Cloudflare, Inc. (NYSE:NET) Piper Sandler Technology and Consumer Growth Frontiers Conference September 13, 2022 2:30 PM ET
Company Participants
Thomas Seifert – CFO
Conference Call Participants
James Fish – Piper Sandler
James Fish
Well, I guess we’ll get started here, people trickling in. Well, for those on the webcast, we have Tom Seifert, CFO of Cloudflare here. There’ll be – keep in mind, everything about the safe harbor, everybody, just for safe – Jason here as well. So thanks for joining us, Thomas. Appreciate your time.
Thomas Seifert
Thanks for having us.
Question-and-Answer Session
Q – James Fish
So Thomas, after last quarter, something you and I have talked a lot about, as well as Matt, you kind of emphasizes around these waves or acts, Waves 1, 2 and 3. Is there a way – I know you don’t want to get into the specific products, but Cloudflare does a lot of this bundling and so forth. But is there way to think about the bookings trends between kind of these Wave 1 versus Wave 2 versus Wave 3 products? Just given kind of the strength that you’ve talked about like with Zero Trust, which I’d put them look to like the Wave 2 there.
Thomas Seifert
Yes. Yes, there are never easy answers when it comes to that. I got this question a couple of times today. When we launch products, when we push those big and new waves, we are rarely ever revenue focused. And because of that, booking is probably not the KPI you would look at.
When we talk about Wave 2 products, and Wave 2 is something we would consider today Zero Trust, so I’d say excellence, the gateway, product isolation, e-mail, would fall in that category, the KPIs we watch for and how we measure our progress, success, our momentum are much more complete suite that we sign up in a given quarter, how is the growth rate from a suite perspective, paying customer count for that group of products.
And you would expect to see momentum already this year, and we do – we see a significant growth rates from a suite perspective, from a paying customer perspective, account perspective for Wave 2 product, as you would see.
Revenue is to come. We are big about adoption and disruption and worrying about the dollars associated with it not right out of the gate. If we think about pricing products, it’s always about what is the most disruptive moves we can make in the market. And then product introduction strategy follows.
So just for those in the audience that are less familiar with us, Wave 1 would be where we started where the company was built on, protecting infrastructure. This is the firewall products, routing, DDoS mitigation, load balancing falls into that category, bot mitigation. Wave 2 is what we now has this neat name of Zero Trust, but moving from protecting infrastructure to protecting people. Wave 3 are what we call our Magic Transit product where you go after the MPLS spend and then comes to Workers in the storage product.
James Fish
Got it. Makes sense. And one thing also we talk about a lot of luckily for clouds that we really don’t have to worry about the supply chain outside of the CapEx kind of investment in terms of getting servers and all of that. But a lot of the history here has been about replacing hardware solutions. So is there a way to think about when you go into a competitive deal? How much of it is replacing those hardware solutions versus competing against some of your software pure plays out there?
Thomas Seifert
The installed base of on-premise hardware or what we call Band-Aid boxes, right, Band-Aid to patch up the Internet to do what it was not designed to do from a performance and from a security perspective is where we go after. This doesn’t necessarily mean it’s a rip and replace, right? You would often find us in front of existing on-premise hardware, and then over time, upgrade dollars or expansion dollars shift to us, right?
Rip and replace happens, sometimes more often. But it’s not the normal go-to-market for us. We literally sit in front of an on-premise load balancing infrastructure or an on-premise firewall infrastructure. And then as I said, budget dollars shift to us over time. We call this winning the war of attrition, that’s how much you coined it.
And I think it’s a quite appropriate description that also is, I think, part of the explanation why we have this steady and paced growth momentum that we see now for a couple of years in succession, but not this jump to 200% because we rip and replace complete infrastructure.
James Fish
Yes. Would you say though in terms of that hardware kind of competition, has that mix shift changed at all that you’re coming up against more like replacing actually software-focused vendors?
Thomas Seifert
That happens, and it happens more and more often. And this is what is high path, of course, by everybody, including folks like you. But the big opportunity is still the wide, I understand that, and we’re excited about that, too. And don’t misunderstand me, but the opportunity is the installed base is going after the on-premise hardware for us and companies that look like us. But we bump into each other more and more often, especially when it’s about sophisticated installations when it’s about cloud native customers.
James Fish
Got it. And one thing that’s been coming up more especially since spring time was around elongating sales cycles. And you guys obviously have a mix between enterprise and commercial customers and a decent international exposure. So I guess, to this point, what are you seeing with that top of the funnel? And has that changed in terms of how you approach customers or customers approach you in terms of that self-serve model with Wave 1, Wave 2 or even Wave 3 products?
Thomas Seifert
We gave quite a lot of color on our last earnings call. around that motion, and nothing has really changed. So it hasn’t improved. It hasn’t done worked, but it is where it was. Sales cycles are extending. They are extending in the big bucket. So in north of $500 million of ACV, people measure twice before they cut. That has not changed. And because of that landing new logos in that bucket has become, it takes longer, I guess. And I don’t think we are the only company seeing that.
We adjusted our go-to-market. Expansion is still is an easier motion for us in an environment like that and we adjusted to that. We will become the, I remember still when we had our first test in the water roadshow and we showed our DNR number, I think at that time it was 110% or 111% and people think about that, I think, rightfully.
So we have spent significant amount of time sophisticating our expansion motions. How we – the playbook we have using a lot of data at hand in order to address that, where does the customer come from, but it’s the most likely land product. If that is the land product, what is the second or third product that customers most likely to buy.
And expanding existing customers has become easier in a recessionary environment. I think the large significant extent because ROI is just much easier to show for an existing customer, right? We can have a customer that is a load balancing customer and you can say, do you know you mentioned this already once today that 40% of your traffic is malicious traffic. So if we switch on bot mitigation, not only does your security posture become better, but you eliminate 40% of your bandwidth costs. So let me switch it on for five days, so just so you see.
So these motions are easier with existing customers. And in a recessionary environment where ROI becomes a bigger topic, that’s something we would lean into.
James Fish
Got it. You actually went directly where I wanted to go next, which was around your net retention rate, which has been mid-120s, let’s say, the last couple of quarters. And you have this now goal of roughly 130, I think you’ve talked about. And your enterprise net retention rate, when you look at that cohort, it’s a bit above that, of course that’s going to help move that as that mix shift happens. But is there a way to think about, I don’t want to say, cohort analysis or what that you see between years 1 versus 2 versus 3 in terms of that expansion opportunity? Does it even matter in this type of environment where the macro is just challenging?
Thomas Seifert
As I said, it’s an important metric for us. We’ve built a team around it as a strategy around it. There’s a ton of data science we throw at that problem. And it has shifted over time. If you understand where we come from, our first customers were what we call PayGo business, pay as you go business.
People give us a credit card, we charge them $20 or $200 a month. And if you go back even back to the S-1 and you look at our early customer cohorts, that’s what you buy is an all-you-can-eat plan, so to speak. And there’s hardly any chance for expansion. Those cohorts are flat. And flat is good because that means there’s no churn. So they are hard to expand, almost impossible to expand. But they are – they have extremely higher retention rates.
When we report on DNR, it’s an all-in KPI. So it includes those early cohorts and the revenue we generate from this [indiscernible]. So in a way, that’s why DNR buzz is a lagging indicator because it’s always diluted by these cohorts as the percentage share of enterprise continues to grow, gets bigger and bigger. That track becomes lesser kind issue. So that is a natural way how to explain that.
The second thing, which I think is really unique to us, the amount of products and innovation and features we put out every quarter, every year. This, even for me, after these many years, quite astonishing. We have more than tripled the TAM that we attacked in the short time since they’ve become a public company. So it’s hard to put a ceiling on DNR because they are constantly new products that can be sold, that can be expanded into from a customer perspective. We said we want to be benchmarking our peer group in the not-too-distant future. And I think with the amount of product that we put out that is a very achievable target.
James Fish
Yes, I would agree with you on the innovative side. It’s almost annoying from my seat is like, okay, what’s the newest product a Cloudflare this week. So it’s birthday week or Cloudflare One week or whatever. But actually speaking of that, it was a couple of months ago, you guys talked about the Cloudflare One partner program for the first time. And indirect is a small part of the business. And when you think about especially the Zero Trust world, your main competition there is selling through the channel. And so this is a major step for you guys. So I guess, first off, how big could the indirect business actually get to with this in place? Why is Cloudflare going to beat out to Zscalers, the Palo Altos for that indirect seat grab?
Thomas Seifert
For a long time, even till the end of last fiscal year, generally partner revenue was maybe in the 10-ish percentage points of overall revenue. And the main reason for that was if you look at what we just called a minute ago, our first wave of products was that there was little a partner or a channel could offer in terms of value-add implementing a product. I mean, this is what made us famous, right? Coming from this pay-as-you-go business, you want to protect your blog or your website as a critical journalist or just a normal individual. It takes less than five minutes to be behind our network, five steps.
We onboard the largest financial institution in North America, and the DDOS attack takes a couple of hours, right, not weeks. There’s no professional services involved and no cloud employees that go on site.
And this efficiency on the even most complex products didn’t offer room for partners to offer value. That’s why our general share was so low. This has changed with the second and third wave of products with Zero Trust, and especially with what we call our SD-WAN products, where you are on the trail after the MPLS spend because onboarding is more difficult. The partners can developed onboarding strategies and packages by vertical, by country, by use case. So that makes it attractive for us to go to a partner.
As I said, 10% was the share last year. If you look at some of our competitors, they arrive up to 80% of their revenue from that part of the go-to-market. So there’s plenty of room for us. What makes it attractive for us for partners to work with us is, for us, our second and third wave product, a highly margin-accretive product. That’s just how the infrastructure of the network was built.
They generate hardly any additional costs from a launch perspective. So we have a lot of margin to share with partners for selling a sour. So we attack this that segment, not by lowering prices, but by moving value to the partners, and the margin allows us to be coming back to what we discussed in the beginning to find the most disruptive path for it. So that’s why you’ve seen quite significant momentum over the last two quarters, signing up partners here in the U.S. but also internationally.
James Fish
One of the hot topics that came out of last quarter was annual versus monthly and the fact that we’re starting to look at more annualized contracts. So is there a way to think about how much of Cloudflare today? How much of the installed base or even just the enterprise base is actually annual versus monthly at this point?
Thomas Seifert
Yes, there’s some color we can give. I mean, going back to where we started, credit card monthly billing that’s driving the business. So our PayGo business today is a monthly business, and you can argue whether you can offer incentives to change that. On the enterprise side, that just rolled over. And I would say about 20% of our revenue last quarter was annually. 80% was still built monthly. So there’s a lot of room for us to improve.
I often get asked how fast can you do that and going to be diligent, right? It’s easier to do that with new customers because it’s all of our peer groups have annual or multiyear billings and contracts. So it’s actually quite easy from a new logo perspective, more touchy are the customers that are existing customers, and you touch them through the renewal cycle and interest depending on where they are, how important they are, differentiation that needs to be had.
But if we measure ourselves, and I do say 20-80 today, 20 annual or 80 monthly, our peer group probably looking just the reverse of that. So over time, this is where we want to be and there are no good reasons, so why chip in the flag.
James Fish
Your peers typically will have like a billing to revenue ratio of like 1.1% to 1.2%. Is that something that Cloudflare could actually get through from – or it’s roughly at today around, I think, 1.05%?
Thomas Seifert
Within ranges, yes, what happens to our PayGo business or bigger share instead of overall revenue. So there’s some gives and takes. But there is no reason why at least for the enterprise business, the contracted business, we couldn’t look like our peer group.
James Fish
Got it. By the way, audience, if you have a question, feel free to raise your hand, and I’ll call on you. But one of the other exciting parts to think about that’s GA here real shortly is R2. How should we think about what that business could look like? I mean, S3 at Amazon is a $10 billion to $15 billion business, depending on who you want to talk to. But obviously, we’re going to talk a little bit smaller today, but are we off to that running start come Q4.
Thomas Seifert
We repeated how we started. You think about product launch and revenue, we don’t. When we think about what we want to do, this mission of serving a better Internet, we take this very literal. So eliminating friction, eliminating charge point, eliminating inefficiencies is just a part of how we think about this universe. And R2 was born from the idea that there are a lot of interesting use cases, large logos, large customers that move data a lot, right?
So R2 is not for somebody to stores, pentabytes of data and never looked at it or archive it. But the heavy transaction, interaction in storage, where those customers generate incredible amounts of e-currencies. And we thought that is a charge point that can be disrupted.
And we’re an open beta now they. There are very large logos in the open beta. There are very large storage use cases that are being looked at. And the momentum is good. But we will not measure it in revenue for the first step, we’ll talk about who do we find on what interesting use cases, what can we learn.
There will be revenue. But we think it’s going to be an integral part of our business model moving forward. It comes back to what I after all these years, find most exciting is that the architecture allows you to have this completely fungible storage and compute capacity.
And this whole network surface is something that we can work with, how you shift customers, how you shift workload, how you – underutilized parts of the network because some part of the world is a lead. And we are running our open beta now without investing $1 into additional storage space, right? It’s just using what we have at this point, and I find this super fascinating. And that doesn’t mean that we need to invest moving forward and find creative solutions to that. But it gives you an idea how – what the elasticity of this network is from a compute capacity and the storage capacity perspective.
James Fish
Makes sense.
Thomas Seifert
No, you couldn’t expect that, right? You go from who buys load balancer to who buys Zero Trust. So the personas, we need to address – are changing, we’re adapting to that. That’s why our Area 1 acquisition was so important, not because it only added an e-mail product, but it is the door opener on a C-suite from a CECL perspective, especially for very large logos, sophisticated, persistent phishing attacks are the attack surface that is – that gets the most focus currently from an attacker perspective.
So having a product there, that is so superior to anything that else is out there, is good but it also open the door. It also allows us to show off the huge amount of threat intelligence we have and time the platform to talk about that.
So the personas are changing, we are adapting to that. It’s learning process. It doesn’t take away from the developer focus from a customer perspective, there’s still people that take us from home to work that happens quite often. We were just in – I was just in New York and an RFQ, there was a financial service institution. So I was part of sponsoring the meeting. And they were four people on the other side that were in [color] t-shirt that is a really nice start in our view. But it doesn’t take away from the fact that the performance are changing, and we need to adopt to that.
James Fish
Time for one last one, otherwise, I can ask. I got plenty.
Unidentified Analyst
[indiscernible]?
Thomas Seifert
Well, first of all, we are not a CDN. So that helps. So all this traffic that doesn’t provide value where you just move a bite from A to B, where we don’t have any Disneys and Netflix and HBOs. That is a highly commoditized service and you get auctioned off at the end of every quarter, and we don’t do that. We happen to have the fastest in the world because this is what you need to deliver security and performance services at the edge of the network without adding a flip from a latency perspective.
So the network was designed for speed to deliver security and not to deliver content. So that is one. So we don’t have this margin dilution in the revenue. We don’t have the volatility of consumption-based revenue either. So that helps.
The most important part is, however, what I said before, is the uniqueness of the architecture of the network, right? If you have a network where every product and every service we offer can run on every server in every city, then this complete network surface becomes your decrease of freedom how you manage costs.
And this is hard to replicate. I would argue it’s our biggest competitive mode because it needs significant scale in order to get there. And it’s highly defendable because literally every product we add had more decrease of freedom. Every server we add, regardless of where in the world, gives us more degrees of freedom. And this is where, I think, to the largest extent, the superiority of the margin performance there.
James Fish
I think our time out almost to the second there in terms of that. So I want to thank you for joining us, everybody, and especially to you, Thomas, for all your insights.
Thomas Seifert
Always a pleasure. Thank you.
James Fish
Thank you. Thanks, everyone.
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