Cloudflare, Inc. Q1 FY2020 Earnings Call

Ladies and gentlemen, thank you for standing by, and welcome to the Cloudflare Q1 2020 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers' presentation, there will be a question-and-answer session. I would now like to hand the conference over to your speaker today, Jayson Noland, Head of Investor Relations. Thank you. Please go ahead.

Thank you for joining us to discuss Cloudflare's financial results for the first quarter 2020. With me on the call, we have Matthew Prince, Co-founder and CEO; Michelle Zatlyn, Co-Founder 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'll be making forward-looking statements during today's discussion, including, but not limited to, the impact of COVID-19 on our and our customers' vendors and partners' operations and future operational performance, anticipated product launches and the time and market potential of those products, the Company's anticipated future revenue, financial performance, operating performance, non-GAAP gross margin, non-GAAP net loss from operations, non-GAAP net loss per share, shares outstanding, non-GAAP operating expenses, free cash flow, non-GAAP effective tax rate, dollar-based net retention rate, free and paying customers and large customers. These statements and other comments are not guarantees of future performance but are subject to risks and uncertainties, some of which are beyond our control including, but not limited to, the expense and duration of the impact of the COVID-19 pandemic and adverse conditions in the general domestic and global economic markets. Our actual results may differ significantly from those projected or suggested in any 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 Securities and Exchange Commission, 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. All current and prior-period financials discussed are reflected under ASC 606. You may find a reconciliation of GAAP to non-GAAP financial measures in our earnings release on our Investor Relations website. For historical periods, the 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 virtually participating in the J.P. Morgan Global Tech Media and Communications Conference on May 12th through the 14th and the Baird Consumer Tech and Services Conference on June 2nd through the 4th. Now, I'd like to turn the call over to Matthew.

Thank you, Jayson. Let me start by saying what feels almost awkward to say, given the circumstances. We had a very strong quarter. Our Q1 revenue finished at $91 million, up 48% year on year, we posted a gross margin of 78%, showing the continued efficiency of our platform. We made substantial progress on our path toward profitability, realizing over 1,000 basis points of operating leverage improvement year on year. That's the easy part. As I said in our first earnings call as a public company, we've been practicing mock earnings calls for years to the point that they already feel like business as usual. However, as I sat down to write up these remarks, I have to confess I struggled because what we're all living through is definitely not business as usual, so in many ways this isn't going to be a usual earnings call; settle in, buckle up. I wanted to take a bit more time to walk through four areas I've been focused on: our team, our platform, our business, and our customers. And in particular, I wanted to give you more of a sense of what we're seeing not just in the last quarter, but focusing on March and April as the world reacted to COVID-19. First, our team. We’re very fortunate that the first customer of all of Cloudflare's products is cloud by ourselves. We are digital natives, and we're able to use our products like Cloudflare for Teams to transition to productive and secure remote work. Our network operation center, security operation center, and technical support center all continued to be fully, securely, and reliably staffed 24/7. But it's not just about technology; it's also an inspiring mission that empowers the team. Cloudflare's mission is to help build a better internet. I have just been banking or agricultural crisis who would likely have felt as powerless as many of our friends and colleagues at other companies do right now. But this was a crisis that caused us all worldwide to lean on the internet more than ever before. Undoubtedly, the superheroes of this crisis are the medical professionals and scientists taking care of the sick and searching for a cure to this disease; but the faithful sidekick, the Ant-Man to Captain Marvel, has been the internet. And as one of the guardians of the internet, I'm proud of how our team has risen to the occasion to support our customers, new and old, as they deal with unprecedented challenges. I wanted to take this opportunity to thank all our teams; you are working incredibly hard to ensure the internet continues to function while the world has needed it more than ever before. I'm proud of how well you've all kept up our level of productivity and excellence, and most importantly, I'm honored to see you support each other, as well as our millions of customers, as we live through these challenging times together. Companies are really just collections of people, and this crisis has reaffirmed to me that we have a great team. Second, our platform. We saw growth in internet traffic that has been unprecedented; across our platform, we saw as much growth in traffic in 12 weeks as we have seen in the previous 12 months. The flexibility of our platform for every server in every city can run every Cloudflare service has allowed us to continue to spread, load, and serve all our customers. Stress does make systems better, and our engineering team has used this time as a way to make our platform more efficient. For instance, our firewall team released a series of improvements that shaved 40% off the processing time on every request. That means we are doing full deep packet inspection and threat analysis in a fraction of a millisecond at our tremendous scale. It also means that our network has actually gotten faster during this crisis, while at the same time acquiring less hardware. We expect these and many more innovations will pay dividends for years to come. One of the concerns we had early in the crisis was our supply chain. Cloudflare sources the hardware that powers our network through multiple ODM partners. These partners, as well as the many component manufacturers they rely on for parts, are largely based in Asia where the virus first hit. Beginning in early January, in light of the then-unnamed virus, our infrastructure team thoroughly analyzed our supply chain, identifying potential bottlenecks. We moved up some purchases of key components we thought may become constrained to prove pressure. Thus far, we've been able to continue to receive the equipment we needed without meaningful delay in order to expand our network during this time of unprecedented demand, and the demand has been unprecedented. We've seen internet traffic use nearly double through March and April versus the beginning of the year. While global traffic is still increasing regionally, we are seeing network traffic plateau. Different categories of traffic have grown more than others. Demand for educational and kids' content, arts and crafts, and parenting content have all more than doubled. On the other hand, traffic to sites about sports scores, travel, and real estate has declined. The scalability and flexibility of our unified platform with its ability to serve our diverse customer base and distribute load globally has served us very well. Third, our business. I've given you the Q1 highlights, but let me zoom into March and April and give you more granularity in what we're seeing. Beginning in March, we saw a modest uptick in the length of our average sales cycle. That added a few days to our closing deals. However, our average sales cycle still remains well under a quarter, and even with the modest uptick is shorter than it was just 12 months ago. Our sales in March were strong, finishing ahead of our plan. What was surprising to us was how much of March's business closed in the last week of the quarter. Our ability to close new business has continued without a break through April, and to date, we are tracking well to our plan for new business this quarter. Our read is that much of the world took a bit of a pause for a few weeks in mid-March, while companies figured out their remote procurement processes. But once those were figured out, deals for critical services like those Cloudflare provides, got done. One more view into what the data are showing us is that we track our sales pipeline closely. While many things may still impact win rates, we are encouraged that we added more new pipeline in February than in January, more in March than in February, and more in April than in March. I'm proud of our team, and while the demand is there, we have no intention of slowing down. Part of the key to our success comes back to our short sales cycle and our ability to sell services without sending accounts or professional service teams on-premise. Businesses large and small have an acute need for a fast, reliable, and secure network. Now more than ever, they come to us every hour of every day. And we can have them up and running in just a few hours, a minute compared to our competitors' weeks or months. And because of our short sales cycle, we can adapt quickly. As we came to understand that certain industries were going to be particularly impacted by the current crisis, we shifted our sales resources to thriving verticals, so our teams could still make their quarter. One surprise for the quarter was our pay-as-you-go business. This segment is for customers who sign up with a credit card on month-to-month agreements and without talking to anyone on our sales team. Today, it's a small portion of our revenue, but it's our roots where we started over nine years ago, and so it's still very important. We were concerned this segment may be more impacted because of its exposure to small businesses and individual developers. To our surprise, last quarter, it had its strongest year-over-year growth in years, and it's continued to show strong growth in April. That won't make a big difference to our bottom line because it's a relatively small portion of our overall revenue. But I'm proud we're still there to serve the small businesses, startups, and individual developers who need a service like Cloudflare now more than ever. Businesses of all sizes and shapes are moving online to survive, and we are helping them. That's the good news, but it's not all rosy; we are seeing an uptick in requests for concessions. Thomas will give you more details, but I wanted to tell you how we're thinking about those requests. Based on our analysis of the customer base and the industries that are most impacted, we believe the vast majority of our customers will get through this. Some, however, may need short-term help. We're using the strength of our balance sheet to help these customers in their time of need, build goodwill, and at the same time, working out beneficial terms to deepen our relationship over the long term. We are fortunate that because of the breadth of our product offerings delivered across our unified platform, we're often able to cost-effectively bundle services together and help our customers replace legacy vendors. Especially now, helping customers save money and simplify their operations leads to a particularly compelling ROI. Our competition, with their narrower set of offerings, does not have this luxury. While some hardware vendors may have had a temporary bump this quarter as CIOs scrambled to ensure they had enough firewall or VPN capacity, we believe that is short-lived. Those same CIOs are emailing me saying, 'We never want to go through something like this again.' There's a cartoon circulating that asks, 'Who led the digital transformation at your company? CEO, CTO, or COVID-19?' History may record this crisis as the last gasp for on-premise network hardware. Similarly, there are a number of cloud providers that only offer limited point solutions. Our platform strategy has positioned us well for this current moment, and we are aggressively leveraging it to take market share. We're seeing a number of new prospects engage in conversations about finding ways of saving money by leveraging our more cost-effective platform. To that end, as we said before, we will continue to use our gross margin as a weapon to gain share. As an example of that, in March we made the call to make Cloudflare for Teams, which we just launched in January, free for any business until September 1st. Cloudflare for Teams solves an acute need as companies shifted to 100% remote work, and their existing firewall and VPN hardware solutions couldn't keep up. In the last few months, we've onboarded over 1,000 companies onto Cloudflare for Teams. Since we made it free, right now they're all costs and no revenue. But we're proud of being there for businesses in their time of need. And what we've learned in the last nine years of running Cloudflare is that once you're part of someone's infrastructure, even if they don't trust you, that builds opportunity. In other words, we feel very fortunate with our results in the short term; we remain relentlessly focused on the long term. However, make no mistake; there will be headwinds in the short term. We are part of the broader economy, and as businesses struggle and go out of business, we will lose some customers. But long-term, we believe we are well positioned to be one of the few networks that will help run a large portion of the internet. So, lastly, I wanted to talk about some of our customer wins for the quarter. We had some incredible wins like a credit reporting service that signed a three-year deal worth $800,000 per year, a major gaming platform with a deal worth over a million dollars per year, a reinsurance provider who will pay us $750,000 over three years to protect their network, and a U.S. government agency using a broad set of our platform's features to secure nuclear research for over $150,000 per year. Let me focus on some customers that are uniquely relevant to this moment. One of the largest telemedicine providers in the United States turned to Cloudflare as the crisis set in; they had to shift the majority of their physicians from clinics where they had legacy on-premise security hardware to their homes, where obviously they did not. As a highly regulated industry, security of patient information is critical; they onboarded their physicians onto Cloudflare for Teams, so they could keep serving patients. Here's what their CIO said about the experience: 'I wish we had done this years ago after seeing how easy it was. Beautiful. This is perfect. I mean on so many levels, I love that.' Accompanying many of us are relying on food delivery to our homes while we shelter in place; they signed a deal for over $600,000 per year in January. In March, their demand was up so much that they increased their deal by more than $500,000 per year. One of their goals was to ensure that they could decrease their dependency on Amazon Web Services. They found Cloudflare was not only faster and more robust but also significantly more cost-effective, and they're using Cloudflare Workers, our edge computing platform, to solve a handful of development challenges they couldn't through any other platform. Beyond the customers who paid us, we're also proud of the customers doing critical work we could support through our project Galileo initiative. Last quarter, we helped to ensure fast, reliable, secure access for projects like covidenearyou.org, a project created by Harvard epidemiologists and software developers to track COVID-19 hotspots; maskaherony.com, which facilitated the donation of more than 27,000 masks to medical professionals in New York City; theamerican.org, which is providing emotional support, resources, and suicide prevention for the millions of lonely people impacted by this crisis; beatcovid19now.org, developed by a team of Australian public health and IT researchers to track and make sense of COVID-19 symptoms; and many, many more. It is inspiring to our whole team that we are able to lend our technology and expertise to help the true superheroes behind these organizations. Finally, this is a hard time, no doubt, and there will be headwinds even for a business like ours, but it's also replete with opportunity. My message to our team has been clear: iconic companies are born out of crisis. They take these opportunities to do two things: focus and invest. So, we are focusing on the products and innovation that leads to the highest returns, and we are investing in building trust, hiring the greatest people, and establishing ourselves for the long term. There are a small number of companies that will power the future of the internet, and we feel very fortunate, very privileged, and very lucky to be one of the internet's guardians during this crisis. I'm confident that we'll serve us well as we strive to build an iconic company over the long term. With that, I'll hand it off to Thomas. Thomas, take it away.

Thank you, Matt, and thanks again to everyone for joining us. We continued the momentum from 2019 and delivered a strong first quarter, exceeding the high-end of our revenue guidance. We believe this reflects our critical role in helping customers transform and digitize their business models. Today, I plan to review our first quarter results, discuss the impact of COVID-19, provide guidance for the second quarter, and update guidance for the full year of 2020. Turning to our results, total revenue for the first quarter grew 48% year-over-year to $91.3 million. The growth in revenue was driven by strong customer demand, both in terms of new logo acquisition as well as expansion within our existing customer base. As Matthew mentioned, we saw significant strength in our pay-as-you-go business. Our pay-as-you-go customers are not committed to a contract but are rather on a month-to-month subscription plan and are predominantly composed of small and medium-sized businesses. We believe the strength of this cohort during a global pandemic speaks to the value of Cloudflare's network and the durability of our business model. To provide some additional transparency, our pay-as-you-go customers represent the strong majority of our paying customer base. Our contract customers represent a strong majority of our revenue. From a geographic perspective, the U.S. represented 40% of revenue, and increased 44% year-over-year. Our international business represented 62% of revenue and increased 62% year-over-year. International growth was driven primarily by Europe, which increased 58% year-over-year. We started making incremental sales investments in Europe last year to drive traction in our pay-as-you-go business. We are pleased to see those investments start to take hold, especially in Germany and the UK. As a reminder, beginning this quarter, we shifted to revenue-based KPIs and moved away from billings as the basis for our KPIs. We believe this move to revenue-based KPIs better aligns with our peer group's publicly disclosed financials and our business model as we continue to scale. We provided eight quarters of revenue-based historical so comparison purposes, which can be referenced in this quarter's supplemental financial information document on our Investor Relations website. We added approximately 250,000 total customers during the quarter to exit the quarter with roughly 2.8 million total free and paying customers, representing an increase of 40% year-over-year. We also added over 5,000 paying customers in the first quarter, bringing the total number of paying customers to over 89,000. We remain focused on expansion within existing customers and growing our large enterprise customer base. We ended the quarter with 536 paying customers with greater than $100,000 in annualized revenue, which is up 65% year-over-year. Our dollar-based net retention rate for the first quarter was 117%, which decreased 2% sequentially and 1% year-over-year. The slight decline was largely driven by higher churn in the Asia Pacific region. Dollar-based net retention measures our ability to retain and expand revenue from existing customers from the prior year period. Our measurement is net of contraction and churn, and excludes the benefit of free customers that upgrade to take a subscription. The first quarter gross margin was 78.3%, down 48 basis points sequentially and up 150 basis points year-over-year. Network efficiency continues to be a defining strength of our business model, allowing us to absorb significantly higher rates of traffic and offer critical solutions like Cloudflare for Teams to new customers at no charge until September 1st. As we said previously, we'll use our gross margin advantage as a strategic weapon when opportunities present themselves. During this crisis, we are focused on doing the right thing for our customers to benefit their long-term business. Therefore, for the second quarter, we expect gross margin closer to our long-term targets of 75% to 77%. Turning to operating expenses, we remain focused on improving leverage in our business while balancing investments for growth. Total operating expenses were $85.9 million for the first quarter, up 2% sequentially and 35% year over year, while we increased our headcount by 43% year over year, bringing our total number of employees to 1,368 at the end of the quarter. We experienced delays in hiring and onboarding, which we expect to catch up on in the current quarter. First quarter operating expenses as a percentage of revenue decreased 6% sequentially and 9% year over year to 94%. Sales and marketing expenses were $43.4 million for the quarter, representing a decrease of 1% sequentially and an increase of 42% year over year. The sequential decrease was largely due to reduced production and travel, and discretionary marketing spending in response to the COVID-19 pandemic. Sales and marketing expenses as a percentage of revenue decreased to 48% from 49% in the first quarter last year and from 52% last quarter. Research and development expenses totaled $20.5 million in the quarter, representing a decrease of 7% sequentially and an increase of 19% year-over-year. R&D as a percentage of revenue decreased to 24% from 28% in Q1 last year and from 26% last quarter. General and administrative expenses were $22 million for the quarter, representing an increase of 18% sequentially and 40% year-over-year. The sequential and year-over-year increase was primarily driven by increased headcount and an increase in bad debt expense, primarily due to the COVID-19 impact of $1.2 million. G&A as a percentage of revenue was 24%, representing an increase of 2% sequentially and a decrease of 1% year-over-year. We continue to see operating leverage in the business as operating margin improved over 1,000 basis points year-over-year and 600 basis points sequentially. Operating loss was $14.4 million in the first quarter, compared to $16.1 million in the same period last year. The net loss in the quarter was $12.3 million, or a net loss per share of $0.04, with an effective tax rate for Q1 at negative 8%. We ended the first quarter with $588 million in cash, cash equivalents, and available-for-sale securities. Q1 free cash flow was negative $30.6 million or 34% of revenue, compared to a negative $22.1 million or 36% of revenue in the same period last year. As we mentioned previously, we expect to see continued variability in cash flow margins due to ongoing fluctuations in working capital and growth in our enterprise business. Before moving to guidance for the second quarter and the full year, I would like to begin with our expectations for COVID-19 related impacts and the associated provisions we factored into guidance. We performed rigorous analysis to understand both risks and opportunities in the current environment. We factored into our outlook the challenges our customers have faced, our views of current and prior trends, and the customer behavior we have seen in our existing customers and pipelines. We saw a notable bifurcation across our customer base emerge during the quarter, with significant acceleration among certain customers. For example, sales cycles that would have taken a quarter or two are being compressed given an urgent need, as well as some blowback from other customers who are highly affected by COVID-related challenges, particularly those in macro-sensitive industries such as transportation, hospitality, and retail. However, only approximately 8% of all businesses are associated with highly impacted transportation, hospitality, and retail industries. During the quarter, we observed an increase in the average sales cycle which extended by five days, and we expect similar sales dynamics to continue and potentially worsen, leading to longer lead time deal closures. We also began to see an uptick in customer contract modification requests, which peaked in March with 133 customers and showed a notable slowdown in April. In spite of the recent slowdown, our guidance assumes these requests will continue and reflects a hit of roughly $2 million in the second quarter. We are committed to helping our customers through these challenging times and providing them with increased payment flexibility, often in exchange for extended contract duration. We are fortunate that our strong margin profile and balance sheet allows us to provide support to our customers in need, which we also believe will benefit our shareholders in the long term. Despite these headwinds, we remain uniquely positioned as a mission-critical security and internet performance partner for all our customers. We have a large and diverse customer base, lending services to customers of all sizes across every industry and all geographies, with no customer contributing more than 5% of revenue. In the first quarter, we met our new customer ACV and customer renewal targets, and our DSO trend is flat to down through the quarter. We also think it's important to point out that April has trended in line with our plans from a net new ACV and renewals perspective. Since March, we've seen organic inbound leads double, and our customer pipeline has reached its highest level on a weekly basis. Turning to our guidance for the second quarter, we expect revenue in the range of $93.5 million to $94.5 million, representing an increase of 39% to 40% year-over-year. We expect operating loss in the range of $20 million to $19 million. The sequential increase is primarily due to anticipated hiring and onboarding effects from Q1 and COVID-related provisions. We expect net loss per share in the range of $0.06 to $0.05, assuming approximately 299 million common shares outstanding, and we expect the effective tax rate to be negative 1.7%. In light of the rigorous analysis, we are pleased to reaffirm our 2020 guidance for revenue, operating loss, and net loss per share despite the uncertainty in the total environment. As such, we expect revenue in the range of $389 million to $393 million, representing an increase of 36% to 37% year-over-year. As a reminder, we have a predictable subscription business with strong visibility into near-term revenue. We expect operating loss in the range of $55 million to $61 million. We expect net loss per share in the range of $0.21 to $0.19, assuming approximately 301 million common shares outstanding, and we expect an effective tax rate will be negative 4%. In weighing both the headwinds and tailwinds of the current environment, we continue to remain optimistic about the demand for all offerings and our long-term opportunity. While the full impact of the macroeconomy from COVID-19 is still unfolding, we continue to closely monitor the business environment, and we believe our guidance is appropriately prudent. In closing, as we navigate through these uncertain times, we feel very privileged to be a mission-critical pillar of our customers' operations and fortunate to be there for them when they need us most. We'd like to thank the Cloudflare employees for their continued dedication and resiliency in delivering exceptional service to our customers, partners, and communities. And with that, I'd like to open it up for questions. Operator, please poll for questions.

Your first question comes from the line of Sterling Auty from J.P. Morgan.

Listen, I know there's a ton of things that you had to get through, but one item that wasn't mentioned was you signed another noticeable partnership agreement in China during the quarter. Just wondering if you can give us some sense of, what that could mean to your growth in the region moving forward?

Yes, thanks, Sterling, for the question. We have been operating in China now for five years in partnership with Baidu, and I think what I've learned in China is that the Chinese tech community, it's a very big country with a very tight-knit community. I think what we really did over the last five years is prove ourselves as a good partner. So, beginning at the end of 2019, we were approached by several different Chinese internet companies wanting to diversify the number of partners that we had in China. We were in the fortunate position to be able to choose who we thought would be a great partner going forward, and JD Cloud really fits that bill incredibly well. We signed an agreement with them, but it's going to take a little bit of time for us to get that online. I'm incredibly excited about it. We're adding 50 new cities per year for a total of 150 pumps across China that will augment the existing network we have outside with Baidu. I think there's a real opportunity here for us to extend what we think is very unique about Cloudflare, which is we are one global network that spans the entire world and allows our global customers to manage their traffic both inside and outside of Cloudflare through a single user interface. So while I'm excited about this, I think it decreases the risk that we have in China in terms of being dependent on one provider there. I believe there's a substantial amount of opportunity that this provides as the world recovers from what we are going through right now.

That makes a lot of sense. And then Thomas, one follow-up for you. Thank you for the information on the exposed industries like travel. You made the comments on the pay-as-you-go program. But a question I get a lot for investors is, how should we think about your business as you stratify between exposure to SMB versus mid-market versus enterprise? How would you kind of characterize your business that way?

I think we pointed out earlier that we really manage our go-to-market across the entire funnel we have. So there's not really a focus that shifts from small to medium to big. It's really important for the efficiency of our business model, and I think this current crisis shows how important it is to manage across this broadness of the funnel. We were surprised how resilient our pay-as-you-go business has been, and as Matthew mentioned in his part of the script, it was the strongest part. It has the highest growth in four years in the segment, and it shows how important it is to deliver those services to small and medium-sized companies and also developers, so it’s really important that we can continue to convey the message of managing across the diversity of this funnel. That is what keeps our cost acquisition low and keeps our go-to-market model efficient, and you heard it in my script: Nobody saw significant strength in Europe in their first quarter, following the investments we made late last year.

Your next question comes from Phil Winslow from Wells Fargo. Your line is open.

And Matthew, obviously you commented on just the sheer amount of volume that's going across the internet and your network as well with the video work from home, etc. What are you targeting about this huge menu of solutions? Have there been any that stand out to you where you're seeing incremental interest, whether it be load balancing, Argo, obviously, you mentioned teams, anything you'd highlight there based on sort of the environment that we're seeing right now?

I think the thing that has been a real standout for this time has been Cloudflare for Teams. We couldn't have, in some ways, gotten more fortunate to have announced that in January. That was a product that was new for us; we kind of knew there wasn't a lot of awareness in the market for it, and as a result, it made it actually a very easy decision for us to say, as we were seeing businesses struggle, let’s make that product free through September 1st, and the response has been really overwhelming. We signed up over 1,000 businesses to be using Cloudflare for Teams, and what was really inspiring for me is that we wanted to make sure that our main sales team was focused on closing the quarter and onboarding customers onto products that generate revenue, and we saw strong demand across our entire product base. We had people on Thomas's finance team, customer support team, engineering team, and product team all raise their hands around the world saying they’ll volunteer to do 30-minute onboarding sessions with literally over 1,000 businesses. I think this has raised the awareness of that product very substantially, and I think that will pay us dividends for a long time to come. In terms of the products that have generated revenue, if you think about what Cloudflare is fundamentally, we are what the future of a network should look like: resilient, secure, and reliable. As more of the world shifted to relying on the internet to keep their businesses online, a modern network is what they needed. So that meant combining various functions—load balancing, firewall, security—together. What this crisis really illustrated was that it isn't about one product or another; customers are looking for a suite where they can say, 'Hey, I don’t have expertise here; I want you guys to handle this,' and that's why they're turning to Cloudflare. Our platform strategy has really been effective in Q1.

Your next question comes from Heather Bellini from Goldman Sachs. Your line is open.

Hi, this is Caroline on for Heather. Thank you again for taking my question and I hope you and your families are doing well. I wanted to dive a little bit deeper into the net expansion rate. Just having a diversified customer base, I'm curious: How have the retention rates been trending within your small, mid-sized as well as enterprise customer base? Specifically, was the weakness in AsiaPac driven by the SMB customers, or were there some changes in churn within the larger enterprise customers?

Yes, thanks for the question. Starting with SMB customers globally, I think that looking at our pay-as-you-go business is a rough proxy for our SMB customers. The pleasant surprise was that globally that segment actually had its strongest growth we’ve seen in any period of time. When we have seen customers in that segment who have gone from paying customers to churn, we're not seeing them switch to another solution; rather, we're seeing instances where companies are going out of business. But again, this is a very small portion of our overall business. Even the pay-as-you-go segment is a relatively small portion. More often than not, we're seeing customers needing some relief on their bill. The number one thing that competes for our sort of pay-as-you-go subscription business is the free version of Cloudflare's products. We're not losing them off our platform, but we’re seeing them struggle to downgrade. That said, the expansion in the pay-as-you-go business—both through new customers and our existing customers upgrading to becoming paying customers—has been the strongest in Q1 as we've seen in several years, which I think is a very pleasant surprise. It speaks to the fact that even small businesses are looking for ways to continue to operate, and that means more and more of them are turning to the internet. That's been a tailwind for us. In terms of Asia, we have encountered some terms from some customers that were impacted by various factors in the region. But again, there's nothing systemic at play here. Overall, I think we see Asia as a region we're excited about going forward.

Let me give you some additional color, because I think it's very important. The first time we saw a revenue-based dollar-based net retention rate at 117%, that is what you would expect from good performance in Q2. However, you will see a higher level of volatility in this measurement because larger customers don't expand their business in a perfectly linear manner, which is why you will see some volatility there. A few of the comments from Matthew convey that revenue perspective is a bit more backend-loaded as everybody paused for the end of March while they figured out new procurement processes. The trend in Asia is not really a regional topic but more of a vertical topic where we saw a couple of customers churn that have a high exposure to verticals that are negatively impacted by COVID-19.

I guess my follow-up really is, Matthew. How do you see the competitive landscape post-crisis? I mean, are you currently seeing more conversations about replacements of the legacy on-premise hardware?

For sure, we're hearing that. The CIOs we've been talking to from very large Fortune 50 institutions have not raised that as a concern. They have made decisions to band-aid their way through the current crisis. But I think it’s become clear, having lived through it, that what I've heard over and over is, 'I never want to live through something like this again.' That has generated inbound interest in our solution, especially from large customers. While I think it’s worth continuing to test and refine, it hasn't been a concern mentioned on any single call we've had. I believe that in every boardroom, people witnessed the pain and lost productivity that relying on on-premise hardware imposed on them, and they're saying, 'We need a different architecture.' In this moment, I think they will tolerate the switch. Because we're a subscription business, it doesn't have near the cash outlay that you have for trying to double down on hardware.

Your next question comes from the line of Matt Hedberg from RBC Capital Markets. Your line is open.

Great, guys. Thanks for taking my questions. Matthew, you have a lot of products that can aid to work from home trends. You've talked about them tonight. Just wanted some high-level context on your exposure to this particular use case and how you expect to continue to invest and also benefit from this long-term trend that is changing how all of us think about work.

Well, I think, first of all, this is a terrible crisis, and there are friends who have been impacted and are not able to work right now because their jobs do require them to go into physical locations, like restaurant workers and salon workers. That said, I believe as a society, we're fortunate this crisis didn't happen ten years ago. Over the last decade, Cloudflare and many other companies have built out cloud solutions that enable people to work remotely. I've been worried as our company traditionally has had a very office-centric culture. I was nervous when we switched almost overnight to being a work from home culture. What I’ve seen has been incredibly encouraging. Our productivity has been very high, we’re getting work done, we’re closing deals, and it feels like we haven’t missed a beat. This illustrates what the future of work is: balancing remote and office work. Our ability to create a reliable network provides a fundamental aspect of any work-from-home strategy. On top of that, we’ve developed Cloudflare for Teams, which is generating a lot of interest based on this crisis. A solution like this will likely become part of every company’s strategy going forward. The flexibility to support a 100% remote workforce in case of a future outbreak is crucial, and we have a big opportunity to play a role in building a secure, reliable, and performant network.

That’s great. A follow-up: You have a unique perspective on China that's expanding now. I'm curious if you can talk about what you're seeing when people go back to work and how trends in China opening up might potentially impact the rest of the world when it comes to opening up.

We have an office in Beijing, so we were very aware of this crisis earlier than some other companies. Our team outside of China was quick to support our team inside of China. We shifted to an entirely remote work environment there. It’s been interesting as they have led the way in sheltering in place and adjusting in that way; they’re now leading the way back. We have reopened our Beijing office. We have split our team into designated groups so that we don't have everyone in the office every day. We’re practicing appropriate measures and watching as the Chinese economy, as well as our team, come back online. This situation reinforces the importance of investments in infrastructure ahead of when things return to normal. All signals we're seeing indicate this economy is going to come back and be a significant source of economic growth for the world.

Your next question comes from the line of Shaul Eyal from Oppenheimer. Your line is now open.

Thank you. Good afternoon, guys. Congrats on the quarterly results. Matthew or Thomas, I know you typically do not provide the RPO metric officially on the call, but any color from a quantitative or even from a qualitative perspective would be highly appreciated? And I have a follow-up.

Normally, we don’t talk about RPO, but given the economic backdrop, it’s valid to ask for more transparency. RPO for us is well over 50% for the remaining year 20 guidance, with backlog and deferred revenue being the primary contributors. The second large contributor would be the renewal base together with our contract business. Especially in our pay-as-you-go business, it was specifically strong in the first quarter. So if you add those two together, you're likely at 70% or slightly above, with new ACV being the smallest contributor. That’s why we can confidently say our visibility into especially near-term revenue is pronounced.

Understood. Thank you for this color. Also, when we think about the few thousand team businesses that joined during the quarter, if we translate this number into subscribers, what could that be like? Is it 1 million, 2 million, 3 million? Any color would be great. And can I also ask what the renewal rate might look like for those 1,000 team businesses once they convert?

We're coordinating our independent sheltering in place, so we’re still mastering our overall response. We're not certain how many of the 1,000 businesses will convert especially at this stage. I am optimistic, as I said in my remarks that once you're part of someone’s infrastructure, it builds a relationship and builds trust, which can grow business over time. However, we prefer to maintain a conservative outlook as we don’t know what will ultimately result from this. We are not forecasting revenue based on this piece just yet, and we expect to have more insight come September.

To underline that, we've been very conservative in our assumptions about how much revenue we will derive from this business in the remainder of the year. Generally speaking, our cross-dollar retention is in the 90s across all paying customers.

Your next question comes from the line of Joel Fishbein from SunTrust.

Matthew, I have one for you. On the commerce, you gave us a lot of very good metrics on your guidance. I wanted to ask you, what kind of testing did you do to look at how the downside risk was? Obviously, you have most of your businesses subscription, and you talked about the strong pipeline, but I’d love to hear more about that and I have one quick follow-up for you as well.

Yes, let me start here. I think we really did not want to assume that an automatic recovery would happen in the second quarter. We wanted to test the downside risk carefully. We used both probabilistic models and Monte Carlo simulations to understand, especially our exposure to verticals and industries that suffered in the 2010 and 2008 crises, to ensure our resilience. We looked at customer size, conversion rates, and ran millions of simulations around the customer landscape to solidify our understanding of the downside and economic stability going into the second half of the year without making inflated projections.

Okay, as a follow-up, it sounds like you’re tracking a little ahead of plan, so what’s the message that we should take away from here?

There’s a lot of uncertainty in front of us. We wanted to be appropriately conservative about projections for the remainder of the year, hence our prudent guidance for Q2 and a less certain outlook for the second half. We have greater visibility in the near term, effectively reflecting our guidance for the second quarter while adjusting for increasing uncertainties in the later part of the year.

We have been conservative in our modeling. There’s been no significant upticks in DSO in April either, which affirms our outlook during challenging times.

Your final question comes from the line of Keith Weiss from Morgan Stanley. Your line is open.

The opportunity you are describing around catalyzing the shift towards security in this environment is compelling. How do you reconcile the fact that many were forced to double down on existing vendors simply because there was a crisis mode and they had to pull forward firewall spending, and incumbency versus the ability to get them to move on a going forward basis?

It’s worth probing that notion. I will say that, I have been spending a lot of my time talking to CIOs from very large Fortune 50 institutions, and that hasn’t been a concern raised by any of them. They have attempted to band-aid their way through the current crisis. However, it has become clear that having gone through the experience they never want to live through something like this again. That sentiment is driving inbound interest from large customers who want a more agile solution. And while this topic deserves continued scrutiny, it has not been mentioned by any of our contacts. I have a strong sense that in every single room, they're reflecting on how the reliance on on-premise hardware became a bottleneck. Going forward, I think they are starting to see the value in switching to subscription-based solutions such as those we offer.

No, I think we are staying true to the guidance we provided. The actions we took were aimed at navigating through this crisis effectively. Our team did an extraordinary job making sure our supply chain is protected, and while it weighs heavily on our cash flow in the first quarter, that should balance out for the remainder of the year. We are well on track.

Thank you, everyone, for tuning in. I want to say again how proud I am of the entire Cloudflare team. You're working under extraordinary conditions that truly help make the internet function. Thanks to all the analysts who tuned in and all of our shareholders. I hope everyone is safe and healthy and washing your hands often. We will talk to you again next quarter.

That concludes today's conference call. You may now disconnect.