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Persistent rate hikes aimed at countering runaway inflation, and a looming recession remains a headwind for long-duration stocks like Cloudflare (NYSE:NET), which has its valuation prospects pinned on cash flows generated further out in the future. On a relative basis to both its high-growth (+30% to +40%) and broader software peers, the stock continues to trade at a lofty premium that further increases vulnerability to investors’ angst hanging over the market.
Specifically on the fundamentals front, management has been warning of anticipated weakness from macro challenges since earlier in the year, which has started to be felt across its operations during the second half. Ensuing uncertainties over enterprise IT budgets will likely remain a near-term overhang on Cloudflare’s operating performance, consistent with elongating sales cycles observed across broader SaaS industry peers like Salesforce (CRM):
Before moving to our guidance, I’d like to comment on the current economic environment. You recall that last quarter we noted measured customer buying behaviour really beginning in July. This led to elongated sales cycles, additional deal approval layers and deal compression, particularly in enterprise.
Source: Salesforce 3Q23 Earnings Call Transcript
In the quarter, we observed an increase in our sales cycle and expect similar sales dynamics to continue, leading to longer lead time deal closures. We are cognizant of the increasingly cautious environment and have factored this into our outlook.
The following analysis will walk through the implications of Cloudflare’s SaaS business model and opportunities stemming from its core serverless business, alongside adjacent offerings addressing the more resilient cybersecurity corner of software amid the looming recession. With the stock still trading at a lofty premium of 10.4x estimated sales on consensus growth estimates of 35%, versus the broader software peer group’s 5.2x (average +16% y/y growth) and the high-growth peer group’s 8.6x (average +33% y/y growth), Cloudflare will likely remain vulnerable to continued market weakness and fragile investors’ sentiment given evolving macroeconomic uncertainties weighing on the market’s outlook. Elevated risks of further multiple compression for growth stocks in response to persistent rate hikes to tame inflation also remains a drag on Cloudflare’s valuation premium at current levels and dampen its near-term valuations prospects. While the company is positioned favorably in a bullish longer-term outlook on secular demand trends, and exhibits a robust land and expand strategy on the provision of mission critical next-generation cloud-based computing solutions, the current market climate will likely create entry opportunities with a better risk-reward pay-out over the coming months.
Cloudflare’s Revenue Model and Near-Term Recession Challenges
Cloudflare provides more than 20 cloud-based computing solutions under the SaaS business model, with core offerings being “Cloudflare Workers“, “Cloudflare Data Localization Suite“, “R2” storage, “D1” database, as well as various cloud-based security solutions:
- Cloudflare Workers: Cloudflare Workers is one of several developer-based solutions offered by the company. The solution refers to Cloudflare’s “serverless computing / programmable network” which allows developers to expand existing and create new applications, and deploy them both locally and worldwide at an efficient and scalable pace. Specifically, serverless computing eliminates the requirement for capital-intensive maintenance of tangible and on-premise infrastructure, such as servers, thus reducing costs and time required for deployment of applications. Essentially, Cloudflare takes care of all customers’ cloud capacity needs under Cloudflare Workers, providing them with a “serverless” operating environment. Within Cloudflare Workers, the company also provides adjacent services like “Cloudflare Pages“, a creativity tool for developers to “quickly and easily build, collaborate on, and deploy websites”, as well as “Cloudflare Registrar” and “Cloudflare Apps” used for domain registration and management, and add-on app development tools.
- Cloudflare Data Localization Suite: Cloudflare Data Localization Suite addresses certain enterprise customers’ compliance requirements on data privacy. Specifically, some businesses are required to keep user data localized to comply with either company-specific and/or government regulations. And Cloudflare Data Localization Suite addresses this requirement by providing solutions that will make it easier for users on its network to “set rules and controls…, adhere to compliance regulations, and keep data locally stored and protected”. For instance, the EU is currently increasing scrutiny on companies processing massive troves of user data from transferring them overseas. And Cloudflare has already started to experience accelerated demand for this product offering in the EU market due to “increasing data residency requirements becoming law in the region”.
- R2: R2 is a data storage solution Cloudflare began offering as of September, and has already scored “over a petabyte of customer data” since. Unlike data storage solutions typically offered by hyperscalers, R2 allows the movement of stored data across various clouds and platforms without “egress tax”, or essentially, transfer fees. This addresses a significant need across users as adoption of a multi-cloud strategy gain momentum due to benefits spanning “risk mitigation, reliability/redundancy”, multi-function availability, and most importantly, cost-efficiencies.
- D1: D1 is Cloudflare’s “first SQL database” that became available in open beta near the end of the third quarter. The database is designed for the serverless network hosted by Cloudflare (i.e. Workers), and enables to users to convenient access data and build “anything from APIs to rich and powerful applications, including eCommerce sites, accounting software, SaaS solutions, and CRMs”. Specifically, users can access D1 to configure their unique database and input data. D1 can then be linked to Cloudflare Worker to enable a fully serverless infrastructure that enhances scalability and cost-efficiencies for users.
- Security: Cloudflare currently offers a suite of cloud-based security solutions “designed to secure any combination of platforms, including public and private cloud, on-premise, SaaS applications, and IoT devices”. Said solutions include “Cloud Firewall”, “Bot Management”, “Unmetered Mitigation” and “Cloudflare Orbit”, which detects, protects and blocks cybersecurity threats and malware from attacking “customers’ Internet properties [and] IoT devices”.
The company currently offers its services on three revenue models:
- Free: Cloudflare currently offers a free-tier for its services to “drive awareness of products” and attract customer growth. The free-tier is enabled by “idle capacity” across Cloudflare’s network stemming from its optimized management of paying customers’ usage. In addition to being used as a “marketing” tool to some extent, the free-tier also makes Cloudflare an “attractive partner for Internet Service Providers globally, which reduces [its] co-location and bandwidth costs”.
- Pay-as-you-go: Free-tier customers typically graduate to a pay-as-you-go sales model, which is billed on a consumption basis. The pay-as-you-go business represents a “relatively small portion of [Cloudflare’s] business” and accounts for less than a fifth of the company’s consolidated revenues. Similar to the free-tier, pay-as-you-go is, to some extent, a landing tool used to attract and expand customers’ usage of Cloudflare’s sprawling portfolio of solutions:
So if you look at who are our largest customers and you go down the top 10 customers, almost all of them came to us originally because some technical leader inside that organization used Cloudflare’s pay-as-you-go services, fell in love with us, understood us and was able to adopt us as part of that…Behind almost every one of those Fortune 500 wins is a pay-as-you-go customer who advocated for us internally, and that is our secret sales force.
- Contracted: Much of Cloudflare’s contracted volumes are billed under a subscription-based – or SaaS – model. The company currently boasts a robust dollar-based net retention (“DNR”) of 124% and annualized recurring revenues (“ARR”) of more than $1 billion. Cloudflare is targeting a DNR in the 130% range over the longer-term, with ARR of more than $5 billion by 2027, which will be primarily supported by its contracted customer base. With more than 156,000 paying customers acquired to date, Cloudflare has “steadily moved upmarket with large [contracted] customers” representing more than half of its revenues from a mere 21% five years ago. Large contracted paying customers with $1+ million annual spend grew at an 81% CAGR over the same period, $500,000+ annual spend at a 54% CAGR, and $100,000+ annual spend at a 64% CAGR, representing a robust land and expand business strategy stemming from its free-tier and pay-as-you-go offerings.
Ahead of the looming economic downturn, IT budgets are becoming increasingly uncertain and the impact is already starting to show across Cloudflare’s business. Despite robust performance in the third quarter with new large paying customer adds and existing deal extensions, management has already started to observe longer sales cycles, as well as an increasing volume of pay-as-you-go churn to the free-tier model.
Specifically on pay-as-you-go churn, the increasing volume of downgrades to the free-tier is consistent with the disadvantage of consumption-based models during a recession. Users adopting the pay-as-you-go model typically represent trialing of Cloudflare’s services. While a plus of the consumption-based pay-as-you-go revenue model is that it attracts new customers by extending a flexible and less costly way to try out a new service, a negative is that growing uncertainty across IT budgets will likely put those decisions on hold.
Ahead of an impending recession, boardroom executives are increasingly leaning in on “talking pennies, not millions”, making pay-as-you-go models an attractive option for flexibly adjusting usage to comply with belt-tightening initiatives. However, this also increases the vulnerability of service providers under the consumption-based revenue model – such as Cloudflare’s pay-as-you-go segment – to a “drastic adverse impact at the first sight of an economic downturn”. Consumption-based revenues are usually the first to go during a recession because the flexibility offered to customers allows them to halt usage almost immediately under tightening financial conditions, subjecting consumption-based service operators like Cloudflare’s pay-as-you-go segment to near-term revenue risks. This is further corroborated by the increasing volume of pay-as-you-go churn to the free-tier at Cloudflare:
Similar to last quarter, we saw a higher level of churn in our pay-as-you-go customer base, primarily due to more customers shifting down to our free customer tier. We think this is a function of a more challenging macro environment…We just spent talked about pay-as-you-go customers churning off and becoming free customers, that is something that hinders across the cohort expansion.
However, we see the free-tier as a compensating “catch” to prevent a total user exit from Cloudflare’s offerings amid looming macro challenges. This means pay-as-you-go revenue expansion will likely return at Cloudflare once near-term macroeconomic headwinds fade, consistent with expectations for consumption-based revenue models to be first in benefiting from an economic recovery, “given there is no time-lag in re-ramping up revenue (e.g. no wait time for subscription-based customers to rehire previously laid-off talent)”. The fact that Cloudflare’s pay-as-you-go segment revenues currently represent a relatively smaller mix of consolidated sales also serves as a partial offset on risks of slowing fundamental growth ahead of the looming downturn.
Meanwhile, contracted revenues typically billed under a subscription model is already starting to experience longer sales cycles as raised by management during Cloudflare’s third quarter earnings call. This is consistent with a rising volume of job cuts across the tech industry, which as inadvertently driven down seat subscription volumes, resulting in a direct impact to SaaS revenues across the board. Job postings across the tech sector has been weakening prevalently in recent months (m/m job posting declines have been consistently accelerating, and reaching double-digits since November) and layoffs are unlikely to be “one-and-done” with more to come as recession risks unfold (cue Amazon / AMZN, which has recently cut more jobs than previously expected). This remains a “leading indicator of softer demand” across SaaS, underscoring continued challenges to Cloudflare’s near-term fundamental prospects.
Increasingly uncertain corporate IT budgets have also led to elongated sales cycles across both Cloudflare and the broader software peer group. While subscription revenue models typically experience a “lag effect” from macroeconomic headwinds, as customer bookings do not get adjusted until the next negotiation period, the growing volume of job cuts across the tech sector observed today will likely drive meaningful weakness over coming months as recession risks play out across the broader economy. This means booking growth will likely slow within the near-term as enterprise belt-tightening continues, which will inadvertently push out billing cycles and revenue recognition, and potentially risk delaying Cloudflare’s trajectory to its $5 billion ARR target within five years, or by 2027.
However, security remains a more resilient corner in SaaS despite near-term macro challenges, given the rapid rise in cyber threats – more than 60% of organizations have been subject to a “ransomware attack in the past 18 months”, encouraging more than 38% of global corporations to identify cybersecurity improvement as a top investment priority. This will likely serve as a partial compensating factor for Cloudflare amid the looming economic downturn. Cost-efficiencies and rapid scalability offered by Cloudflare’s portfolio of serverless cloud-based computing solutions also make them an attractive deflationary force for ongoing enterprise digital transformation needs. And the company’s engagement in multiple mission critical software offerings – spanning “external-facing infrastructure” like security, performance and reliability; “internal infrastructure” like networking and security solutions; “developer-based solutions” like serverless computing and data localization; and “consumer offerings” like VPNs and home network security – will likely reduce revenue concentration risks. Cloudflare’s offering of a mixed revenue model – free, pay-as-you-go serverless consumption-based, and contracted subscription – is also a likely competitive advantage to better addresses customer needs and partially offset challenges from mounting macroeconomic uncertainties, as it addresses the increasing demand for “flexible pricing options” while also catering to the preferred SaaS pricing model across software.
The Bottom Line
With management estimating a $115 billion TAM that exhibits potential to balloon beyond $135 billion by 2024 with added services like R2 storage and D1 database to further Cloudflare’s serverless network opportunities, the company benefits from a longer-term growth tailwind, especially with less than 1% penetration today. The $5 billion ARR target by 2027, which represents a 38% five-year CAGR, also suggests expectations for “elevated growth for the foreseeable future”, buoyed by a secular demand environment. The company is also on track to achieving positive FCF by the end of the year, playing favorably for a shift in investors’ preference for profitable growth over hyper-growth only.
Yet, looming recession risks will remain an overhang on Cloudflare’s near-term fundamental prospects based on the foregoing analysis, the company’s sales models, and their respective sensitivity to the impending downturn. This, accordingly, raises uncertainty over whether the aforementioned growth and profitability targets will be sustainable. And with growth stocks still vulnerable to downward valuation adjustments in response to rising borrowing costs, the Cloudflare stock’s lofty premium relative to peers also raises its susceptibility to further volatility in tandem with broader market weakness within the near-term. We believe volatility will remain the near-term theme for Cloudflare at current levels, with risks still skewed to the downside as both fundamental and valuation headwinds remain prominent within the foreseeable future.
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