources to be able to run those inference tasks. That I actually think will be the lesser of the 2 advantages for us. The larger one, which again doesn't feel like it's a big deal, but we're already seeing it play out, some of the regulatory efforts that are happening around the world, Is that a lot of times for the inference tasks, the data that's there is very private and people and governments want that to stay as close The actual end user as possible. So we've already seen action in Italy that has restricted the use of certain AI tools because it sends data out of the country. What Cloudflare can uniquely do because we're positioned across more than 2 50 cities worldwide, we're in the vast majority of countries worldwide Is that we can actually process that information locally.

Speaker 1

So again, we think that on device or very close to where the user is on Cloudflare's network It's going to be the place where inference is going to take place. I'll take a quick stab at your second question as well and then hand it off to Thomas Thanks for anything that he would add. I think the thing yes, sorry, go ahead.

Speaker 8

Just asking for like one clarification. So in that world view, It sounds like you think we're going to see more kind of smaller open source and distribution of a lot of very small models versus like a world view that Everything is going to come up into a big GPT or Lambda model over time. Is that correct?

Speaker 1

Not necessarily, but we run enough capacity out at the edge of our network That we can run fairly large, I mean very, very, very large models out at our network. And what I think is a little bit confusing is most of If you're trying to do the training of the models, then having the absolute latest greatest GPU, the H100 from NVIDIA right now. There's a lot of constraint in getting those chips. But there's actually a sweet spot For inference tasks, which isn't necessarily at the absolute cutting edge of the models. And so Cloudflare is not the right place to actually process the training of models.

Speaker 1

That makes much more sense to do in a more traditional centralized data center model, much like much of the traditional hyperscale public clouds. And in those cases, you have to have the latest, greatest GPUs. But when you're doing inference, again, a lot of that's going to run on your device. And a lot of that is also going to run inside the network. And we're going to be able to with a much lower CapEx spend leverage the edge of our network in order to be able to do that processing extremely efficiently.

Speaker 1

And maybe we don't need the H100s, maybe we can live with an A100 or whatever is, again, a generation or 2 behind. But That's also the difference between training and inference. And inference doesn't need necessarily the latest, greatest GPU. Does that make sense? Yes, super helpful.

Speaker 1

Thank you.

Speaker 2

Yes, Christy. What I would add is, I always remind people to truly understand the competitive mode of Cloudflare and the efficiency of their business model. You have to start with a network and how it's efficiently targeted using off the shelf hardware completely integrated homogeneous software stack that allows you to run every product on every server in every location. So you have this now massive globally distributed network that is not only efficiently designed to handle large volumes of data, but also large volumes of simultaneous requests. And that makes it already today very well suited For inference task, which by nature often involves processing a request simultaneously.

Speaker 2

So And it requires less computational power than the training model. So I think the architecture of the network itself puts us in this really advantageous position, and that's why we are so confident that the business model is going to hold. And it's one of the reasons While we're able to even guide CapEx ratio down for the year despite the fact that AI workloads are putting are being put more and more on our network. So you really have to as I always say, go back He can really understand the efficient architecture of the network itself, and you'll find the answer there.

Speaker 1

Excellent. Super interesting guys. Thank you.

Speaker 3

And we will take our next question from Andrew Nowinski with Wells Fargo. Your line is open.

Speaker 9

Okay. Thank you and congrats on another great quarter. I wanted to shift gears and ask about 0 Trust. Is there any more details you could provide on that record 0 Trust contract you talked about and whether that was a displacement of another vendor and maybe why they selected Cloudflare? And then I have a quick follow-up.

Speaker 9

Thank you.

Speaker 1

Sure. I think that in almost all of the Zero Trust deals that we see, we are at least in competition with some of the 1st generation 0 Trust vendors. In many of them, There's an incumbent vendor and we are displacing them. Usually when that happens, it's because the usability of the existing 0 Trust vendor has been really bad. It's crazy that with some of the leading 0 Trust vendors, if you Try to use your laptop when you're on a United Airlines Wi Fi flight that the captive portal on United Airlines Doesn't work.

Speaker 1

That's obviously unacceptable. Maybe that was acceptable in the pandemic when no one was traveling, but now that people are traveling, that's something that just doesn't hold up anymore. So, I think the thing that has been an advantage of Cloudflare is that because we almost think of ourselves at times as a consumer company and we have A 0 Trust product that you can download to your phone right now and use. It's 1.1.1. That is you've been running on So many millions of devices.

Speaker 1

And as we work with device manufacturers to actually build our network directly into their application. Those things give us the visibility to be able to focus on performance, to be able to focus on end user experience And to be able to directly replace oftentimes what have been those sort of 1st generation 0 Trust vendors that frankly don't Have the same user experience and the same performance. And so in many of these cases, in all the cases, we're at least competing with the other more traditional Zero Trust vendors and in many cases now we're displacing them.

Speaker 9

That's great. Thank you, Matthew. And then as a follow-up, I think most people assume that Microsoft's new entrust solutions will be targeted at that SMB sector at the lower end of the market. But that is a market that I think Cosplay can also serve. So I'm just wondering what you're seeing in terms of competition with the new Entra solutions?

Speaker 1

Yes. That's my sense of how Microsoft is thinking about this. And in fact, Microsoft's Long been a really great partner of ours and specifically, in even their announcements of this, Looked for ways to actually highlight the part of the market that's the SMB market. But No, we're not satisfied just winning the SMB market. We're winning some of the largest enterprises and I think it's the biggest enterprises that have The most interest here.

Speaker 1

And so, I think Microsoft has been a great partner to Cloudflare. We're directly integrated into their Edge browser. The network that we have delivers them very unique benefits, but we also respect them as a competitor. And so I think what We have as an advantage is that network, a network that they use themselves. But it's something where Over time, I think their entry into the market has just validated the market.

Speaker 1

It's defined it and we look forward to competing In the places that we do and cooperating and the other places where we don't. And what we see is that what customers really want He's a network provider that can protect your front door and your back door. What customers really understand is that there's a reason that we have You know, accountants and auditors and those are separate things. And that what customers really want is they want a solution that works across not just one vendor's products, but the entire IT stack. And I think that's what we see time and time again as the reason why customers are selecting selecting Cloudflare 0 Trust Solutions.

Speaker 2

That's great.

Speaker 9

Thank you very much.

Speaker 3

And we will take our next Question from Mark Murphy with JPMorgan. Your line is open.

Speaker 5

Thank you. And I'll add my congrats. Matthew, can you elaborate on your vision For how Cloudflare can protect companies from leaking sensitive data out and maybe having some of that land inside a generative AI model. What kind of opportunity do you see? And since that traffic to Microsoft and OpenAI is so tremendous in that area And you have the partnerships there, that you've mentioned.

Speaker 5

Is there a role you can play directly to try to help control some of the data flows in that Azure OpenAI Service.

Speaker 1

Yes, I think that, this is an area that We really listened to what customers' concerns were and built a product that specifically addresses the concern that you're highlighting, because it's one that is on the mind of just about every GC and CISO that's out there and that is that whether they're telling their employers or not, the best data is that almost half of workers at in knowledge industry companies are using AI in one way or another in their jobs. And the risk it with AI is that if you send A piece of information up to one of these models, it gets incorporated in the same way that if your 2 year old here is a bad word, It's really hard to get them to unlearn that thing. And so the key is really making sure that the data doesn't actually leave. And so what we've created is leveraging our existing data loss protection products, the DLP products, and making them specific To tag data in such a way that you can say, here's a piece of information, maybe it's from our marketing website. I am totally fine with that going out to the public, 0 trust excuse me, not 0 trust, out to the public AI vendors And being able to train on that.

Speaker 1

In fact, it's great if they're trained on my marketing messages. Here's another piece of information, which is much more sensitive, where maybe I'm going to restrict that specifically to my own internal or sandboxed solutions that are the AI training models for that. And then maybe there's something else that sort of cliche example of the secret formula of Coca Cola or Yes, maybe what all of your internal pay schemes are, maybe that you don't ever want to get out to anything. And so We've used our DLP solutions in order to specifically address the concern that CISOs and general counsels have about data leaking out. What we think that that can do is over time add not only those controls, but then start to add things like this particular task has a certain value.

Speaker 1

So I'm going to send that to maybe GPT 3.5 rather than GPT 4 to save money on that. And so We think that because of the position we're in, because so much of the AI universe relies on us, that it puts us in a great position to not only provide the security to the AI companies, but also provide security to anyone who is using AI in their business. And so we can benefit from both sides of the equation. Thank you. It's extremely helpful.

Speaker 3

And we will take our final question from Alex Henderson with Needham. Your line is open.

Speaker 10

Great. Thanks so much. I was hoping you could talk a little bit about the fairly massive change in tone Between the 1Q call and the current call, which highlights An improvement in pretty much every metric that you track and specifically Maybe call out some of the differences between various geographies, whether the improvement was in large enterprise, was it also in the mid market in the SMB market. Can you give us some granularity as to Where that tone is changing, because ultimately, you've called out that you're one of the advanced bellwethers over the last year and if you're seeing that change in inflection in tone, would love to know where it is coming from?

Speaker 1

Yes, Alex, I'll start and then Thomas will have some more. I think that Q1 was scary, because Having a 20% increase in your sales cycle in a single quarter, and we've seen sort of something around that, around 20% of an increase, but over the entire course of 2022. And so when that then spiked In Q1, what we didn't know was whether that was going to whether we were going to be another 20% longer in sales cycles in Q2. And thankfully, that's not what happened. It came back down.

Speaker 1

But again, I wouldn't say that it's come back down to a point where we feel super optimistic about the macro. I think the macro is Still very hard and that the next period of time is going to be a grind. But it is we didn't have the same just explosive expansion in sales cycles that I think we and a lot of other peers in the industry SAW in Q1. And so I think that's what that has been that's what led to the conservatism that we had in Q1 and I think that returning to something which again is still elevated, but not but is back to what we were seeing In Q more around what we're seeing in Q4, that is I think that's the primary driver at least from my perspective in terms of what maybe is what you put it as a more optimistic tone.

Speaker 10

Any sense of specifically any verticals or any categories or Geographies or any size business that changed most dramatically?

Speaker 2

Let me give you some more color. We saw a lot we saw forward improvement. We talked about this. We also saw a lot of inconsistencies in this in the environment that made it much harder to predict what the second half is going to carry. APAC was Very promising.

Speaker 2

As we said before, we saw a lot of very large deals, especially coming from APAC. The European business was very much security driven and very encouraging, probably because of the very Specific to your political situation, Europe is in and then the Americas were more muted in general. We saw very specific performance, really good performance in the Middle East, but also in South America. North America was probably more muted than Anything else. Vertical wise, there's not a lot to talk about.

Speaker 2

It was very consistent performance, I would say. There's not one vertical that I would pick out in terms of overall underperformance.

Speaker 10

Great. Thank you so much.

Speaker 3

And ladies and gentlemen, I would now like to turn the conference back to Matthew Prince for closing remarks.

Speaker 1

I just want to take a second to thank everyone at Cloudflare. Again, as the macro environment continues to be challenging, I'm proud of how our team has stepped up and executed towards operational excellence. Everyone is working incredibly hard to help Live up to our mission of helping build a better Internet. So thank you to all the Cloudflare employees, to all of our customers and all of the investors And we really appreciate everything that you're doing for us.

Speaker 3

Ladies and gentlemen, this concludes today's call, and we thank you for your participation. You may now disconnect.

Remove Ads
Powered by Quartr
Earnings Conference Call
Cloudflare Q2 2023
00:00 / 00:00
Remove Ads