Cloudflare, Inc. (NYSE:NET) Q4 2023 Earnings Call Transcript
Cloudflare, Inc. (NYSE:NET) Q4 2023 Earnings Call Transcript February 8, 2024
Cloudflare, Inc. beats earnings expectations. Reported EPS is $0.15, expectations were $0.12. Cloudflare, Inc. isn’t one of the 30 most popular stocks among hedge funds at the end of the third quarter (see the details here).
Operator: Good afternoon and welcome to the Cloudflare Q4 2023 Earnings Conference Call. Please note that this call is being recorded. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question-and-answer session. [Operator Instructions] I will now turn the call over to Mr. Phil Winslow, Vice President of Strategic Finance, Treasury and Investor Relations. You may begin your conference.
Phil Winslow: Thank you for joining us today to discuss Cloudflare's financial results for the fourth quarter of 2023. With me on the call, we have Matthew Prince, Co-Founder and CEO; Michelle Zatlyn, Co-Founder, President and COO; and Thomas Seifert, CFO. By now, everyone should have access to our earnings announcement. This announcement as well as our supplemental financial information may be found on our Investor Relations website. As a reminder, we will be making forward-looking statements during today's discussion, including, but not limited to, our customers, vendors and partners operations and future financial performance, our anticipated product launches and the timing and market potential of those products, our anticipated future, financial and operating performance and our expectations regarding future macroeconomic conditions.
These statements and other comments are not guarantees of future performance and are subject to risks and uncertainty, much of which is beyond our control. Our actual results may differ significantly from those projected or suggested in any of our forward-looking statements. These forward-looking statements apply as of today, and you should not rely on them as representing our views in the future. We undertake no obligation to update these statements after this call. For a more complete discussion of the risks and uncertainties that could impact our future operating results and financial condition, please see our filings with the SEC as well as in today's earnings press release. Unless otherwise noted, all numbers we talk about today other than revenue will be on an adjusted non-GAAP basis.
You may find a reconciliation of GAAP to non-GAAP financial measures that are included in our earnings release on our Investor Relations website. For historical periods, a GAAP to non-GAAP reconciliation can be found in the supplemental financial information referenced a few moments ago. We would also like to inform you that we will be participating in Baird's Software Silicon Slopes event on February 28th and the Morgan Stanley Technology, Media and Telecom Conference on March 6th. Before wrapping up, please save the date for our Investor Day on Thursday, May 30th, 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. Now I'd like to turn the call over to Matthew.
Matthew Prince: Thank you, Phil. We had an exceptionally strong quarter. We achieved revenue of $362.5 million, up 32% year-over-year. We added 198 new large customers, those that pay us more than $100,000 per year and now have 2,756 large customers, up 35% year-over-year. We saw particular strength in our largest customers with a record number of net new customers spending more than both $0.5 million a year and $1 million a year on an annualized basis. We signed our largest new logo with an expected total contract value over $30 million and our largest customer renewal with a total contract value of $60 million. We blew away our previous record for new ACV booked in the quarter. In Q4, new ACV booked grew nearly 40% year-over-year, making it not only our record in absolute ACV, but also the fastest percentage growth we've seen since 2021.
Our pipeline closed rates sales force productivity, average steel size and linearity all improved markedly quarter-over-quarter. I continue to be encouraged by the early results we're seeing from our new sales recruiting and training programs. During the fourth quarter, the pipeline generated by the cohort under the new program was 2.1 times higher than the year ago cohort. And account engagement increased by 3.5 times compared with a year ago. I'm excited by our maturing sales execution and believe it will pay dividends in 2024 as these sales professionals fully rank. Our dollar-based net retention ticked down 1% quarter-over-quarter to 115%. Our gross margin was 78.9%, again, above our long-term target of 75% to 77% and up from 78.7% last quarter.
We delivered an operating profit of $39.8 million, representing an operating margin of 11%. We also meaningfully outperformed on free cash flow generating $50.7 million during the quarter and approximately $120 million in free cash flow for the year. I'm proud of our team for their continued execution. The machine that underlies Cloudflare is firing efficiently on all cylinders, and we've been able to execute even as the macro environment remains choppy. Key to that execution has been improvement in our go-to-market efforts. 15 months ago, we brought on Marc Boroditsky to execute effectively a turnaround of Cloudflare's go-to-market team. At the time, we had enterprise customers, but we hadn't operationalized repeatedly and consistently landing them.
We were also suffering from a COVID hangover and like much of the industry, have been flat on performance management. Mark changed all that. He's brought in the process and discipline we needed to be world-class in sales the same way we already were in product and engineering. It's hard to be the turned-around-guy, and we owe Mark a huge debt of gratitude for playing that role. But there's someone we always whispered about as our ideal go-to-market leader if we could ever have him as a full-time member of our team, Mark Anderson. He built Palo Alto Networks' world-class sales organization into the machine it is today. He has an incredible domain expertise and contacts in our industry. He's one of the great B2B sales software leaders. And as we were getting ready to go public, we couldn't quite commence them to run our go-to-market org, but we did the next best thing, inviting him to join our Board.
Over the last four years, we've gotten to know each other on Cloudflare's Board. From there, he's provided invaluable counsel to me, Michelle and our go-to market leaders. And so after Alteryx, the company he's been running as CEO agreed to go private. He reached out and asked whether we'd be interested in not just having him as a coach, but also a player on the field, rolling up his sleeves and getting back to what he's best at. Running a world-class go-to-market organization, selling great products and delivering incredible value and support to customers. Given the deep relationship and trust we developed and his expertise and leadership in our field it was as close to a no-brainer, as I can remember in a long time. I wanted to invite Mark Anderson to the call to say a few words.
Mark?
Mark Anderson: Thank you, Matthew. I've had the privilege to work closely with the great leadership team here at Cloudflare in my role as a member of the Board of Directors for the last 4.5 years, and I've been amazed, not at just what Cloudflare has accomplished to-date, but more importantly, how the market is increasingly moving to where Cloudflare is already uniquely positioned. The time to capitalize on these major technology shifts is now. When I start to think about where I could make the most impact during the next stage of my career. I reached out to Matthew and Michelle to see if I can help elevate Cloudflare's go-to-market organization to the next level. Operationalizing productivity at scale at Cloudflare will involve.
One, augmenting foundational systems and tools that are already in place with the framework of execution that applies discipline and rigor to all that we do for customers and two, bringing on more stage appropriate talent to blend with our amazing sales team to best capture the massive market opportunity ahead of us. We all agree that my skill set and experience building and enabling world-class go-to-market organization matched perfectly with Cloudflare to further accelerate its next stage of growth at scale. And I'm extremely excited to work together with Matthew, Michelle and all of my fellow Cloudflarean to make Cloudflare one of the most iconic technology companies in the history of the industry.
Matthew Prince: Thanks, Mark. I want to again thank Marc Boroditsky for getting us to this place. We couldn't have done it without him. He will continue to be an adviser to Cloudflare for the next several months to make sure Mark Anderson is set up for success. He will always be part of the Cloudflare team, and I'm excited to hear what challenges he takes on next. I also wanted to take this time to reaffirm that Michelle and I aren't going anywhere or changing our roles in anyway. I wake up every morning more excited about the opportunities we have to fulfill our mission of helping build a better internet. If you study the iconic technology companies, they are often mission-driven, founder-led but include a dynamic and evolving leadership team surrounding the founders who bring a wealth of experience for each stage of the company's journey.
That a leader like Mark Anderson can get to know us over the last four years from his seat on our Board and then choose to join our team standing side-to-side with the other senior team we have assembled gives me confidence that we're on a path to being one of the iconic technology companies ourselves. We're not there yet. So I'm not satisfied, and I remain fully committed to that journey. With that, let me walk through some of the customer wins we had in the quarter. We were awarded a three-year contract with a ceiling value of $33 million for the US Department of Commerce which will be deploying services across our SASE application performance and security solutions. We believe deals like this validate the criticality of converging application performance, security, network and Zero Trust services on a unified platform and how Cloudflare can deliver a comprehensive, commercially off-the-shelf platform from a single vendor as compared with numerous point product competitors.
A leading technology company, expanded their relationship with Cloudflare, signing a three-year, $6.6 million contract for Cloudflare's Zero Trust Suite to protect access for 10,000 employees and contractors. Given the company's highly complex and secure environment, implementing a first-generation Zero Trust vendor proved to be a challenge. This company had done a Zero Trust RFP a year prior, but when they reviewed Cloudflare's Zero Trust solution again, they were impressed by our significant progress in innovation. Not only was our rate of innovation a key differentiator, but with Cloudflare, they are able to simplify and consolidate Zero Trust application performance and security all on a single platform. A Fortune 500 hospitality company expanded their relationship with Cloudflare, signing a five-year, $4.3 million contract for 20,000 Zero Trust seats.
This company approached us 15 months ago with a basic Zero Trust use case. The scope quickly expanded from one to several as this company sought to re-architect their entire Zero Trust approach. The lack of platform integration and the absence of strategic vision from their incumbent vendors, including a first-generation Zero Trust competitor, led them to Cloudflare for our easy-to-use comprehensive platform with a cloud-first architecture. Although performance improvement was not an important consideration early on, after a six-month paid pilot, the team was blown away by how much improvement they saw with Cloudflare stating, holy bleep, I've never seen Jira go this fast. A sophisticated tech company with one of the technical and daring engineering teams signed a two-year, $646,000 contracts.
The company had recently experienced a breach, driving them to increase their security posture and adopt a Zero Trust approach. This company considered nearly every relevant vendor in the market, over 13 in total, and Cloudflare and one other competitor were selected for a proof-of-concept and 30-day pilot. After just 14 days, Cloudflare was fully configured and completed all success criteria, whereas our competitor was unable to get off the ground. The ease of deployment was key for this company who needed to design a solution in a very complex environment with Cloudflare, everything worked out of the box. A Fortune 500 technology company signed a two-year $6 million contract for advanced application security. The company was experiencing an increased DDoS attacks that a large hyperscale public cloud was unable to mitigate.
These unmitigated attacks created significant latency resulting in a loss of traffic and potential revenue. They view Cloudflare as the leading expert in DDoS mitigation based on our HTTP/2 rapid reset publication and the compatibility of our Layer 7 security bundle with their self-hosted technology and public cloud vendors made Cloudflare an easy choice. It's just the beginning with this customer. A large US commercial airline expanded their relationship with Cloudflare signing a two-year $857,000 contract to procure Zero Trust seats. A great land-and-expand example. This is the third deal we've done with this customer in 2023 as they undergo a digital transformation project. They're using our full Zero Trust suite along with application services.
They love our unified network, single pane of glass and speed of implementation. A fourth deal with them is already on the horizon. A local government authority in the UK signed a five-year $2.1 million contract for 4,700 Zero Trust seats. The government authority was pursuing a very large digital transformation project to modernize and improve security posture with a complete network refresh and the adoption of Zero Trust. Following a three-year engagement process, the authority was evaluating two competing Zero Trust vendors. Cloudflare entered the process in the late stages. Cloudflare One was selected as the core component of their modernization program due to our ease of use, seamless integration and expansive platform with a single control plane.
In their words "Cloudflare is easy, it just works." These days, no earnings conference would be complete without an update on AI. As of the end of 2023, we deployed GPUs in 120 cities globally, meaningfully ahead of our target of 100 cities. By the end of 2024, we plan to have inference tuned GPUs deployed in nearly every city that makes up Cloudflare 's global network and within milliseconds of nearly every device connected to the Internet worldwide. The breadth and potential impact of the use cases we are seeing with workers AI are extraordinary. And we're super excited about the opportunity to establish workers' AI serverless model built on Cloudflare's trusted global network as the best infrastructure for running AI inference tasks. From our launch in September to the month of December, the average number of daily workers' AI request increased 9x.
Furthermore, one-third of the thousands of workers' AI account are new to the workers' platform, suggesting that workers' AI is not just significant opportunity in and of itself, but also a potential accelerant to adoption of the workers' overall platform. Inference, however, is only part of the AI equation. We are also extremely encouraged by the interest in Vectorize, our vector database which makes it easy, fast and affordable to index and store vectors to support use cases that require access not just to running models, but customized data too, as well as AI Gateway, which gives organizations the tool to cash, rate limit and observe their AI deployments regardless of where they're running. AI on workers platform is just getting started and there are exciting things on the road map that we look forward to sharing with you in the not-so-distant future.
As I reflect back on the last quarter, I'm proud of our team. It feels like we're once again firing on all cylinders, but a quarter is only one data point. As we talked about throughout the last year, the macro environment remains challenging. IT buyers are still skittish. The world is not getting any less complicated. And as a company, we still have a ton of proof. Those were the dominant themes of 2023, and I think it's likely that will remain the themes of 2024. So while I'm encouraged by our results, we continue to remain prudent and focused on disciplined execution, building and improving our team, delivering exceptional value to our customers and solving some of the hardest engineering challenges the internet faces. With that, I'll hand it over to Thomas to walk through our financials.
Thomas, take it away.
Thomas Seifert: Thank you, Matthew, and thank you to everyone for joining us. I want to take a moment to welcome Mark Anderson to the Cloudflare team too. Mark, we're incredibly excited to have you on board to further accelerate our next phase of growth at Cloudflare. Turning to our financial results. I'm pleased to share that the positive momentum from our focus on refining our go-to-market strategies and operations continued during the fourth quarter. As Matthew mentioned earlier, pipeline growth rates, sales productivity, average deal size and linearity all improved compared with last quarter. Strength in our business this quarter was driven by robust momentum with large customers, significant progress in the public sector and growth in Cloudflare One, including the largest new customer win in the company's history with a contract ceiling value of $33 million.
Importantly, we also continue to maintain our strong commitment to being fiscally responsible and act as good stewards of investors' capital. Operating profit increased nearly 2.5 times year-over-year and we significantly outperformed on free cash flow, generating a record $50.7 million during the fourth quarter. Turning to revenue. Total revenue for the fourth quarter increased 32% year-over-year to $362.5 million. From a geographic perspective, the US represented 52% of revenue and increased 30% year-over-year. EMEA represented 28% of revenue and increased 38% year-over-year. APAC represented 13% of revenue and increased 25% year-over-year. Turning to our customer metrics. In the fourth quarter, we had 189,791 paying customers representing an addition of roughly 27,700 paying customers in 2023 and an increase of 17% year-over-year.
We were pleased to see revenue contribution from large customers during the quarter increased again to 66% of revenue up from 63% in the fourth quarter last year. For fiscal 2023, revenue from large customers represented 64% of total revenue compared to 61% in 2022 and 54% in 2021. As Matthew referenced earlier, we added a record number of net new customers spending more than $500,000 and $1 million on an annualized basis with Cloudflare. For the full year, we ended the year with 346 customers that spend over $500,000 with us, a 56% increase year-over-year, and we ended the year with 118 customers that spent over $1 million with us, a 39% increase year-over-year. We also exited 2023 with three customers spending at least $20 million on an annualized basis with Cloudflare.
One of which signed the largest total contract value renewal agreement in our company's history of $60 million in the fourth quarter. Our dollar-based net retention rate was 115% during the fourth quarter representing a decrease of one percentage point sequentially. As we mentioned last quarter, there can be some variability in this metric quarter-to-quarter, but we continue to believe the prior decelerating trend in DNR is stabilizing near these levels. Moving to gross margin. Fourth quarter gross margin was 78.9%, representing an increase of 20 basis points sequentially and an increase of 150 basis points year-over-year. Gross margin was 78.3% for fiscal 2023, remaining of our long-term target range of 75% to 77%. Network CapEx represented 8% of revenue in the fourth quarter as we continue to benefit from our focus on driving greater efficiency from our infrastructure and the uniqueness of our platform to onboard new workloads.
We expect network CapEx to be 10% to 12% of revenue in fiscal 2024. With the evolution of the composition of our infrastructure, we undertook an assessment of the useful lives of our service and network equipment. In January 2024, we determined that continuous advancements in hardware technology and improvements in our data center designs have increased the efficiency in how we operate our equipment, resulting in the estimated useful lives of these assets extending from four to five years starting in fiscal 2024. We estimate this change will reduce depreciation by approximately $20 million for fiscal 2024 for assets and service as of December 31st of 2023, recorded primarily in the cost of revenue. As we discussed previously, we view our margin efficiency as one of Cloudflare's key competitive advantages, and we intend to leverage this opportunity as a strategic weapon to increasingly disrupt markets through continued innovation on our platform and differentiated product packaging.
Turning to operating expenses. Fourth quarter operating expenses as a percentage of revenue decreased by 3% year-over-year to 68%. Our total number of employees increased 14% year-over-year bringing our total headcount to 3,682 at the end of the quarter. We'll continue to pace hiring based on market conditions over the course of fiscal 2024 and remain committed to driving higher productivity and greater efficiency across our operations. Sales and marketing expenses were $145.2 million for the quarter. Sales and marketing as a percentage of revenue decreased to 40% from 41% in the same quarter last year. Research and development expenses were $59.5 million in the quarter. R&D as a percentage of revenue decreased to 16% from 18% in the same quarter last year.
General and administrative expenses were $41.5 million for the quarter. G&A as a percentage of revenue decreased to 11% from 12% in the same quarter last year. Operating income was $39.8 million compared to $16.8 million in the same period last year. Fourth quarter operating margin was 11%, an increase of 490 basis points year-over-year. These results highlight our continued focus on becoming more efficient and more productive given that operational excellence is a long-term competitive advantage. Turning to net income in the balance sheet. Our income in the quarter was $53.5 million or a dilutive net income per share of $0.15. We ended the fourth quarter with $1.7 billion in cash, cash equivalents and available-for-sale securities. Free cash flow was $50.7 million in the fourth quarter or 14% of revenue compared with $33.7 million or 12% of revenue in the same period last year.
Remaining performance obligations or RPO came in at $1.245 billion, representing an increase of 15% sequentially or 37% year-over-year. Current RPO was 73% of total RPO. Moving to guidance for the first quarter and full year 2024. We are encouraged by the progress we delivered during the fourth quarter in terms of improving close rates and productivity metrics. However, mixed macroeconomic data points serve as a reminder that we are operating in a business environment that also showing signs of improving exiting 2023, continues to be challenging to predict. As a result, we remain prudent in our outlook for 2024, and we are fully committed to continuing to adapt our tactics and strategies in response to any positive or negative external variables just as we did in 2023.
Now turning to guidance. For the first quarter, we expect revenue in the range of $372.5 million to $373.5 million, representing an increase of 28% to 29% year-over-year. We expect operating income in the range of $34 million to $35 million, and we expect an effective tax rate of 11%. We expect diluted net income per share of $0.13, assuming approximately 356 million shares outstanding. For the full year 2024, we expect revenue in the range of $1.648 billion to $ 1.652 billion, representing an increase of 27% year-over-year. We anticipate the weighting of revenue in the first half versus second half of 2024 to be similar to 2023. We expect operating income for the full year in the range of $154 million to $158 million. We expect an effective tax rate of 11% for 2024 and we expect diluted net income per share over that period to be $0.58 to $0.59, assuming approximately 358 million shares outstanding.
After having achieved significant free cash flow of approximately $120 million in 2023, we expect free cash flow to be relatively consistent with operating profit for the full year 2024. With the first half lower and the second half higher compared with operating profit. In closing, our team remains committed to driving operational excellence, ensuring long-term growth and delivering significant shareholder value. I'd like to thank our employees for their dedication to our mission as well as our customers for trusting us to help them solve some of the hardest problems that they face when modernizing, transforming and securing their businesses. And with that, I'd like to open it up for questions. Operator, please poll for questions.
Operator: Thank you. [Operator Instructions] Your First question comes from Brent Thill with Jefferies. Please go ahead.
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