Cloudflare Q4 2023 Earnings Call Transcript

There are 12 speakers on the call.

Operator

Good afternoon, and welcome to the Cloudflare Q4 2023 Earnings Conference Call. Please note that this call is being recorded. All lines are being on mute to prevent any background noise. I will now turn the call over to Mr. Phil Winslow, Vice President of Strategic Finance, Treasury and Investor Relations.

Operator

You may begin your conference.

Speaker 1

Thank you for joining us today to discuss Cloudflare's financial results for the Q4 of 2023. With me on the call, we have Matthew Prince, Co Founder and CEO Michelle Zatwin, 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 the timing and market potential of those products our anticipated future financial and operating performance and our expectations regarding future macroeconomic conditions.

Speaker 1

These statements and other comments are not guarantees of future performance and are subject to risks and uncertainty, 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, please see our filings with the SEC as well as in today's earnings press release.

Speaker 1

Unless otherwise noted, all numbers we talk about today, other than revenue, will be on an adjusted non GAAP basis. 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 Verint's Software Silicon Slopes event on February 28 and the Morgan Stanley Technology, Media and Telecom Conference on March 6. Before wrapping up, please save the date for our Investor Day on Thursday, May 30, which is being held in conjunction with our user conference, Cloudflare Connect in New York City.

Speaker 1

A live webcast will also be accessible from our Investor Relations website. Now,

Speaker 2

I'd like to

Speaker 1

turn the call over to Matthew.

Speaker 3

Thank you, Phil. We had an exceptionally strong quarter. We achieved revenue of $362,500,000 up 32% year over year. We added 198 new large customers, those that pay us more than $100,000 per year and now have 2,756 large customers, up 35% year over year. We saw particular strength in our largest customers with a record number of net new customers spending more than both $500,000 a year $1,000,000 a year on an annualized basis.

Speaker 3

We signed our largest new logo with an expected total contract value over $30,000,000 and our largest customer renewal with a total contract value of $60,000,000 We blew away our previous record for new ACV booked in a quarter. In Q4, new ACV booked grew nearly 40% year over year, making it not only our record in absolute ACV, but also the fastest percentage growth we've seen since 2021. Our pipeline close rates, sales force productivity, average deal size and linearity all improved markedly quarter over quarter. I continue to be encouraged by the early results we're seeing from our new sales recruiting and training programs. During the Q4, The pipeline generated by the cohort under the new program was 2.1x higher than the year ago cohort And account engagement increased by 3.5 times compared with a year ago.

Speaker 3

I'm excited by our maturing sales execution and believe it will pay dividends in 2024 as these sales professionals fully ramp. Our dollar based net retention kicked down 1 quarter over quarter to 115%. Our gross margin was 78.9%, again, above our long term target of 75% to 77% and up from 78.7% last quarter. We delivered an operating profit of $39,800,000 representing an operating margin of 11%. We also meaningfully outperformed on free cash flow, generating $50,700,000 during the quarter approximately $120,000,000 in free cash flow for the year.

Speaker 3

I'm proud of our team for their continued execution. The machine that underlies Cloudflare is firing efficiently on all cylinders and we've been able to execute even as the macro environment remains choppy. Key to that execution has been improvement in our go to market efforts. 15 months ago, we brought on Mark Boroditsky to execute effectively a turnaround of Cloudflare's go to market team. At the time, we had enterprise customers, But we hadn't operationalized repeatedly and consistently landing them.

Speaker 3

We were also suffering from a COVID hangover and like much of the industry have been flat on performance management. Mark changed all that. He's brought in the process and discipline we needed to be world class in sales the same way we already were in product and engineering. It's hard to be the turnaround guy and we owe Mark a huge debt of gratitude for playing that role. But there's someone we always whispered about as our ideal go to market leader If we could ever have him as a full time member of our team, Mark Anderson.

Speaker 3

He built Palo Alto Networks' world class sales organization into the machine it is today. He has an incredible domain expertise and contacts in our industry. He's one of the great B2B sales software leaders. And as we were getting ready to go public, we couldn't quite convince them to run our go to market org, but we did the next best thing, inviting him to join our board. Over the last 4 years, we've gotten to know each other on Cloudflare's Board.

Speaker 3

From there, he's provided invaluable counsel to me, Michelle and our go to market leaders. And so after Alteryx, the company he'd been running as CEO, agreed to go private, he reached out and asked whether we'd be interested in not just having him as a coach, but also a player on the field, rolling up his sleeves and getting back to what he's best at, running a world class go to market organization, selling great products and delivering incredible value and support to customers. Given the deep relationship and trust we developed and his expertise and leadership in our field, it was as close to a no brainer as I can remember in a long time. I wanted to invite Mark Anderson to the call to say a few words. Mark?

Speaker 4

Thank you, Matthew. I've had the privilege to work closely with the great leadership team here at Cloudflare in my role as a member of the Board of Directors for the last four and a half years. And I've been amazed Not at just what Cloudflare has accomplished to date, but more importantly, how the market is increasingly moving to where Cloudflare is already uniquely positioned. The time to capitalize on these major technology shifts is now. When I start to think about where I could make the most impact during the next stage of my career.

Speaker 4

I reached out to Matthew and Michelle to see if I could help elevate Cloudflare's go to market organization to the next level. Operationalizing productivity at scale at Cloudflare will involve 1, augmenting foundational systems and tools that are already in place with a framework of execution that applies discipline and rigor to all that we do for customers. And 2, bringing on more stage appropriate talent to blend with our amazing sales team to best capture the massive market opportunity ahead of us. We all agreed that my skill set and experience building and enabling world class go to market organizations matched perfectly with Cloudflare to further accelerate its next stage of growth at scale. And I'm extremely excited to work together with Matthew, Michelle and all of my fellow Cloudflarians to make Cloudflare one of the most iconic technology companies in the history of the industry.

Speaker 4

Thanks,

Speaker 3

Mark. I want to again thank Mark Boroditsky for getting us to this place. We couldn't have done it without him. He will continue to be an advisor to Cloudflare for the next several months to make sure Mark Anderson is set up for success. He will always be part of the Cloudflare team and I'm excited to hear what challenges he takes on next.

Speaker 3

I also wanted to take this time to reaffirm that Michelle and I aren't going anywhere or changing our roles in any way. I wake up every morning more excited about we have to fulfill our mission of helping build a better Internet. If you study the iconic technology companies, They are often mission driven, founder led, but include a dynamic and evolving leadership team surrounding the founders who bring a wealth of experience for each stage of the company's journey. That a leader like Mark Anderson can get to know us over the last 4 years from his seat on our board and then choose to join our team standing side to side with the other senior team we have assembled gives me confidence that we're on a path to being one of the iconic technology companies ourselves. We're not there yet, so I'm not satisfied And I remain fully committed to that journey.

Speaker 3

With that, let me walk through some of the customer wins we had in the quarter. We were awarded a 3 year contract the ceiling value of $33,000,000 for the U. S. Department of Commerce, which will be deploying services across our SASE Application Performance and Security Solutions. We believe deals like this validate the criticality of converging application performance, Security, network and 0 Trust services on a unified platform and how Cloudflare can deliver a comprehensive commercially off the shelf platform from a single vendor as compared with numerous point product competitors.

Speaker 3

A leading technology company expanded their relationship with Cloudflare, signing a 3 year $6,600,000 contract for Cloudflare's 0 Trust suite to protect access for 10,000 employees and contractors. Given the company's highly complex and secure environment, Implementing a 1st generation Zero Trust vendor proved to be a challenge. This company had done a Zero Trust RFP a year prior. But When they reviewed Cloudflare's 0 Trust solution again, they were impressed by our significant progress and innovation. Not only was our rate of innovation a key differentiator, but with Cloudflare, they're able to simplify and consolidate 0 trust, application performance and security all on a single platform.

Speaker 3

A Fortune 500 hospitality company expanded their relationship with Cloudflare, signing a 5 year $4,300,000 contract for 20,000 Zero Trust seats. This company approached us 15 months ago With a basic Zero Trust use case, the scope quickly expanded from 1 to several as this company sought to re architect their entire Zero Trust approach. The lack of platform integration and the absence of strategic vision from their incumbent vendors, including a 1st generation Zero Trust competitor, led them to Cloudflare for our easy to use comprehensive platform with a cloud first architecture. Although performance improvement was not an important consideration early on. After a 6 month paid pilot, the team was blown away by how much improvement they saw with Cloudflare stating, Holy bleep, I've never seen Jira go this fast.

Speaker 3

A sophisticated tech company with one of the most technical and daring engineering teams signed a 2 year $646,000 contract. The company had recently experienced a breach driving them to increase their security posture and adopt a 0 trust approach. This company considered nearly every relevant vendor in the market, over 13 in total, And Cloudflare and one other competitor were selected for a proof of concept and 30 day pilot. After just 14 days, Cloudflare was fully configured and completed all success criteria, whereas our competitor was unable to get off the ground. The ease of deployment was key for this company who needed to design a solution in a very complex environment.

Speaker 3

With Cloudflare, everything worked out of the box. A Fortune 500 technology company signed a 2 year $6,000,000 contract For advanced application security, the company was experiencing an increased DDoS attack that a large hyperscale public cloud was unable to mitigate. These unmitigated attacks created significant latency resulting in a loss of traffic and potential revenue. They view Cloudflare as the leading in DDoS mitigation based on our HCV2 rapid reset publication and the compatibility of our Layer 7 secondurity bundle With their self hosted technology and public cloud vendors made Cloudflare an easy choice. It's just the beginning with this customer.

Speaker 3

A large U. S. Commercial airline expanded their relationship with Cloudflare, signing a 2 year $857,000 contract to procure 0 Trust A great land and expand example, this is the 3rd deal we've done with this customer in 2023 as they undergo a digital transformation project. They're using our full Zero Trust suite along with application services. They love our unified network, single pane of glass and speed of implementation.

Speaker 3

A 4th deal with them is already on the horizon. A local government authority in the UK signed a 5 year $2,100,000 contract for 4,700 Zero Trust seats. The government authority was pursuing a very large digital transformation project to modernize and improve security posture with a complete network refresh and the adoption of 0 Trust. Following a 3 year engagement process, The authority was evaluating 2 competing 0 Trust vendors. Cloudflare entered the process in the late stages.

Speaker 3

Cloudflare 1 was selected as the core component of their modernization program due to our ease of use, seamless integrations and expansive platform with a single control plane. In their words, Cloudflare is easy, it just works. These days, no earnings conference would be complete without an update on AI. As of the end of 2023, we deployed GPUs in 120 cities globally, meaningfully ahead of our target of 100 cities. By the end of 2024, we plan to have inference tuned GPUs deployed in nearly every city that makes up cloud based global network and within milliseconds of nearly every device connected to the Internet worldwide.

Speaker 3

The breadth and potential impact of the use cases we are seeing with Workers dotai are extraordinary and we're super excited about the opportunity to establish Workers dotai's serverless model built on Cloudflare's trusted global network as the best infrastructure for running AI inference tasks. From our launch in September to the month of December, the average number of daily Workers' AI requests increased 9x. Furthermore, 1 third of the thousands of Workers' AI accounts are new to the Workers' platform, suggesting that Workers' AI is not just significant opportunity in and of itself, but also a potential accelerant to adoption of the workers' overall platform. Inference, however, is only part of the AI equation. We are also extremely encouraged by the interest in Vectorize, our vector database, which makes it easy, fast and affordable to index and store vectors to support use cases that require access not just a running model, but customized data too, as well as AI Gateway, which gives organizations the tools to cache, rate limit and observe their AI deployments regardless of where they're running.

Speaker 3

AI on workers' platform is just getting started And there are exciting things on the roadmap that we look forward to sharing with you in the not so distant future. As I reflect back on the last quarter, I'm proud of our team. It feels like we're once again firing on all cylinders, but a quarter is only one data point. As we talked about throughout the last year, the macro environment remains challenging. IT buyers are still skittish.

Speaker 3

The world is not getting any less complicated. And as a company, we still have a ton to prove. Those were the dominant themes of 2023, and I think it's likely they'll remain the themes of 2024. So while I'm encouraged by our results, We continue to remain prudent and focused on disciplined execution, building and improving our team, delivering exceptional value to our customers and solving some of the hardest engineering challenges the Internet faces. With that, I'll hand it over to Thomas to walk through our financials.

Speaker 3

Thomas, take it away.

Speaker 2

Thank you, Matthew, and thank you to everyone for joining us. I want to take a moment to welcome Erik Andersen to the Cloudflare team too. Mark, We're incredibly excited to have you on board to further accelerate our next phase of growth at Cloudflare. Turning to our financial results. I'm pleased to share that the positive momentum from our focus on refining our go to market strategies and operations continued during the Q4.

Speaker 2

As Matthew mentioned earlier, pipeline growth rates, sales productivity, average deal size and linearity all improved compared with last quarter. Strength in our business this quarter was driven by robust momentum large customers, significant progress in the public sector and growth in Cloudflare 1, including the largest win in the company's history with a contract ceiling value of $33,000,000 Importantly, We also continue to maintain our strong commitment to being fiscally responsible and act as good stewards of investors' capital. Operating profit increased nearly 2.5 times year over year, and we significantly outperformed on free cash flow, generating a record $50,700,000 during the Q4. Turning to revenue. Total revenue for the Q4 increased 32% year over year to $362,500,000 From a geographic perspective, the U.

Speaker 2

S. Represented 52% of revenue and increased 30% year over year. EMEA represented 28% of revenue and increased 38% year over year. APAC represented 13% of revenue and increased 25% year over year. Turning to our customer metrics.

Speaker 2

In the Q4, we had 189,791 paying customers, representing of roughly 27,700 paying customers in 2023 and an increase of 17% year over year. We were pleased to see revenue contribution from large customers during the quarter increase again to 66% of revenue, up from 63% in the Q4 last year. For fiscal 2023, revenue from large customers represented 64 of total revenue compared to 61% in 2022 and 54% in 2021. As Matthew referenced earlier, we added a record number of net new customers spending more than $500,000 $1,000,000 on an annualized basis with Cloudflare. For the full year, we ended the year with 346 customers that spent over $500,000 with us, a 56% increase year over year, And we ended the year with 118 customers that spent over $1,000,000 with us, a 39% increase year over year.

Speaker 2

We also exited 2023 with 3 customers spending at least $20,000,000 on an annualized basis with Cloudflare, 1 of which signed the largest total contract value renewal agreement in our company's history of $60,000,000 in the 4th quarter. Our dollar based net retention rate was 115% during the 4th quarter, representing a decrease of 1 percentage points sequentially. As we mentioned last quarter, there can be some variability in this metric quarter to quarter, but we continue to believe The prior decelerating trend in DNR is stabilizing near these levels. Moving to gross margin. 4th quarter gross margin was 78.9%, representing an increase of 20 basis points sequentially and an increase of 150 basis points year over year.

Speaker 2

Gross margin was 78.3 percent for fiscal 2023, remaining above our long term target range of 75 to 77%. Network CapEx represented 8% of revenue in the 4th quarter as we continue to benefit from our focus on driving greater efficiency from our infrastructure and the uniqueness of our platform to onboard new workloads. We expect network CapEx to be 10% to 12% of revenue in fiscal 2024. With the evolution of the composition of our infrastructure, we undertook an assessment of the useful life of our service and network equipment. In January 2024, we determined that continuous advancements in hardware technology and improvements in our data center designs have increased the efficiency in how we operate our equipment, resulting in the estimated useful lives of these assets extending from 4 to 5 years starting in fiscal 2024.

Speaker 2

We estimate this change will reduce depreciation by approximately $20,000,000 for fiscal 2024 for assets in service as of December 31, 2023, recorded primarily in the cost of revenue. As we discussed previously, we view our margin efficiency as one of Cloudflip's key competitive advantages, and we intend to leverage this opportunity as a strategic weapon to increasingly disrupt markets through continued innovation in our platform and differentiated product packaging. Turning to operating expenses. 4th quarter operating expenses as a percentage of revenue decreased by 3% year over year to 68%. Our total number of employees increased 14% year over year, bringing our total headcount to 3,682 at the end of the quarter.

Speaker 2

We'll continue to pace hiring based on market conditions over the course of fiscal 2024 and remain committed driving higher productivity and greater efficiency across our operations. Sales and marketing expenses were $145,200,000 for the quarter. Sales and marketing as a percentage of revenue decreased to 40% from 41% in the same quarter last year. Research and development expenses were $59,500,000 in the quarter. R and D as a percentage of revenue decreased seen from 18% in the same quarter last year.

Speaker 2

General and administrative expenses were $41,500,000 for the quarter. G and A as a percentage of revenue decreased to 11% from 12% in the same quarter last year. Operating income was $39,800,000 compared to $16,800,000 in the same period last year. 4th quarter operating margin was 11%, an increase of 4.90 basis points year over year. These results highlight our continued focus on becoming more efficient and more productive, given that operational excellence is a long term competitive advantage.

Speaker 2

Turning to net income and the balance sheet. Our income in the quarter was $53,500,000 or dilutive net income per share of $0.15 We ended the 4th quarter with $1,700,000,000 in cash, cash equivalents and available for sale securities. Free cash flow was $50,700,000 in the 4th quarter or 14% of revenue compared to $33,700,000 or 12% of revenue in the same period last year. Remaining performance obligations or RPO came in at $1,245,000,000 representing an increase of 15% sequentially was 37% year over year. Current RPO was 73% of total RPO.

Speaker 2

Moving to guidance for the first quarter and full year 2024. We're encouraged by the progress we delivered during the Q4 in terms of improving close rates and productivity metrics. However, mixed macroeconomic data points serve as a reminder that we are operating in a business environment that also showing signs of improving exiting 2023 continues to be challenging to predict. As a result, We remain prudent in our outlook for 2024, and we are fully committed to continuing to adapt our tactics and strategies in response to any positive or negative external variables, just as we did in 2023. Now turning to guidance.

Speaker 2

For the Q1, we expect revenue in the range of $372,500,000 to $373,500,000 representing an increase of 28% to 29% year over year. We expect operating income in the range of 34 to $35,000,000 and we expect an effective tax rate of 11%. We expect diluted net income per share of 0.13 cents assuming approximately 356,000,000 shares outstanding. For the full year 2024, We expect revenue in the range of $1,648,000,000 to $1,652,000,000 representing an increase of 27% year over year. We anticipate the weighting of revenue in the first half versus the second half of twenty twenty four to be similar to 2023.

Speaker 2

We expect operating income for the full year in the range of $154,000,000 to $158,000,000 We expect an effective tax rate of 11% for 2024, and we expect diluted net income per share over that period to be $0.58 to $0.59 assuming approximately 358,000,000 shares outstanding. After having achieved significant free cash flow of approximately $120,000,000 in 2023, We expect free cash flow to be relatively consistent with operating profit for the full year 2024, with the first half lower and the second half higher compared with operating profit. In closing, our team remains committed to driving operational excellence, ensuring long term growth and delivering significant shareholder value. I'd like to thank our employees for the dedication to our mission as well as our customers who are trusting us to help them solve some of the hardest problems that they face when modernizing, transforming and securing their businesses. And with that, I'd like to open it up for questions.

Speaker 2

Operator, please poll for questions.

Operator

Your first question comes from Brent Thill with Jefferies. Please go ahead.

Speaker 3

Matthew, it seems like there's a confluence of factors that led to your outperformance. I was wondering if you could just unpack a little bit deeper in terms of some of the common themes. I know you mentioned enterprise strength, but What else are you seeing that's leading to this magnitude of outperformance? Yes. Thanks, Brent.

Speaker 3

I think the first thing really is what we talked a lot about on the call, which is just real focus on go to market excellence. And I think Mark Boroditsky, who really worked hand in hand with Mark Anderson On our Board, have done a great job over the last 15 months of really focusing on how we make sure that we're as great in go to market as we have been in product and engineering. And I think that's the biggest thing to point out. I think the second thing is that We've really seen strength in our Zero Trust and Sassy products. Some of the biggest wins that we saw in the quarter were big 0 trust deals.

Speaker 3

And I think that those products have caught up significantly. And you'll see, in the analyst The industry analyst reports and others that we're very quickly becoming one of the real leaders in that space. And I think over time, we will surpass many of the 1st generation 0 Trust vendors and that really opens up another leg on the stool. And then lastly, I just continue to be really astonished by the rate at which our developer platform is growing. AI is not yet contributing materially to revenue, but it has contributed materially to developer excitement over the platform and we're seeing more and more large deals, more and more interesting applications coming in using the workers platform.

Speaker 3

And that has gone well as well. So I think operational excellence and go to market, I think that, really strength around our 0 trust product and then just continued, outperformance on our developer platform and those things all came together in Q4 of 2023. Thanks, Matthew.

Operator

Your next question comes from Matt Hedberg with RBC Capital Markets. Please go ahead.

Speaker 5

Great. Thanks for taking my question, team. Great hire in Mark Anderson. I realize it's fresh, Still fresh and Matthew, you talked a little bit on the call about what he's going to be focused on. But I guess maybe just I wanted to double click on that.

Speaker 5

Are there some specific sales processes or partner motion that you think Mark's going to be focused on to really drive that next level of enterprise growth? And maybe could you talk about overall rep productivity, which I know has been a big focus for you all over the last year? Which I know has been a big focus for you all over the last year?

Speaker 3

Sure. Matt, I appreciate it. So first of all, I think working with Mark Anderson has been a big piece behind the scenes of the improvements that we've seen in the go to market performance that we've had so far. And so his as a board member, his hands have been involved in A lot of the strategic decisions we've made, a lot of the focus that we've made. And so I think this is less of a radical change in terms of the strategy and it's more of a continuation of what we have done.

Speaker 3

That said, I think that the thing which Mark brings, which is unique and as we thought of who would be our ideal sales leader, and we really started thinking about that before we went public. Mark was top of the list, because of the domain expertise, Because of the relationships that he has, because of the trust that he's built in the industry and because of the other sales professionals that really have worked with him and want to follow him and have their own, again, expertise and relationships in the industry as well. And so I think that Mark Anderson will continue a lot of what Mark Boroditsky has done, continue to professionalize our organization, continue to move up market, continue to really focus on rep productivity, focus on making sure that we have all of the right training, all of the right ramping resources that reps need, focus on making sure that Our sales process is as efficient as possible. And I think that will be a big piece of what he is delivering. I think if you zoom out from that, The other thing which is a big initiative for us is just looking at our overall platform and saying how can we make it actually much easier only for our internally team to sell, but also for partners to sell as well.

Speaker 3

Right now, we have a ton of different products and I think bringing that together and finding ways to make that those products, not just individual products, but as a platform and an overall platform, that's where we tend to win is when people buy that overall platform. And that's where there really isn't a ton of competition when people are comparing the total platform that Cloudflare offers versus anyone else in the space. We are able to deliver a much more robust network security performance reliability package than any other vendor that's in that space. And I think Mark helps us deliver that and continue again on some of the great work that Mark Boroditsky had started and really set him up for success.

Speaker 5

Great color. If I could ask one follow-up to Thomas. Your guide for 2024 revenue, I think it calls for about 600 a little bit more some of the assumptions there. I think you noted maybe NRR might be nearing a bottom. But just what's built into that in terms of like new logo ads, Maybe an improvement in NRR, but just sort of unpack that a little bit more.

Speaker 5

Thank you.

Speaker 2

Yes. Obviously, we had a very good Q4 with a lot of good data points pointing in the right direction, the improvement that Matthew was talking about on the go to market side, Not only in terms of productivity, but pipeline improved, deal sizes improved linearity went better. We also saw their best quarter over quarter improvement from an RPO perspective. This is all pointing in the right direction, But we still have to cope with the fact that one data point alone is hard to change your prediction and your trajectory. So we are still cautious about everything else that is going on.

Speaker 2

As you mentioned in his part that the big scenes that we saw last year From a macroeconomic perspective, skittishness of buyers and budget releases is still continuing. And I think this informed our view for the year. And obviously, we'll adjust our strategy and our approach to the year as we have and as we collect more data points. But it served us well over the last 4 years as a public company to look really hard at the data we have and draw the right conclusions from it. And I hope that 2024 will get us to the same outcome.

Speaker 5

Thank you.

Speaker 6

Your next question comes from the line of Andrew Nowinski with Wells Fargo. Your line is open.

Speaker 7

Thank you so much for taking the question and congrats on a great quarter. I wanted to start with a question on Sassy. So you rattled off about a dozen large, Zero Trust deals in your prepared remarks. You're clearly seeing some very strong demand from large customers, which I think Coincides with a lot of the feedback we've been hearing about how Cloudflare is having more success penetrating that mid and large enterprise space with your 0 trust solution. So Maybe if you could comment on your sort of secret to success in getting these large deals closed because it seems like it's there's more to it than just the maturation of your platform.

Speaker 5

Yes, Andy, I

Speaker 3

think that first of all, the We didn't start out as a company that had a 0 Trust platform. And so, that's something that was very natural add on to our network. We think it's very complementary with the other services that we offer. And I think that as we studied the industry and studied the space, it was clear that This set of solutions ended up squarely in our bailiwick of what it was that we were delivering. And so that, I think that that was a very natural place, but we are new to this space.

Speaker 3

And things take time. And especially in the larger buyers, they want validation like Gartner and Forrester and other industry analysts saying that you should be in the consideration set. And so there's a bit of a chicken and egg, if you were, you'd have to sort of start to get your first large customers and your early adopters in order for the Gartners and Forrester's to put you in consideration. And then from that, You start to build that reputation with the industry analysts and that gets you in more deals. And what we find is when we're in the consideration set, We're just a next generation platform and we're faster, we're more secure, we're more reliable and we're a better solution for a lot of vendors.

Speaker 3

And so not only are we winning the greenfield opportunities, but we're increasingly winning opportunities from 1st generation 0 Trust vendors where their customers aren't satisfied with the solutions they have and they're moving fully to us. So I think that a lot of it has been just the maturing of our platform, but not just from a technology perspective. We're pretty

Speaker 5

good at that and we

Speaker 3

have a lot of control of that. But also just from an understanding in the industry that this is something that we offer, an understanding of how the various components of Cloudflare fit well together. And I think that that's something that becomes itself a flywheel, which we expect will continue to deliver success for us in this space over time.

Speaker 7

Sounds like especially with Mark Anderson joining now as well too. I want to ask a quick follow-up on Vectorize because I think it's really interesting And how it may potentially be driving growth of R2 as well. From talking to some industry folks, it sounds like customers are starting to recognize how important Vector databases as it relates to inference and fine tuning models. But I'm curious, I know it's still early days, but What is the feedback on Vectorize? And are you actually seeing a pull through or sort of a push to revenue on to R2 as well from that?

Speaker 7

Thanks.

Speaker 3

Yeah. The way that we see the space in general is we want to have all of the different components that you need in order to build just a full featured AI application. And there are there and that means supporting as many models as possible and some of the work that we're doing with the major model vendors like the Metas of the world, the marketplaces like Hugging Face gives us that. We want to have the best place for inference and we think We're Goldilocks in that space where the centralized public clouds are too far away And your device that you're holding in your hand or wearing on your wrist is often, doesn't have enough power. But where we are sitting in between gives that really incredible place, for inference.

Speaker 3

But then the next step of that is you have to be able to take those models and make them your own. And that's exactly what Vectorize does. It allows you to customize those models and tune them through the fine tuning around making them your own. And so What's been interesting about that is that being local and having presence all around the world ends up mattering in In various places, an example that a customer gave us the other day was that if you have a model, and it responds In the United States and it's spelled color, colou r, it feels very foreign, whereas if it's in the UK and it's spelled as color, it also feels very foreign. And so the ability to not just tune models, but tune them locally, while still having the power of beefy GPUs that can then run the inference tasks.

Speaker 3

That's a really killer combination. And And as you said, it's built on top of the existing primitives that we have, including R2, which is our object storage space. And so While it's early in the entire AI space, I think we are very well positioned and very strategic. And if you look at things like The various downloads of our libraries on public open source repos, they are taking off like crazy. And It is incredibly encouraging and I think will become a larger and larger part of our business going forward.

Speaker 3

Thank you.

Speaker 6

Your next question comes from the line of Hamzah Fodderwala with Morgan Stanley. Your line is open.

Speaker 8

Hey, good evening. Thank you for taking my question. Maybe just stick on the Edge AI theme. Matthew, I'm just curious, I know it's very early days, but as you deploy these GPUs at all your locations worldwide, How are you feeling from a capacity standpoint, from a CapEx perspective in your ability to meet the demand as some of the sort of inference starts to ramp. And then maybe a follow-up for Thomas.

Speaker 8

I think variable revenue is a very low percentage of your overall sales. Can you give us any context of how that looked for Q4 relative to Q3? Thank you.

Speaker 3

Yes. So I'll take the first question and Thomas can take the second. I'll start with a in a place that you might not expect, which is that our success in the 0 trust market has actually helped empower our ability to invest in the developer platform and especially the AI market. To understand that, the nature of how our business works is that Every single service that we run is capable of running on every single piece of equipment that's out there. So we don't run a different network for our security products than we do for our performance products.

Speaker 3

We don't run a different network, for the CASB service that we have versus our access versus our DDoS mitigation, it's all the same machines that are running across that. And so One of the secrets to Cloudflare's success has been that we've been able to always look for places where there is more sort of unused capacity and then effectively act as a giant scheduler in order to make that capacity more productive. And what's been interesting about the Zero Trust space is that the very nature of how that traffic works where Our first generation services were all reverse proxy services. The traffic was flowing kind of in one direction, whereas our Zero Trust services are always called forward proxy services, the traffic is flowing in the other. But it turns out that you can actually have traffic flow both directions without having additional CapEx costs.

Speaker 3

And so as a bigger and bigger part of our revenue is these 0 Trust products, It means that it actually frees up CapEx as a percentage of revenue for us to go after other opportunities. And so that's what has freed up our us to go after a lot of the AI opportunities that we've had is what's freed up our ability to Acquire the GPUs and invest behind the demand that we're seeing. And I feel really good Because at core, what we are really good at is running a giant network as a giant scheduler and then ringing as much efficiency and utilization out of that as possible. And so we have been able to stay ahead of the demand that we've seen for the GPUs and other resources that we need for some of these newer products. And we're complementing that by also adding revenue, which is just much less CapEx efficient because it's much less CapEx intensive and much more CapEx efficient because it's running on top of the same platform.

Speaker 3

Hopefully, that makes sense, but it really is part of the key to our business and it's part of why we have the gross margins that we do, where some of the other companies that are point solutions only doing one of these things have much worse margin profiles.

Speaker 2

And before I answer your second question, maybe A bit more color to what Matthew just said. I mean, you really could see the inherently efficient architecture of the network In the Q4, our network CapEx was 8% of revenue in the Q4. And we were ahead of delivering GPU capacity. We were at the 100 and 20 cities out of our plan of 100. And the guidance of 10% to 12% of revenue for this year includes a full build out and bringing GPU capacity into pretty much every location we have.

Speaker 2

And on top of that, and making sure that the network grows with the traffic that we put on our network. So that is, I think, one of the Key competitive advantages we have is the network architecture, and that's just another proof point in the Q4. Regarding your question on variable revenue, variable revenue in the 4th quarter was a bit higher than it was in the 3rd quarter, but it's still a small percentage of our overall revenue. This will change over time as our packaging and the offerings we bring to the market will have higher variable components. But for the Q4, it was still a small part of our overall revenue

Speaker 4

mix. Thank you.

Speaker 6

Your next question comes from the line of Jonathan Ho with William Blair. Your line is open.

Speaker 9

Hi, good afternoon. Matthew, you mentioned that a third of workers AI accounts are new to workers. How could this be potentially an accelerant to your developer platform overall? And could you maybe give us some color on the adoption of workers in terms of the serverless model by developers relative to competitors?

Speaker 3

Yes. It's, I think that if you study developer platforms, they inherently take some time to really take off and take hold. And it averages about 10 years from when they launch before they seem like they're getting to that. And the reason for that is because of the fact that you need early adopters. Those early adopters need to build something which is a killer app, which people say, wow, I couldn't have built that in any other way.

Speaker 3

Some of the people who are behind that first killer app need to then go on and start other services, other companies build other things. There's an ecosystem that has to develop around all of that. And that inherently takes some time to take off. Developer platforms are adopted, They're not sold. And so again, I think that we've been Very excited about the rate at which things have been adopted at Cloudflare for our developer platform, but we've also been realistic that for that developer platform to take off, inherent in how these develop, there is some time.

Speaker 3

There are a handful of ways that you can have shortcuts. One of those is to attach yourself to other developer ecosystems, which are really robust. And so some of the ways that we are effectively Providing the underlying infrastructure for some major other platforms that are out there, a number of the big e commerce platforms and other things. That helps train developers early on, on how to build with us and again is one of the shortcuts to get there. Another one is attaching yourself to wherever there is a lot of interest in the developer ecosystem.

Speaker 3

And so I think that as you look out at the AI space And we try to survey what are the most common cloud platforms that are being used across The hottest AI startups and companies that are out there, Cloudflare is the most common to that. And I think that, that again accelerates the rate at which you're able to get that adoption. And so if you look at things like NPM downloads the packages and you compare sort of the things that you would download to run on Cloudflare Workers versus competitors like AWS' serverless offering, it's been pretty amazing that we've actually caught and now passed AWS by some measures in terms of the packages which are being downloaded that are out there. And again, we're a much newer platform. And so I'm encouraged that we'll be hopefully taking that average time for new developer platforms to get Reach scale down because of some of the success we've seen.

Speaker 3

And again, I'm really proud of our team and how they've executed in delivering this. Excellent. Thank you.

Speaker 6

Your next question comes from the line of Tim Horan with Oppenheimer. Your line is open.

Speaker 10

Thank you. Related to the previous question, can you maybe update us on your best guess on timing when the workers platform starts to drive some material revenue when it starts to move the needle and maybe the same thing for AI. I know you said kind of not this year. And what do you think for both these platforms? What does this mean for overall growth rates for the company?

Speaker 10

Thank you.

Speaker 5

Yes. I think

Speaker 3

What has been interesting has been that Workers is a big piece of a lot of the deals that we see. So, it's still in Somewhere around 20% of the large deals that we closed have some workers component to it. And that's held actually fairly steady, but those deals have continued to go up and up. So it depends on how we don't Break out the various pieces of Cloudflare because we think that the platform functions very well as one unified platform. And we close more deals because we have workers involved.

Speaker 3

But a lot of times, That includes our reverse proxy security services and oftentimes includes our 0 trust security services. And what we really want to be is not a one trick pony for any one of our customers. We want to actually have multiple different things that they rely on and be that strategic vendor that provides a broad set of solutions to them. So I think it's already purely driving new business and large deals, but as the workers platform. I think the AI space, I think a lot of the money which is being spent on AI right now, especially with some of the Hyperscale public clouds, a lot of that is for, training of models that is not we are not the right place to actually do model training.

Speaker 3

But as that transitions over time and people start to figure out, how can you take those the models that you've built and turn them into real products, I think that's where you'll start to see a much more significant share of you'll start to see revenue that is showing up as meaningful to us in terms of delivering the value in the AI space. But I think it's we're still so early. And I think that the thing to track is less about us, it's more about how long does it take product managers and engineers to really figure out how to harness these new tools into providing customer value. I think we've seen a ton of I mean, the challenging thing with AI is, it is really easy to make a demo, but it's very hard to make a product. There's a ton of value that will be created here.

Speaker 3

But I think it's still it's going to still take some time and I think it's going to be up to some things that are somewhat out of our control. But I can't imagine being better positioned than we are. Thank you.

Speaker 6

Your next question comes from the line of Trevor Walsh with Citizens JMP Securities. Your line is open. Great.

Speaker 9

Hi, team. Thanks for taking my question. Matthew, maybe for you, wanted to just sort of round up all the different kind of themes and things that you've been talking about throughout, you've got a platform of platforms where you're playing in AI, you're playing with developers and workers and 0 Trust, etcetera, creates a big TAM, but then at the same time from a go to market perspective, you have a lot of different stakeholders and buyers within an organization that you have to try to round up and sell that vision. So where do you think you need to go from just a go to market perspective, especially with Mark coming on board now in terms of whether it's internal enablement, simplifying packaging pricing and packaging like you talked about, kind of How do you thread that needle, I guess, of all those different kind of people? And how do you see that kind of playing out kind

Speaker 3

of this coming year and beyond? Thanks. Yes. So I think our strategy remains our strategy, which is land with 1 product and then demonstrate, build trust, demonstrate value and then expand to help customers, both create more value and save money, across their overall all platform. And what we see over and over again is the customer that just this last quarter signed a $60,000,000 total contract value renewal.

Speaker 3

They started with 1 product and were a $60,000 customer a year when they first started. So that works. I think operationalizing that now is the thing which we've made huge strides on over the last 15 months, and I think Mark Anderson will continue to help with that. What I think is really attractive about Mark Anderson is, yes, he knows the security space and the network security space from his time at Palo Alto Networks, but also from his time at Palo Alto Networks, they went from really a one product company to a platform company. And that's something which we really admire and think is rare When companies figure out that play, we've got that set of products.

Speaker 3

We've got a lot of customers and now It's how do we again continue to demonstrate value, and I think bringing on incredibly talented leaders Like Mark Anderson, who are trusted and respected in the space, who have run this play before and been successful with it. And it can now take the breadth of products that we have and the opportunity we have and build an iconic company and an iconic go to market organization. Again, I'm incredibly honored to have him on board and his first day was today. He's already rolling up his sleeves and getting to work.

Speaker 1

Great. Appreciate it.

Speaker 6

Your next question comes from the line of Joel Fishbein with Truist Securities. Your line is open.

Speaker 11

Thanks for taking the question. Matthew, just two quick ones. You mentioned in the prepared remarks about the public business just Getting being fairly strong and you mentioned the U. S. Department of Commerce.

Speaker 11

Can you give us any color about on adoption in the public sector? And then just Tied to that, you are very early and very right in talking about the macro becoming weak several years ago. And I'm just curious, I know I listened to your prepared remarks and just wanted to take your temperature about how you're just feeling in general about the way that the demand environment is currently? Thanks.

Speaker 3

Yes. So sort of related questions actually. I think that Our federal business, as well as our SLED business, state, local education, and Our global government business has all been real signs of strength. And I think that, that in part is because of the fact The world's getting scarier and, we're seeing more attacks. 2020, 2 is actually very quiet On the cyber front, whereas the back half of twenty twenty three and especially after The Hamas invasion and kidnappings in Israel really took off in terms of cyber attacks that were going on around the world.

Speaker 3

And I think governments recognize the importance of staying safe and secure. More than half of the world population will vote in 2023 in elections. And so I think the fact that we've been leaders in Protecting elections and making sure that elections are run without cybersecurity being part of the story has gotten us in the conversation in a lot of places around the world. And I think that we have a maturing set of just go to market motions and a really great leadership team around our state and local business or excuse me, our federal and state business, which is showing real signs of promise. So I would expect that that business continues to be strong throughout 2024.

Speaker 3

Your second question is kind of the flip side of that, which is, I think that the macro continues to be challenging. There are 2 Hot wars going on right now. I think we are not out of the woods, economically. And in terms of getting totally ahead of inflation, again, I think in the U. S, that looks better than some of the other places In the world, there's a lot of ways that you can imagine the world continues to get more complicated.

Speaker 3

And I think IT buyers continue to be Giddish, Q4 definitely felt like people were starting to make decisions and they were starting to say that there are certain things that are must haves versus nice to haves. And I think we continue to be sorted into the must have bucket. But we continue to be very prudent and very thoughtful as we think about our business. We're trying to scale behind the demand that we see, not get cocky about ramping anything too fast. But in a world that is increasingly difficult and increasingly complicated.

Speaker 3

I'm glad that we're in the business of helping provide cybersecurity and I'm incredibly proud of our team for living up to our mission of helping make sure the Internet stays safe, secure and reliable.

Speaker 6

That is all the time we have for questions today. I will turn the call back to Matthew Prince for closing remarks.

Speaker 3

I just wanted to thank the entire Cloudflare team for just all the incredibly hard work over Q4 and into the beginning of 2024. And we're just so incredibly proud of the work that everyone is doing. I'm excited to add Mark Anderson to our team full time. He started actually today, as I said, and is already rolling up his sleeves. I want to thank Mark Boroditsky, who will continue to act as an advisor to Cloudflare and help with transition.

Speaker 3

He's been nothing but a class act throughout this and we couldn't have gotten here. Thanks to all of our customers, investors. We'll see you back here in about 3 months. Thank you.

Speaker 6

This concludes today's conference call. We thank you for joining. You may now disconnect your lines.

Earnings Conference Call
Cloudflare Q4 2023
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