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Cloudflare: ChatGPT, AI And The Competitive Advantage Most Miss

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Exterior position of Cloudflare headquarters, San Francisco

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During economical slowdowns, we judge that it's important to show subject and optimize for efficiency. We person our hands connected nan levers of our business and a full-throttle invention motor that is nan envy of nan industry. There's nary amended time to outpace nan title and proceed to present products connected our customers' 'must-have' list."

- Matthew Prince, laminitis and CEO of Cloudflare during nan Q4 2022 call

Introduction

On Thursday, February 9, Cloudflare (NYSE:NET) released its Q4 2022 net results and nan banal changeable up, to +25%. After hawkish Fed comments, nan full marketplace and maturation successful peculiar plummeted successful nan past 2 days of past week, but Cloudflare is still up 11% since nan earnings.

ChartData by YCharts

Why was nan marketplace truthful enthusiastic astir these earnings? Let's analyse them.

The Numbers And What They Mean

For Cloudflare, arsenic a richly weighted stock, gross maturation is very important. Revenue came successful astatine 274.7M, up 41.9% year-over-year, beating nan statement by $630K aliases 0.23%.

This hit whitethorn look lackluster astatine champion compared to what investors person travel to expect from Cloudflare, but galore had anticipated that Cloudflare would not meet nan consensus. The logic is that nan hyperscalers, Amazon (AMZN), Microsoft (MSFT) and Alphabet (GOOGL) (GOOG) had each shown weakness successful their unreality divisions. And these are nan strongest companies successful nan world. Growing gross by 42% successful specified an situation is really strong, moreover though it's a slowdown, arsenic you tin see.

Overview Cloudflare gross maturation per quarter

Made by nan author

But fto maine beryllium clear, nan banal would not person been up truthful overmuch without nan guidance, which was seen arsenic very bullish. The institution guided for gross of $290.0 to $291.0 cardinal successful Q1, much aliases little successful statement pinch nan statement of $290.99M. It would mean gross maturation of 37%. Beforehand, this statement was seen arsenic somewhat excessively optimistic, based connected what different unreality players had guided for. But still, that would not explicate nan banal value surge.

Therefore we person to look astatine full-year guidance. Cloudflare guided for gross of $1.33 cardinal to $1.342 billion, beating nan statement of $1.31B. Analysts couldn't judge this. During nan call CFO Tom Seifert had assured them respective times that guidance was very conservative.

In our guidance, we person not factored successful immoderate betterment successful nan macroeconomic situation aliases from our go-to-market initiatives. Specifically, contempt a notable betterment successful our pipeline exiting 2022 arsenic compared to pinch nan first half of nan year, we person assumed nan summation successful income cycle, which we observed successful nan 2nd half of past year, continues successful 2023 and have, therefore, incorporated adjacent rates beneath caller humanities lows.

Still, analysts were skeptical. This was nan very first mobility erstwhile nan lines were opened for nan Q&A:

I conjecture 1 of nan questions I'm getting is astir nan conservatism successful your '23 gross outlook. Obviously, Tom, you talked astir immoderate of nan levers of conservatism. But I conjecture pinch 37% maturation for some Q1 and nan afloat year, obviously, your comps easiness arsenic nan twelvemonth progresses. But is location thing that possibly kicks successful during Q2 aliases nan 2nd half of nan year, possibly for illustration nan value summation you announced past year, aliases possibly a ample customer renewal that would thrust linearity this year?

This aforesaid mobility came backmost respective times. Management could only repetition what it said before, that it believes nan guidance is conservative. Founder and CEO Matthew Prince added this:

We person our hands connected nan levers of our business and are adjusting them based connected nan macroeconomic conditions.

The logic why analysts were skeptical is nan quarter-over-quarter growth, which came successful astatine 8.2%. If you annualize that, you get to 32.8%, truthful this implies immoderate shape of re-acceleration. From a institution pinch a way grounds that is conscionable a spot little than that of Cloudflare, I would beryllium very skeptical arsenic well. But Matthew Prince and his squad person built a batch of credibility complete nan years.

There was besides a number that gave credibility to this guidance. RPO, nan remaining capacity obligation, came successful astatine $907 million. That was up 45.5% year-over-year, but besides 9% quarter-over-quarter. If you annualize that quarterly number, you are adjacent to nan 37% guidance. Remaining capacity responsibility is for contracts that are already signed but cannot beryllium recognized yet. If a institution signs a 2-year statement for $800,000, usually, each quarter, $100,000 will beryllium recognized (depending connected nan terms). The remainder will beryllium put successful RPO.

Another logic nan banal is up rather a spot is astir apt its free rate flow. It came successful astatine $33.7 million, aliases 12% of full revenue, overmuch much than anyone had expected. Management added:

While location will beryllium immoderate variability successful our free rate travel quarterly, we expect to beryllium free rate travel affirmative successful 2023 and successful nan years aft that.

Also important, guidance reaffirmed nan extremity of $5 cardinal successful yearly gross successful nan adjacent 5 years. In 2022, gross came successful astatine $975.2 million. $5 cardinal successful 5 years would mean a compound yearly maturation complaint of 38.65%. That's a very eager extremity for a institution of Cloudflare's size. A portion of nan banal value surge whitethorn person been connected pinch this too, not conscionable that Cloudflare has this eager extremity and reiterates it contempt patient economical headwinds, but besides that it wants to do this profitably.

Cloudflare wants to execute this done a three-pronged approach.

How Cloudflare will scope $5B successful revenue

There are respective basal elements for Cloudflare to get to that very eager goal. Let maine commencement pinch a very evident one.

DBNRR: Cloudflare wants to scope a 130% dollar-based nett retention rate. That intends it would already turn its gross by 30% without attracting a azygous caller customer. That would bring Cloudflare already rather adjacent to its goal.

The dollar-based nett retention complaint for Q4 2022 came successful astatine 122%, little than successful erstwhile quarters. Matthew Prince explained:

while our gross renewal rates stay arsenic precocious arsenic ever, for illustration others successful nan industry, we're seeing customers return longer to motion caller and description deals pinch us. Procurement departments are decidedly successful nan mode of measurement 2 aliases 3 times earlier cutting one. We still spot a clear way to dollar-based nett retention complete 130% arsenic we ramp seat-based products, for illustration Zero Trust and storage-based products for illustration R2, and we won't beryllium satisfied until we get there.

The different strategy is 2nd quality for Cloudflare: innovation. The institution releases hundreds of caller products and features each year. Products for illustration Workers and R2 are already generating gross and Zero Trust is getting traction arsenic well. Matthew Prince announced different Innovation Week successful March, which will beryllium astir information and respective caller products and features astir Zero Trust will beryllium launched.

The 3rd method will beryllium done a much master go-to-market strategy. Don't hide that Cloudflare started from nan bottom, pinch galore individual users and immoderate tech-advanced SMBs. With maturation came products that were fresh for bigger companies.

Cloudflare still has its enthusiastic instrumentality base. They get nan caller products first, often free and supply much-needed feedback. Cloudflare is simply a ready-fire-aim company. It first releases a good-enough merchandise and perpetually refines it done nan valuable feedback it gets from its enthusiastic tech instrumentality base. When nan merchandise is really bully done implementing each that feedback, it goes upmarket. In nan meantime, respective different products are already being tested by nan fans.

But now, Cloudflare is playing astatine a level it was not astatine before, pinch products that person a overmuch broader reach. Big enterprises often activity top-down, not bottom-up, arsenic Cloudflare was utilized to. That intends nan institution needs different go-to-market strategy. Matthew Prince was very enthusiastic astir this successful his emblematic consecutive style.

If we're honorable pinch ourselves, our go-to-market statement hasn't yet been afloat optimized.

As our merchandise go much analyzable and we are trading to larger and larger customers, it's progressively clear that we request to measurement up our crippled successful trading and sales. I introduced Marc Boroditsky who joined past 4th to lead our income organization.

Last week, he briefed maine and Michelle connected his first 100 days. My first reaction, if I'm honest, was embarrassment complete immoderate of nan basal things we should person been doing better. But my 2nd guidance was excitement arsenic location are truthful galore opportunities for america to improve.

I liked that condemnation "My first reaction, if I'm honest, was embarrassment complete immoderate of nan basal things we should person been doing better." Too galore CEOs talk what I telephone "businessish," a sometimes analyzable and unclear substance of business talk and English. By including that first sentence, Matthew Prince shows he's not nan almighty tech deity connected his throne, but a quality being pinch strengths and flaws. And clearly, nan go-to-market strategy of Cloudflare is not optimized truthful far. But indeed, arsenic Matthew Prince added, that is besides a large opportunity.

In a year, you tin alteration a go-to-market considerably, but Cloudflare didn't return immoderate betterment into information for its guidance. With still projected maturation of 37%, this could group it up to 40%+ growth. Do you deliberation that's excessively optimistic? Maybe, but Cloudflare has a beardown way grounds of beating guidance considerably.

Look astatine really nan institution guided for nan adjacent twelvemonth successful Q4 of nan erstwhile years:

2020: 37%

2021: 38%2

022: 42%

2023: 37%

And now look astatine nan results.

2020: 50% (+13%)

2021: 52% (+14%)

2022: 49% (+7%)

For 2023, we don't cognize yet, but I deliberation 3% higher would not beryllium a large stretch.

No Layoffs

There were a fewer different topics nan institution touched connected during nan convention call. One is that they will not laic disconnected people. One of nan things I retrieve from reference 'From Good To Great' by Jim Collins was that successful companies often don't laic disconnected group during bad times. And if they do it, they fto less group spell than akin companies.

Matthew Prince said Cloudflare anticipated what was going to hap and acted accordingly. He besides showed again really galore tech fans Cloudflare has and that translates into nan number of group applying to activity for nan company.

Based connected that, astir this clip past year, we began slowing our gait of hiring to guarantee we didn't get complete our skis. That paid disconnected and kept america from having to return much drastic actions for illustration galore of our peers. It's besides fixed america nan expertise to sensibly put successful our squad arsenic astonishing talent comes connected nan market.

To springiness you immoderate sense, successful 2022, we person complete 400,000 group use for astir 1,300 positions astatine Cloudflare. That request to activity astatine Cloudflare has allowed america to proceed to prosecute unthinkable talent while remaining disciplined successful wide compensation.

Zero Trust: still early

As he has done connected nan past fewer quarterly net calls, Prince besides was enthusiastic again astir Cloudflare's Zero Trust, competing pinch companies for illustration Zscaler (ZS) and Palo Alto Networks (PANW). Prince pointed retired what nan opportunities and difficulties are.

What I deliberation our situation is successful nan Zero Trust abstraction is not winning customers that cognize astir us, but making judge that customers that are successful nan marketplace for Zero Trust services are alert that that's thing we do.

The vexation that I still person is erstwhile I'll meet pinch a customer and oftentimes they'll virtually say, you should build thing that is successful nan Zero Trust space, competing pinch Zscaler aliases Palo Alto Networks. And truthful erstwhile we're successful those deals, we find ourselves winning very often.

It's still very early for Cloudflare's Zero Trust solution, but it has awesome promise, conscionable for illustration galore different of nan company's products.

Cloudflare's Competitive Advantage

If group look astatine Cloudflare, they sometimes miss nan advantage of utilizing its products for companies, nan competitory advantage sometimes prematurely called 'moat.' A existent moat, successful nan measurement Buffett uses tin only travel complete time. When Matthew Prince talks astir a caller $1M+ customer, he shows a competitory advantage of Cloudflare.

The customer loves that we person a azygous pane of solid solution and that our exertion is built from nan crushed up connected a azygous level alternatively than a Frankenstein solution bolted together done M&A.

And different example:

A European financial services institution signed a five-year $1.8 cardinal deal, replacing a twelve different information and web vendors pinch Cloudflare. This institution settles hundreds of millions of securities transactions annually for nan largest banks and governments successful nan world. As a result, information and regulatory compliance are paramount for them. They wanted to consolidate and simplify their galore constituent solutions into a azygous pane of solid solution.

If stitched-together solutions cannot compete pinch Cloudflare, what astir caller companies entering nan market? Matthew Prince thinks this will beryllium very difficult.

12.5 years agone erstwhile clouds sewage started that allowed america nan conditions and opportunities to build nan company. I deliberation it would beryllium very challenging coming for personification to replicate nan web that we have, and that web continues to let america to present much and much services

Cloudflare's ticker is not by coincidence NET. The institution wants to beryllium a afloat web of services, and it's becoming that much and more.

FedRAMP And IoT

Cloudflare is now FedRAMP certified. FedRAMP stands for Federal Risk and Authorization Management Program and it opens up a full caller marketplace for Cloudflare. The nationalist assemblage abstraction is only 3% of Cloudflare's gross now, truthful there's a batch of room for growth. Prince shared an example.

The authorities of North Carolina signed a three-year, $3 cardinal deal. The authorities had primitively travel to america nether our Athenian Project for free thief pinch predetermination security. They learned nan powerfulness of Cloudflare utilizing america to protect their elections infrastructure and signed nan woody to grow Cloudflare's protection crossed 50 authorities agencies.

Another absorbing illustration Prince shared had to do pinch IoT aliases nan Internet of Things, which is besides expected to support increasing accelerated complete nan adjacent fewer years.

A nationalist inferior institution successful Africa signed a $2.8 cardinal 75-month woody to thief support a really cool business IoT rollout. They're utilizing Cloudflare's intelligent web to show 3,300 sensors, search shipments of materials. This is different usage lawsuit of Cloudflare's web we wouldn't person imagined connected our own, but 1 we're uniquely positioned to present for nan customer and now opens moreover much markets and opportunities.

This again shows that Cloudflare is wherever nan invention is. In that context, we person to talk astir AI, of course.

Cloudflare Powering ChatGPT And Other AI

AI has been nan buzzword of nan past months and Cloudflare's guidance besides utilized it connected nan convention call. But dissimilar galore buzzword addicts, Cloudflare is really astatine nan frontlines of this breathtaking development. ChatGPT is simply a Cloudflare customer and Matthew Prince talked astir it, besides showing Azure's Front Door was insufficient for ChatGPT.

A starring generative AI institution signed a one-year $1 cardinal deal. The institution had been a personification of our free tier since 2017. And this woody primitively started retired arsenic a comparatively mini gateway DNS opportunity to switch Cisco Umbrella. However, erstwhile their browser-based exertion debuted successful precocious November, request for nan company's AI-generated contented perfectly exploded pinch unprecedented rates of adoption.

Their Azure Front Door had quickly proved insufficient astatine handling nan monolithic load connected their services from morganatic users arsenic good arsenic keeping fraudulent users from exhausting their resources. They started disconnected pinch CVM, DDoS, bot management, gateway DNS and more. We are actively exploring various paths for description to support their unthinkable maturation arsenic good arsenic emerging usage cases of their AI models and applications pinch Cloudflare Worker, API Shield, imagery sizing and more.

Prince talked astir really AI companies usage Cloudflare successful a measurement nan institution had not anticipated. This could very good beryllium nan adjacent maturation opportunity for Cloudflare.

They are, by their very nature, multi-cloud, but nan information egress policies make it prohibitive to move ample training sets betwixt nan clouds. Enter Cloudflare Worker.

What we're uncovering pinch these AI companies is that R2 and different Workers products people go nan glue astatine nan halfway of a multi-cloud ecosystem. R2 has go nan earthy neutral spot for these AI companies to shop their training information successful bid to make judge it tin beryllium inexpensively and efficiently accessed from anywhere. It's evident successful retrospect. But it's a usage lawsuit we didn't anticipate.

This is still very early, arsenic everything pinch AI, but Matthew Prince has said respective times Cloudflare wants to support increasing accelerated by stacking S-curve products complete time. He repeated that.

At Cloudflare, we've ever thought of ourselves arsenic stacking S curves 1 down another. And truthful I ever deliberation of benignant of our exertion services products arsenic benignant of our first act. We deliberation of our Zero Trust products arsenic our 2nd act. And we deliberation of our Workers products arsenic our 3rd act.

For nan 3rd act, Workers, it's already going fast. There are already much than 1 cardinal developers connected Workers, truthful this could really go a awesome gross driver successful nan future.

Conclusion

Cloudflare chalked a decent 4th erstwhile it comes to revenue. The areas wherever it did amended than expected were profitability, measured successful free rate flow, and guidance. Guidance was truthful bully that analysts couldn't judge it. With each nan other colour guidance gave connected nan convention call, I was erstwhile much impressed by nan immense maturation imaginable Cloudflare still has. It's only scratching nan aboveground of nan endeavor market, nan astir profitable marketplace for companies for illustration Cloudflare.

Of course, Cloudflare's banal is still very costly but if it continues to turn astatine astir 40% annually, it tin turn into that valuation quickly. With a precocious DBNRR, precocious gross margins, precocious maturation and now connected apical of that bully profitability, Cloudflare shows it tin beryllium a awesome banal for nan adjacent decade. I ever purpose to put for a decade and longer, unless nan business drastically deteriorates, which often happens successful investing.

Over nan short term, location mightiness beryllium a batch of volatility and that intends that if you don't put pinch a very agelong finance horizon, you should astir apt not put successful Cloudflare aliases person immoderate shape of protection. Over nan agelong term, I deliberation nan banal will springiness shareholders satisfactory returns, arsenic agelong arsenic this guidance keeps executing successful specified a awesome manner.

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Editor: Naga



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