Cloudflare - Q4 2022

Transcript

Phil Winslow (VP of Strategic Finance, Treasury, and Investor Relations)

Thank you for joining us to discuss Cloudflare's Financial Results for the Fourth Quarter of 2022. With me on the call, we have Matthew Prince, our Co-founder and CEO, and Thomas Seifert, our CFO. Michelle Zatlyn, our Co-founder, President, and COO, is unable to join us on the call today, as she is in Asia meeting with prospects and customers. 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'll be making forward-looking statements during today's discussion, including but not limited to our customers, vendors, partners, operations, and future financial performance, our anticipated product launches and the timing and market potential of those products, and our anticipated future financial and operating performance.

These statements and other comments are not guarantees of future performance and are subject to risks and uncertainties, much of which are 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. You should not rely on them as representing our views of 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. 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'd also like to inform you that we will be participating in Baird's 2023 Silicon Slopes event on March 2nd, the Morgan Stanley Technology, Media, and Telecom conference on March 8, and William Blair's 7th Annual Tech Innovators Conference on March 14. Before wrapping up, I would also like to invite you to join us for our Investor Day on Thursday, May the 4th, which is being held in conjunction with our user conference, Cloudflare Connect, in New York City. A live webcast will also be accessible from our investor relations website. With that, I'd like to turn the call over to Matthew.

Matthew Prince (Co-founder and CEO)

Thank you, Phil. It's great to have you on this side of the table. We had another strong quarter in spite of continued challenging macroeconomic conditions. We generated $274.7 million of revenue, up 42% year-over-year. We achieved a record operating profit of $16.8 million, representing an operating margin over 6%. We continue to invest to capture the huge market ahead of us, we believe that during economic slowdowns like the one we're in the midst of, it's important to show discipline and optimize for efficiency. We have our hands on the levers of our business and are adjusting them based on the macroeconomic conditions.

Our free cash flow in the quarter was $34 million, representing a free cash flow margin of 12% allowing us to generate $29 million of free cash flow in the second half of 2022. While there will be some variability in our free cash flow quarterly, we expect to be free cash flow positive in 2023 and the years after that. We achieved a gross margin over 77%, above our long-term target range of 75%-77%. Our dollar-based net retention ticked down to 122%. While our gross renewal rates remain as high as ever, like others in the industry, we're seeing customers take longer to sign new and expansion deals with us. Procurement departments are definitely in the mode of measure 2 or 3 times before cutting once.

We still see a clear path to a dollar-based net retention over 130% as we ramp seat-based products like Zero Trust and storage-based products like R2, and we won't be satisfied until we get there. We added 134 large customers, those that pay us over $100,000 per year, and now have 2,042 large customers, including 33% of the Fortune 500. Revenue from large customers grew 56% year-over-year, and they now contribute 63% of our total revenue. We were fortunate that given our visibility into the overall internet traffic and e-commerce trends, we started to see a slowdown in the economy all the way back in December 2021.

Based on that, around this time last year, we began slowing our pace of hiring to ensure we didn't get over our skis. That's paid off and kept us from having to take more drastic actions like many of our peers. It's also given us the ability to sensibly invest in our team as amazing talent comes on the market. To give you some sense, in 2022, we had over 400,000 people apply for approximately 1,300 positions at Cloudflare. That demand to work at Cloudflare has allowed us to continue to hire incredible talent while remaining disciplined in overall compensation. We are committed to incremental equity compensation dilution well below many of our peers, targeting less than 3% net burn rate annually. Tough economic times like these make you assess your strengths and weaknesses.

Cloudflare has long had a product and engineering team that delivered an innovation engine that is the envy of the industry. Jen Taylor, who leads that team, briefed me recently on everything we have lined up for the year ahead, and that engine is definitely not slowing down. Our next innovation week is in March with Security Week, where we'll be launching a number of new products and feature enhancements, especially around our Zero Trust products. While our innovation engine is the best in the industry and has unlocked a $125 billion total addressable market we have ahead of us, if we're honest with ourselves, our go-to-market organization hasn't yet been fully optimized. As our products have become more complicated and we are selling to larger and larger customers, it's increasingly clear that we need to step up our game in marketing and sales.

I introduced Marc Boroditsky, who joined last quarter to lead our sales organization. Last week, he briefed me and Michelle on his first 100 days. My initial reaction, if I'm honest, was embarrassment over some of the basic things we should have been doing better. My second reaction was excitement because there are so many opportunities for us to improve. In addition to Marc, Brent Remai joined us last quarter to lead our marketing team. Brent was previously CMO at FireEye and CMO of Core Services at AWS. His career perfectly prepared him for Cloudflare's delivery of cloud security services. We've seen early results with Brent's team generating pipeline in Q4 and January of Q1 coming in ahead of our targets. We've been leaders on the product and engineering side. Now we're focusing on becoming a leader in the go-to-market side as well.

I hear the excitement from our existing sales and marketing teams at the rigor and discipline Marc and Brent are bringing to those teams. What I'm watching carefully is another important pipeline, the pipeline of new sales talent. We're seeing incredible people from the leading sales team in the world apply to work at Cloudflare. We aim for nothing less than to build one of the leading sales organizations in the world. That's all exciting. While I believe there's a substantial opportunity for us to improve our go-to-market engine, I'm also cognizant that these efforts can take time. That's why we're not relying on any improvement in sales or marketing efficiency or any rebound in the economy as we look at the year ahead and formulate our guidance. Focusing on the present, let me highlight some customer wins from the quarter.

A Fortune 500 energy company signed a 3-year, $1.6 million deal that was a takeout of a first-generation Zero Trust networking competitor. We were replacing both their Secure Web Gateway and Zero Trust Network Access products. Because the competitor's network is actually broken into multiple distinct clouds as compared with our unified network, their reliability and performance were underperforming the customer's expectations. We were able to replace the competitor's feature set and more. The customer ultimately purchased Gateway, Access, Remote Browser Isolation, and DNS filtering. The customer was attracted to our better pricing, performance, and ease of use, as well as the single pane of glass manageability of our platform. We worked with a large channel partner to win and service this customer and expect we'll be doing more with them going forward.

A Fortune 500 financial services company expanded their relationship with Cloudflare, signing a 3-year, $1.1 million deal. They've been a Cloudflare customer since 2014 using our core application services. Like we're hearing from many of our customers, they wanted to consolidate vendors, reduce costs, and have more flexibility and control over their traffic flows, as well as implementing a Zero Trust architecture. They wanted to move away from legacy on-premise hardware to modern cloud-based services. The customer loved that we have a single pane of glass solution and that our technology is built from the ground up on a single platform rather than a Frankenstein solution bolted together through M&A. They purchased Access, Gateway, Remote Browser Isolation, Magic WAN, and Magic Firewall. They're a terrific customer.

A Fortune 500 telecom signed a $400,000 1-year deal to bring a portion of Cloudflare's Zero Trust services to their consumer base. They're bundling Cloudflare's DNS content filtering into their consumer security bundle. After evaluating competition, they found Cloudflare's solutions to be the most secure and reliable on the market. This deal is not only valuable for the obvious reasons, but also because it will feed data back to our Zero Trust security products to further extend their lead over the competition. A leading generative AI company signed a 1-year, $1 million deal. The company had been a user of our free tier since 2017, and this deal originally started out as a relatively small Gateway DNS opportunity to replace Cisco Umbrella. However, when their browser-based application debuted in late November, demand for the company's AI-generated content absolutely exploded with unprecedented rates of adoption.

Their Azure Front Door setup quickly proved insufficient at handling the massive load on their services from legitimate users, as well as keeping fraudulent users from exhausting their resources. They started off with CDN, DDoS, Bot Management, Gateway DNS, and more. We are actively exploring various paths for expansion to support their incredible growth, as well as emerging use cases of their AI models and applications with Cloudflare Workers, API Shield, Image Resizing, and more. We saw success with other AI companies in the quarter as well. Given the resource constraints they all face, as well as how attractive they are as a target to fraudulent users, Cloudflare's security solutions are an obvious choice for all of them. But many of them came to us for other reasons as well.

AI companies in particular need to find wherever it's most cost effective to run their models across multiple different cloud providers. They are by their very nature multi-cloud, but the data egress policies make it prohibitive to move large training sets between the clouds. Enter Cloudflare Workers. What we're finding with these AI companies is that R2 and other Workers products naturally become the glue at the center of a multi-cloud ecosystem. R2 has become the natural neutral place for these AI companies to store their training data in order to make sure it can be inexpensively and efficiently accessed from anywhere. It's obvious in retrospect, but it's a use case we didn't anticipate. Today, our largest R2 customer is another AI company using us for exactly the purpose of being a neutral place to store their training data.

Of course, being a neutral network Supercloud that stitches together the traditional public clouds isn't a problem exclusive to AI. A European financial services company signed a 5-year, $1.8 million deal, replacing 12 different security and network vendors with Cloudflare. This company settles hundreds of millions of securities transactions annually for the largest banks and governments in the world. As a result, security and regulatory compliance are paramount for them. They wanted to consolidate and simplify their numerous point solutions into a single pane of glass solution. After receiving regulatory approval, the customer signed on for multiple solutions across our core application services portfolio, as well as both Zero Trust and network services of Cloudflare One, including Access, DNS filtering, and Magic Transit.

In addition to consolidating their spend across multiple point solution vendors onto Cloudflare's broad platform, our Data Localization Suite, in particular, won them over. Competing vendors simply do not have an equivalent solution. As companies increasingly face localization and data residency requirements becoming law in various geographies, our differentiated Data Localization Suite is becoming more and more critical to customers. A public utility company in Africa signed a $2.8 million 75-month deal to help support a really cool industrial IoT rollout. They're using Cloudflare's intelligent network to monitor 3,300 sensors, tracking shipments of materials. This is another use case of Cloudflare's network we wouldn't have imagined on our own, but one we're uniquely positioned to deliver for the customer, and now opens even more markets and opportunities. The state of North Carolina signed a 3-year, $3 million deal.

The state had originally come to us under our Athenian Project for free help with election security. They learned the power of Cloudflare using us to protect their elections infrastructure and signed the deal to expand Cloudflare's protection across 50 state agencies. I'm happy to report that after a longer than expected wait at the proverbial DMV, we officially received Cloudflare's FedRAMP certification. The certification covers nearly our full suite of products, with the notable exception of Area 1 email security product, which we acquired after we started the FedRAMP process, but we expect to add it to our certification at the FedRAMP renewal. Our first federal contract after our certification was a great start. We were awarded the $7.2 million 5-year deal to operate the .gov registry.

We were awarded the contract because of our modern infrastructure, technical prowess, relentless innovation, and proven ability to defend against the largest cyber attacks. Every email sent to the White House, every agency's webpage, and most of the other ways the U.S. government connects to the Internet now depend on Cloudflare and our network. We're proud to have won this business, the public sector space is only 3% of our revenue today. We believe it's only the beginning of what we'll be doing in the future. With that, I'll turn it over to Thomas. Thomas, take it away.

Thomas Seifert (CFO)

Thank you, Matthew, and thank you to everyone for joining us. I want to take a moment to welcome Phil Winslow, our new VP of Strategic Finance, Treasury, and Investor Relations to the team. As an influential equity research analyst who has been following Cloudflare even before our IPO, Phil brings a wealth of knowledge, expertise, and relationships to his role at Cloudflare, and we are excited to have him on board. Turning to the fourth quarter, economic uncertainty resulted in businesses being more cautious with their spending, leading to longer decision-making processes and ultimately longer sales cycles during the quarter, pressuring revenue growth across the technology industry, including Cloudflare. We remain focused on controlling what is in our control, which is to maintain our commitment to the efficient unit economics of the business and to prudently allocate capital with a focus on maximizing shareholder value.

As a result, we delivered a record quarter in terms of operating profit, operating margin, and free cash flow. I'm particularly proud of our free cash flow performance during the fourth quarter. We are committed to continuing to scale free cash flow generation going forward. Turning to revenue. Total revenue for the fourth quarter increased 42% year-over-year to $274.7 million. From a geographic perspective, the U.S. represented 53% of revenue and increased 44% year-over-year. EMEA represented 27% of revenue and increased 42% year-over-year. APAC represented 13% of revenue and increased 40% year-over-year. Turning to our customer metrics in the fourth quarter.

We had 162,086 paying customers, representing an addition of roughly 22,000 paying customers in 2022 and an increase of 16% year-over-year. We were pleased to see retention improve in the pay-as-you-go customer base in the fourth quarter, returning to the levels we achieved in the late 2020 through early 2022. Turning to large customers. We ended the quarter with 2,042 large customers, representing an increase of 44% year-over-year, an addition of 134 large customers in the quarter. During the quarter, we also added a record number of net new customers paying us more than $500,000 a year.

As Matthew mentioned earlier, we are also pleased to see large customer revenue contribution increase again sequentially to 63% of revenue, up from 57% in the fourth quarter last year. For fiscal 2022, large customers represented 61% of total revenue compared to 54% of total revenue in 2021 and 46% in 2020. For the full year, we are also breaking out large customers into cohorts of those who spend greater than $500,000 and $1 million. We ended the year with 222 customers that spent over $500,000 with us, an 83% increase year-over-year. We ended the year with 85 customers that spent over $1 million with us, a 52% increase year-over-year.

Our dollar-based net retention rate was 122% during the fourth quarter, a decrease of 200 basis points sequentially, and a decrease of 300 basis points year-over-year. We've not experienced elevated churn. Instead, similar to last quarter, the decline was primarily driven by less net expansion in customers spending less than $100 thousand with Cloudflare, as well as pay-as-you-go customers. Conversely, our large customer net expansion was flat quarter-to-quarter and remains consistent with our average quarterly DNR for this customer segment since the end of 2019. We continue to expect DNR to trend upward over time to our long-term target of 130%+. We anticipate some variability from time to time, particularly as customers are more cautious in their near-term spending, which as I mentioned before, has impacted sales cycles.

Moving to gross margin. Q4 gross margin was 77.4% and 78.2% for fiscal 2022, both of which remain above our long-term target range of 75%-77%. Network CapEx represented 10% of revenue in Q4. For full year 2022, network CapEx represented 11% of revenue as compared with our guidance at the beginning of the year at 12%-14%, which demonstrates the flexibility, elasticity, and scalability we have achieved in our network. For fiscal 2023, we expect network CapEx to be 11%-13% of revenue. Turning to operating expenses. There are economic challenges for every business currently. We again took proactive measures during Q4 to improve operational efficiency and control discretionary spending.

As a result of these actions, fourth quarter operating expenses as a percentage of revenue decreased 1% sequentially and 7% year-over-year to 71%. Our total number of employees increased 32% year-over-year, bringing our total headcount to approximately 3,220 at the end of the quarter. We'll continue to pace hiring for the year based on current market conditions to deliver consistent results with a keen focus on allocating our talent to key strategic areas of the business to help us achieve our objective of $5 billion in annualized revenue in 5 years, and to do so profitably, predictably, and productively. Sales and marketing expenses were $113 million for the quarter.

Sales and marketing as a percentage of revenue remained consistent sequentially and decreased to 41% from 44% in the same quarter last year. Research and development expenses were $49.4 million in the quarter. R&D as a percentage of revenue remained consistent sequentially and decreased to 18% from 19% in the same quarter last year. General and administrative expenses were $33.3 million for the quarter. G&A as a percentage of revenue decreased by 1% sequentially and decreased to 12% from 14% in the same quarter last year. Operating income was $16.8 million compared to an operating income of $2.3 million in the same period last year. Fourth quarter operating margin was 6.1%, an increase of 490 basis points year-over-year.

These results underscore our responsiveness to market conditions and our ability to scale up or scale down our spending as needed to meet demand, highlighting the efficiency and elasticity of our business model, which remain key elements of Cloudflare's success. Turning to net income and the balance sheet. Our net income in the quarter was $21.6 million or diluted net income per share of $0.06. Tax expenses for the quarter was $2.3 million. We ended the fourth quarter with $1.6 billion in cash equivalents, and available for sale securities. Free cash flow was $33.7 million in the fourth quarter or 12% of revenue, compared to $8.6 million or 4% of revenue in the same period last year.

Operating cash flow was $78.1 million in the fourth quarter or 28% of revenue, compared to $40.6 million or 21% of revenue in the same period last year. Remaining performance obligations or RPO came in at $907 million, representing an increase of 9% sequentially and 45% year-over-year. Current RPO was 74% of total RPO. Before moving to guidance for the first quarter and full year, I would like to begin with our expectations and the provisions we have factored into guidance. We performed rigorous scenario analysis across multiple vectors from pipeline and ACV growth to productivity in order to understand both our company's specific opportunities as well as the risks from the current economic uncertainty.

In our guidance, we have not factored in any improvement in the macroeconomic environment or from our go-to-market initiatives. Specifically, despite a notable improvement in our pipeline exiting 2022 as compared with the first half of the year, we have assumed the increase in sales cycle, which we observed in the second half of last year, continues in 2023 and have therefore incorporated close rates below recent historical lows. As Matthew discussed earlier, we believe sales and marketing can be broken down into a series of processes that can be organized, measured, and continuously optimized. Marc and Brent are establishing a consistent structure, model, and process that simplifies how we operate and how we interact with prospects, customers, and partners.

Because the new leadership team we've already assembled has successfully executed these go-to-market playbooks before at other companies, we are confident in the ramp of implementing these models and tactics, which we expect will ultimately improve revenue growth and productivity. However, we have not incorporated any improvement in sales productivity in our guidance for 2023, embedding, in fact, productivity levels below our recent historical lows. Turning to guidance for the first quarter. We expect revenue in the range of $290 million-$291 million, representing an increase of 37% year-over-year. We expect operating income in the range of $11.5 million-$12.5 million. We expect dilutive net income per share of $0.03-$0.04, assuming approximately 342 million common shares outstanding. We expect an effective tax rate of 36%.

For the full year 2023, we expect revenue in the range of $1.33 billion-$1.342 billion, representing an increase of 37% year-over-year at the midpoint. We expect operating income for the full year in the range of $54 million-$58 million, and we expect dilutive net income per share over that period in the range of $0.15-$0.16, assuming approximately 344 million common shares outstanding. We expect an effective tax rate of 36%. Beginning in 2023, Cloudflare is subject to BEAT, the Base Erosion and Anti-Abuse Minimum Tax, which is the primary driver for the increased tax rate year-over-year.

After having achieved positive free cash flow in the second half of last year, we anticipate being free cash flow positive for the full year 2023. While we expect free cash flow to trend upward on an ongoing basis for modeling purposes, we anticipate near-term variability in our cash flow generation, with the first half of 2023 expected to be relatively break even. We remain confident in the elasticity and durability of our business model and will continue to pursue the enormous opportunity ahead of us while raising the bar on our operational excellence. In closing, I'd like to thank our employees for the continued dedication to our mission, customers, and partners. With that, I'd like to open it up for questions. Operator, please poll for questions.

Operator (participant)

Thank you, sir. Once again, it is star one if you have a question today. We will take our first question from Matt Hedberg, RBC Capital Markets.

Matt Hedberg (Managing Director and Software Research Analyst)

Great. Thanks for taking my question, guys. Congrats, Phil, on your new role. Looking forward to working with you, on that side of the table. I guess one of the questions I'm getting is around the conservatism in your 2023 revenue outlook. Obviously, Thomas, you talked about some of the levers of conservatism, but I guess, you know, with 37% growth for both Q1 and the full year, you know, obviously your comps ease as the year progresses. Is there something that, you know, perhaps kicks in during, you know, Q2 or the second half of the year, like maybe like your price increase you announced last year, or maybe a large customer renewal that would drive linearity this year?

Thomas Seifert (CFO)

John, I think we stick to our rule of trying to be prudent and thoughtful how we think about the future, especially in a rather uncertain environment. I think that the important takeaway in the guidance that we put forward is that we did not assume any help from the macroeconomic environment. We did not plan that things would get better. We have a lot of initiatives that will accelerate sales productivity and accelerate growth, things that we can control. But we've been rather conservative there too, in terms of what we anticipated in the guidance we gave.

I think it was our goal in a world where there are a lot of variables that shift around to find some ground of stability from which where we can build on moving forward. I think prudent is what we said during COVID, and thoughtful is what we said during COVID. I think we stick to that philosophy, keeping our hands on the steering wheel, as Matthew would call it, and work on what we can control.

Matt Hedberg (Managing Director and Software Research Analyst)

Great. Maybe just a quick one, Matthew. You know, within your security portfolio, you noted some nice wins in your prepared remarks. I'm wondering, can you talk about maybe just some of the win rates specifically on your enterprise-grade customers within Zero Trust deals, I guess specifically against some best-of-breed customers that you noted on the call?

Matthew Prince (Co-founder and CEO)

I think that we're really happy with our win rates. What I think our challenge is in the Zero Trust space is not winning customers that know about us, but making sure that customers, that are in the market for Zero Trust services, are aware that that's something we do. The frustration that I still have is when I'll meet with a customer and oftentimes they'll literally say, "You should build, you know, something that is in the Zero Trust space competing with a Zscaler or a Palo Alto Networks." When we're in those deals, we find ourselves winning very often.

I think we are especially successful with very technical, rigorous companies that measure performance and care about making sure that they have the best possible end user, and especially developer experience. Our challenge now and what Brent and Marc are really focused on is how in that space do we increase our awareness. I think you're gonna see a lot of us doing that. When we're in the deal, we tend to have very, very strong win rates that rival what we see from our other products.

Matt Hedberg (Managing Director and Software Research Analyst)

Great. Thanks, guys.

Operator (participant)

Next up, we'll hear from Sterling Auty, SVB.

Sterling Auty (Senior Managing Director on Technology Equity Research)

Thanks, guys. Matthew, I think it'd be helpful for investors to understand, you had talked about the AI opportunity and the use cases, but help investors understand how the revenue opportunity with those types of customers actually ramped, you know, since you have that subscription model versus a consumption model.

Matthew Prince (Co-founder and CEO)

Yeah. The way that's sort of been natural way that we thought companies like AI companies would consume Cloudflare would be looking at our security products, and those are products that, as you said, are subscription-based. They, you know, there's some opportunity there, but there really aren't yet that many AI companies. That opportunity, you know, is fine, but I don't think it's anything that we would get, you know, really excited about. I think what we're seeing though is in that cluster of AI companies, they have a real use case for the cloud, which is somewhat different than what we see, you know, some from some other companies.

It is, I would say, more forward-leaning, and that is that they're constantly looking for wherever the best model or wherever the cheapest GPUs are to process their data. They are looking around across multiple different cloud providers, whether that's Google or Microsoft or AWS, and they're always saying, "What can we take advantage of and get as much out of that as possible?" What the challenge for them is, the AI training sets are these big lumps of data that they then have to sort of bring to wherever the model or bring to wherever that GPU is.

In that case, a lot of the Workers products, and in particular our R2 product, are a very natural way that they can put the data in one neutral location and then be able to access it all around in other locations as well. What we're seeing is that that neutral position of R2 is actually not just appealing for people in the AI space, but for anyone that has shared data that they want to use, not in just one cloud, but across multiple different clouds. I think by having a way to embed data into the network and store data into the network, that is an opportunity for us to service anybody who is trying to be multi-cloud, which is frankly what every big enterprise today is doing. In that case, R2 is very much a consumption-based product.

As AI data sets get larger and larger, we expect that we will be able to grow R2 revenue along with that. Actually, our largest R2 customer, as I mentioned, in the prepared remarks, is a AI company, and they're growing at just extraordinary rates, as they put more data into their models.

Sterling Auty (Senior Managing Director on Technology Equity Research)

Just a quick follow-up is how much of that ramp is factored into the full year guide?

Matthew Prince (Co-founder and CEO)

You know, I think that we are not looking for anything exotic here. I think again prudence is very much the sort of word of the quarter for us. I think that we're not sort of counting on, you know, something that is the new hot thing doubling down on Cloudflare. While we're very proud of what we have done with companies in the AI space, and we're excited about the ramp in products like R2 and the overall Workers ecosystem, we still think of that more as a long-term opportunity than a short-term, you know, quarterly or even 2023 opportunity.

I think that we're not relying on sort of an AI miracle in order to make the numbers that we that we put up.

Sterling Auty (Senior Managing Director on Technology Equity Research)

Understood. Thank you.

Operator (participant)

Next up, we'll take a question from Jim Breen, William Blair.

Jim Breen (Senior Equity Research Analyst)

Thanks for taking the question. Just one is a little bit of a runoff from that one. Just around some of the new products that you launched, the went full in the back half of last year, R2 being one. Could you just give some commentary around how that's picking up and, you know, launching those into maybe a more challenging sales environment, has it helped keep the NDR a little more stable than otherwise could have been? Just financially, Thomas, if you could just talk a little bit about the decline in operating income sequentially into the first quarter, you know, the seasonality there and what's happening? Thanks.

Matthew Prince (Co-founder and CEO)

Yeah, Jim. I'll start and then Thomas can take the second part. I think we're really happy with the ramps of those new, those new products. You know, Cloudflare, we've always thought of ourselves as stacking, you know, S curves one behind another. I always think of of sort of our application services products as sort of our first act. We think of our Zero Trust products as our second act, and we think of our Workers products as our third act. I think that they're maturing at rates that are that continue to make us very excited and happy, and we're seeing more and more new use cases that are coming from that.

I think some of the, you know, trade-offs around NDR are, have been interesting here. One of the things that we really, you know, talked about last quarter optimizing for was just our how we did cash collections and converting customers to paying upfront. I think that, you know, one of the things that we made a trade-off on was, you know, at times saying we would optimize for getting more customers to be paying us, you know, upfront, and that might not, you know, allow us to expand those customers as much in this quarter. I think that's the right thing for us to do.

We want to optimize in these times, making sure that we can co-collect cash as quickly as possible, can be, you know, paid upfront as much as possible. continues to be an ongoing effort for us. I think that that was more of a drag on DNR. I think you'll start to see as those new products come online, that those will be positive. Remember that DNR only starts to kick in for a customer that's been with us for an entire year. For those products that are new, they, even if they are wildly successful, the expansion won't actually show up in our numbers until 12 months after the products were actually in the market.

Thomas Seifert (CFO)

The all of last year was a year where we did very active management of our expenses, and we reacted really early to the slowdown in the macro environment by slowing down our hiring, especially the velocity of hiring. We'll stay committed to this course during the course of this year and align our spending to the development of the business. You know, there were a lot of companies out there during this season's earnings calls that talked about efficiency. You know, I always like to point out that efficiency is DNA, in the DNA of the company of Cloudflare. That is something that Matthew and Michelle already wrote in the founder letter for their prospect for the S-1.

This is what you want to expect from us, not only for the first quarter, but for the remainder of this year, as long as the environment, is what it is.

Jim Breen (Senior Equity Research Analyst)

Great. Thanks.

Operator (participant)

We'll go to Shaul Eyal with Cowen.

Shaul Eyal (Managing Director of Equity Research)

Thank you. Good afternoon, guys. Congrats, Phil, on the new role. Looking forward to working with you. Actually two product related questions for Matthew this afternoon. Starting with Workers. Earlier today, Shopify came out with a press release discussing speeding up their storefront in 2023. Reads like it is based on Cloudflare Workers. I think back in the summer actually, they also had a blog where they confirmed the shutdown of their internal project Oxygen, opting out to Cloudflare. Can you talk to us, Matthew, about Shopify relations, maybe just a flavor on Workers and additional win rates?

Matthew Prince (Co-founder and CEO)

Shopify has been a terrific Cloudflare customer for a number of our different products, including Workers. I think what we've talked about in previous calls is that one of the most effective ways for us to sort of turbocharge the adoption of Workers is to work with other great partners that have an existing developer ecosystem. We were proud that Shopify has really standardized around Cloudflare Workers. We've worked with them to make sure that we're doing the right things for the overall community, that we've open sourced, for example, the runtime of Workers.

I think that as you see companies like that adopt Workers for their developer platform, that's a real opportunity for us to again turbocharge what Workers is and make sure that more developers are on top of it. What's incredible is just watching how as again, we get more reps with really talented and smart engineering teams like the team at Shopify, that's just making the Workers platform better for everyone involved. Again, we're really proud to have them as a customer.

Shaul Eyal (Managing Director of Equity Research)

Understood. Understood. Maybe back to the security side of things. Matthew, in your prepared remarks, you talked about that, you know, big win, big security win displacement, but I'm just curious whether it also involved the email security, kind of the Area 1 related product?

Matthew Prince (Co-founder and CEO)

Yeah, I want to be careful that I might misspeak, but I don't believe that Area 1 was included in that particular deal, so that's still an expansion opportunity with that customer. We do see that email security is a terrific entry into getting people to move to our Zero Trust platform. The reason why is that with Zero Trust, one of the first challenges is enumerating, you know, how many people are within an organization, how many seats effectively does that organization make up. If we can get somebody to use our email security product, that inherently defines that in a very natural way. Migrating somebody from sort of the, our application services portfolio to our email security portfolio is one click.

It's a simple DNS change. They don't have to. They can continue to use, you know, any of their existing email vendors, and we effectively just proxy that traffic and are able to provide additional layers and enhancement of security as well. Once we've done that, it then makes it a very natural step to go from the email security product to the rest of our Zero Trust suite. That is a standard play that we run. It's very successful, but in the case of this particular oil and gas company, it wasn't the reason that they adopted us for Zero Trust. Hopefully, hopefully we can go the other direction as well.

Shaul Eyal (Managing Director of Equity Research)

Thank you.

Operator (participant)

Next up is Joel Fishbein, Truist Securities.

Joel Fishbein (Managing Director)

Thanks for taking my questions. Congrats to Phil as well. Matthew, for you know, I wanna take a step back. You know, notwithstanding the current economic situation, I would love to just talk about the barriers to entry for Cloudflare and your top priorities for the next 3 years, in terms of growing the business.

Matthew Prince (Co-founder and CEO)

Yeah. Joel, by barriers to entry, do you mean, for competitors competing against us or what exactly do you mean by that?

Joel Fishbein (Managing Director)

Yeah. Exactly, Matthew. I think that there's a little bit of, you know, in the investment community, there's a little bit of thought process that it's easy to do what Cloudflare does and as you and I both know, that's not true. I think it's important for you to explain that, you know, from the perspective of, you know, how difficult it is to provide the services that you do.

Matthew Prince (Co-founder and CEO)

Sure. You know, I think the thing that is at the core of Cloudflare is our network. The reason that our ticker is NET and not CLFLR is because of the fact that we are fundamentally a network, and that network has taken us, you know, over 12 years to build. It is not something that you can just throw money at and buy your way into. It's not something that even some of the large hyperscale public clouds have.

You know, we hear regularly from companies like Microsoft that they're like, "Wow, you guys have something very special in the network you've built, and it is very different than anything else that's out there." The somewhat counterintuitive bit about our network is that as we expand into, you know, further corners of the universe, whether that's, you know, opening an additional data center in St. Louis or going into, you know, Djibouti, any of those things actually help us lower our costs because it drives down the cost of delivering all of our services.

The other important bit is that unlike some of the competitors that are out there, whether those are competitors in the application services space that have grown through a series of M&A acquisitions or even in the Zero Trust space, you know, someone like Zscaler actually runs multiple independent networks to provide their various services. That means that if customers that are using those different services, not only is it more inefficient for them to service those customers, but those customers experience very performance setbacks, when they're delivering their services. That's something that, you know, a lot of the customers that are switching from Zscaler to us, note time and time again.

What's different about us is we have relentlessly said that we run 1 single network, and every single server across our entire network is capable of running and performing any of the functions that we may need it for. That means that as we grow our services, it allows us to deliver them incredibly quickly, incredibly efficiently and anywhere in the world. And that is paying off today by allowing us to continue to scale as efficiently as possible. You know, I think that it was a unique period of time, you know, 12 and a half years ago when Cloudflare started, that allowed us the conditions and opportunities to build the company.

I think it would be very challenging today, for somebody to replicate the network that we have. That network continues to allow us to deliver more and more services, whether that's our traditional application services, the Act 1 products, our Zero Trust services, the Act 2 products, or even the Supercloud products that we have with Workers, which are our Act 3 products. All of those rely on that network and the efficiency that it has, and I think that's where the fundamental barrier to entry to our products is. The other thing which is important is we just experienced significant network effects. That comes in a number of different ways.

You know, one is just with every piece of data that we see, we're able to make our security products significantly better. The fact that that consumer, ISP is rolling us out to all of their customers that use their security bundle, that's just feeding data back into our system, which makes us smarter and smarter across that. It's more than that. The fact that we are today somewhere in front of 20%-25% of the web, means that for customers that use our Zero Trust products, if they are going to that 20%, 25% of the web that uses us, then they never have to leave Cloudflare's network, and we can deliver a much more significant product.

As we are in front of more content and as we are in front of more eyeballs, that just makes the experience for both sides of that network better and better, and that catalyzes a network effect, which again, is very difficult for other competitors to catch up with. We like our position. We like where we are for the next 3 years, and we continue to be committed to our goal of getting to $5 billion of run rate in 5 years from last quarter.

Joel Fishbein (Managing Director)

Really appreciate it. Thank you so much.

Operator (participant)

We will now hear from Andrew Nowinski, Wells Fargo.

Andrew Nowinski (Senior Research Analyst)

Great. Thank you. Congrats on the great quarter and the really strong guidance for the year. I wanted to start with a question on that big Fed deal. I know you mentioned a lot of interesting deals, but I wanna dig into the $7.2 million, 5-year deal with the Fed. First I guess, you know, will that be recognized as revenue ratably over the next five years? Then did they bake in any sort of expansions that might not yet be included in that $7 million? Because it seems like that's a, you know, certainly a lot of your big competitors are very strong in that space as well.

I was just curious like how, you know, how it progressed, how you want it and, you know, what might also be down the road in that deal.

Thomas Seifert (CFO)

Maybe I get started. There's no expansion baked into the deal. That's the deal we signed, and that's the deal we announced. If there is expansion opportunity, it will add to that opportunity. Revenue will be recognized ratably. It's a little bit more tricky. It's not necessarily linear over the contract period. It's the amount of entities that are signing up and how fast they are on our network. For modeling purposes, you know, to assume a ratable distribution over the lifetime of the contract is probably a good start.

Andrew Nowinski (Senior Research Analyst)

Okay. Thank you, Thomas. It looks like, you know, your channel momentum has continued, and I think, you know, channel accounted for about 13% of revenue this quarter, which is the highest it's ever been. I guess, where are you seeing that traction from? Is that more from the GSIs or the traditional resellers?

Matthew Prince (Co-founder and CEO)

You know, I think that channel remains a big opportunity for us, but we're proud of the progress that we've made, and it's a real priority for Marc as he's there. I think that we're seeing both the traditional resellers as well as some of the GSIs that are increasingly adopting Cloudflare. I think the big opportunity here is really Act 3 and then to some Act 3 products. We're seeing Act 3 products, those are very much products that oftentimes we are winning in cooperation with a channel partner. Those initial wins help unlock future wins going forward.

The second thing that we're seeing is that in our Act 3 products, a lot of times, we're seeing as customers are coming to their partners to say, "You know, we're looking to consolidate vendors, we're looking to save money on some of our cloud spends," that we're seeing more and more that Cloudflare is a solution that is in the toolkit for people who are trying to figure out how they can save money. So moving from an S3 to an R2 is a substantial savings. And we're seeing that even with some non-traditional partners. So someone like a Palantir we announced a partnership with, they were driving a lot of their customers to their cloud solution.

They saw how much money was wasted in some of the public clouds and so built a tool to help people understand what their cloud spend was. They came to the conclusion that oftentimes if customers could move more of their workloads to Cloudflare Workers, that was a real money saving for them. Again, that spend, it's early days, but we think that's definitely, you know, saving money, consolidating vendors, those are all gonna be trends throughout 2023, and we're very well positioned to be able to help partners as they work with their customers to take advantage of those trends.

Andrew Nowinski (Senior Research Analyst)

Okay. Thank you, guys, and congrats, Phil.

Operator (participant)

Alex Henderson Needham is up next.

Alex Henderson (Managing Director Security, Data Networking, and Optical Research)

Thanks for the great print and welcome to have you on board, Phil. I was hoping you could talk a little about as we're at the end of the year here, about how many coders are currently working on your platform and give us an update on that. I think that is the major positive strategic advantages that you have, you know, going to an earlier question.

Matthew Prince (Co-founder and CEO)

Yeah. I think that we announced at the end of last year that we'd crossed through 1 million developers that were building on Cloudflare Workers. I don't know what the latest numbers are on that, but the growth rates have continued to drive more and more developers to that. Again, partnerships with companies like a Shopify that have their own developer ecosystem just further accelerates the number of people who are using Cloudflare Workers. And we're doing more and more.

I think one of the exciting things that we announced yesterday was a very small team on our side, you know, wanted to see if they could get Mastodon, which is sort of the open source federated Twitter client, to run on Cloudflare. That's a fairly sophisticated application. They built not only a way for them to deploy that for any developer to be able to deploy that on Cloudflare Workers, it scales just beautifully. Where, you know, if you wanted to build, you know, kind of the next generation Twitter that just scaled and scaled and scaled, they have proven that that can be done on top of Cloudflare Workers.

I think we're starting to see more and more sophisticated applications like that get built on Workers and that's an exciting development for us.

Alex Henderson (Managing Director Security, Data Networking, and Optical Research)

The second question I wanted to address was your strategy around pricing. I know back in November you raised prices for the first time in, was it a decade? Which is pretty amazing in and of itself. Can you talk about the magnitude of the pricing lever as we look at the full year for 2023, and whether that is broader than just the low-end entry fees?

Matthew Prince (Co-founder and CEO)

You know, I think that we were very hesitant and a little bit nervous about raising pricing. Cloudflare is fundamentally infrastructure for our clients, and we wanna be reliable and predictable for them, and so we thought about this a lot. The primary goal of the price increase, which was really only for our pay-as-you-go business, which is well less than 20% of Cloudflare's revenue. The primary goal was to shift that business from what was mostly a monthly payment business to one that was paid upfront and annually. If you pay us upfront annually, you can keep the same price that we've had historically.

You know, we sort of we obviously did all the work, talking to users, figuring out what the tolerance was, but you have to just sort of hold your breath and see what happens. We've seen a handful of examples, you know, where I think with Slack, I think with Shopify, they've had price increases that have gone over well. We've seen a handful of price increases from companies where there's really been pushback that they've received. I'm really happy that our customers...

If anything, I think we were very pleasantly surprised how many of our customers said, you know, over the course of the last 12 years, Cloudflare has added so much additional value that they want to pay us more. We've seen a substantial number convert already to the annual billing, which is great 'cause it's helped us pull forward some cash, which is important. The second is that those people who we had price increases for, and it was about a 25% price increase that. Actually, no, it so it went from $20 to $25, so not 25%. That's me misspeaking.

That was, that was a, that was well-received and we have not seen elevated churn, as a result of that. It's been a about as, it went about as smoothly as we could possibly have hoped.

Alex Henderson (Managing Director Security, Data Networking, and Optical Research)

Yeah. No.

Thomas Seifert (CFO)

Operator, we have time for one last question.

Matthew Prince (Co-founder and CEO)

Alex, what was that?

Operator (participant)

That final question today will come from Trevor Walsh, JMP Securities.

Trevor Walsh (VP of Equity Research)

Great. Thanks for squeezing me in and taking my question. Matthew, thanks for the color around the SLED business and congrats on hitting the FedRAMP certification. You indicated that you thought 3% was, I think, low. You said only 3%. Just curious around that public sector business, kinda what you think the, you know, the kind of the opportunity is and maybe what's held you back on that front up to now and if any of your sales and marketing, your new leaders there have kinda any plans to kinda help expand that part of the business. Thanks.

Matthew Prince (Co-founder and CEO)

Yeah, you know, I think we have had some business around.

Thomas Seifert (CFO)

We just lost Matthew, I step in until he gets his line back. You know, the federal business, as you know, is a very local business. Getting all the certifications in place across the globe was one of the big targets, we have made great progress both in Europe and now finally also here in the U.S. As the certifications have been coming in and the products and the data centers get certified, we have been building up the teams in parallel, not only here in the U.S., but also outside of the U.S., especially in Europe, we expect business to grow with it. I would shy away from giving a concrete target or number for this year.

You know, as you heard from Matthew, we think we have an overwhelming opportunity in front of us. Now with the certifications in place and the team that gets hired, we are quite excited about this space.

Trevor Walsh (VP of Equity Research)

Great. Thank you.

Thomas Seifert (CFO)

I think Alex was cut off on his last question. I think he wanted to find out how much of the price increase was baked in in our guidance. I think it's fair to assume, and you can draw that conclusion from Matthew's comments, for this year it's probably more a tailwind to cash flow than it is a tailwind to revenue. Most of the customers have opted in to convert to annual billing and lock in the historic prices for one more year. Less of a tailwind for revenue, but more a tailwind of cash flow, free cash flow for this year at least.

Matthew Prince (Co-founder and CEO)

Apologies. My cell phone provider doesn't use Cloudflare it turns out, so my call dropped. That's a first. Thomas, I'm sure Thomas' answers were exactly right.

Operator (participant)

That does conclude our question and answer session. Did you have any closing remarks?

Matthew Prince (Co-founder and CEO)

Yeah, sorry about the technical snafu. I really just, I wanted to end by thanking all of our customers, partners, and especially the Cloudflare team. We have proven that we can do more even in very difficult economic times. I'm proud of all the work that we're doing to keep the internet safe, secure, reliable for all of our customers around the world. Thank you for helping us deliver the quarter, and it's gonna be a great 2023. Appreciate everyone being on the team.

Operator (participant)

Everyone, that does conclude today's conference. We would like to thank you all for your participation today. You may now disconnect.