Cloudflare, Inc. Q2 FY2020 Earnings Call

Ladies and gentlemen, thank you for standing by, and welcome to the Cloudflare Q2 2020 Earnings Conference Call. 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 second 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 the COVID-19 pandemic on our and our customers, vendors and partners operations and future financial performance, anticipated product launches and the time and market potential of those launches, 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 net retention rate, free and paying customers and large customers. These statements and other comments are not guarantees of future performance but rather are subject to risks and uncertainty, some of which are beyond our control, including, but not limited to, the extent 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.

Thank you, Jayson. We had a very strong quarter. Our Q2 revenue came in just shy of $100 million, up 48% year-over-year. We saw strength from our customers of all sizes. We grew our large customer accounts, those paying us more than $100,000 annually by 65% year-over-year. We also added nearly 7,000 new paying customers, bringing our total paying customer count to over 90,000. At the same time, we saw strong growth across our existing customer base as they adopted more features of the Cloudflare platform. While we are very happy with our results, our nature is always to be on the lookout for what could go wrong. We see good reasons to be optimistic. COVID-related concession requests peaked in early April and have since tapered off. We came in well below what we forecast for potential downside. Today, much more so than on our last earnings call, we feel we have clear visibility into the effects of the pandemic on our business, which has given us the confidence to raise both our Q3 and our annual guidance. Another consequence appears to be that we saw a peak in customer concession requests earlier than other companies. One thing we are increasingly seeing is customers who were surprised by their large usage-based bills from other vendors now coming to us for predictable and consistent pricing. I’m proud of how our team worked to accommodate those of our customers that were struggling due to COVID. These are tough times for many businesses. Great partnerships are often formed during tough times and consistency and predictability are particularly valued. For our own business, we are relentlessly paranoid. We’ve been watching a handful of metrics to help understand the impact of these unusual times. As I mentioned on our last earnings call, our sales cycle kicked up by a few days in Q1 and trended back down in Q2, remaining well under a quarter and at the low end of our historic range. We worried sales productivity would slow as our team adapted to working remotely. Instead, sales productivity per ramped rep hit a new record high. We monitor our receivable collection period closely. We speculated that as businesses struggled during the pandemic, our collection period may lengthen. We were pleasantly surprised to see it stay stable over the last two quarters. We believe the pandemic forced companies to categorize their vendors into two buckets: nice to have and must have. All indications from the quantitative and qualitative metrics we’re watching are that Cloudflare is squarely in the 'must-have' bucket. Of course, we are part of the larger global economy, and let's not forget we're still in the midst of a global pandemic. So lots of risks remain, but we see no indication that we are uniquely exposed to the effects of the crisis. For example, for new customers, segments that have traditionally been slow to adopt the cloud are increasingly embracing digital transformation and turning to us for help. In Q2, we saw particular strength in Europe, industrial companies, and small businesses. Those are not the first three segments you think about when you think about cloud adoption. Yet, COVID has caused these segments, that are usually slower to change, to adapt in order to survive. The nimbleness of our go-to-market team and our short sales cycles have allowed us to adjust our playbook and be there for new customers in these segments as they accelerate their digital and network transformation plans. May was the busiest month the internet has ever seen for distributed denial-of-service attacks. We blocked 37% more cyber attacks per day for the same cohort of customers in Q2 compared to Q1. When faced with cyber threats, companies increasingly turn to Cloudflare. I’m thankful for our team and our technologies' flexibility and proud of all the customers we’ve helped ensure a fast, reliable, and secure internet through these challenging times. Our team rose to the challenge, and it's incredible to see the rate of innovation that has continued, in fact, accelerated, even as we’ve had to adapt to a new work environment. Unlike many in the industry, we did not slow down. In Q2, we hired 257 new team members, a record for us, ahead of our hiring plan. We had nearly 47,000 applicants, up 750% year-over-year. We extended offers to less than 0.6% of applicants with a 96% acceptance rate company-wide. We continue to make substantial progress on our path toward profitability. This quarter, we delivered nearly 2000 basis points in operating leverage year-over-year. Even as we saw an unprecedented spike in traffic and cyber attacks, our gross margins remain over 76% and within our long-term target model. To judge the health of any business and its ability to win new customers, I wanted to walk through a handful of customer stories for the quarter. A major financial services firm signed a three-year deal for $450,000 per year for Cloudflare for Teams, our zero trust cloud-based solution replacing legacy VPNs and firewalls. A large U.S.-based industrial manufacturer signed a deal for $350,000 per year to adopt Cloudflare’s web application firewall solution. A leading identity management provider signed a two-year deal worth $0.5 million per year, moving workloads away from AWS. A Born In The Cloud gaming platform signed an expansion of their existing Cloudflare contract for an additional $1.8 million annually. Cloudflare Workers launched nearly three years ago, and today, approximately 10% of traffic through our network is powered by Workers with 22,000 new developers writing their first application using Workers, up 440% year-over-year. We want to be the go-to serverless computing platform for all developers and applications. We announced several new features, including raising CPU limits, and pricing that is up to 75% less expensive than AWS Lambda while remaining margin accretive for us. It’s easy for developers to use Cloudflare Workers to help solve thorny global compliance issues.

Thank you, Matthew. As Matt mentioned, we continued the momentum from our first quarter, facing fewer headwinds from the COVID pandemic than previously anticipated and delivered another outstanding quarter with strengths in multiple areas of the business. Total revenue for Q2 grew 48% year-over-year to $99.7 million. The growth in revenue was driven by strong customer demand, both from acquiring new logos as well as expansion within our existing customer base. We exited the quarter with over 3 million total free and paying customers, which is a 40% year-over-year increase. In Q2, we added about 7,000 paying customers, bringing the total number to over 96,000. Dollar-based net retention was 115%, which decreased 2% sequentially and 7% year-over-year. This decline was primarily driven by non-strategic accounts in Asia Pacific that turned off our platform. Still, overall expansion in the quarter from large enterprise customers was strong, with nine of our top 10 deals coming from existing accounts. Second quarter gross margin was 76.8%, down 150 basis points sequentially and year-over-year, which is in line with our expectations and long-term target of 75% to 77%. Sales and marketing expenses were $47.4 million in the quarter, reflecting an increase of 9% sequentially and 33% year-over-year. We achieved record hiring in the second quarter, bringing our total number of employees to 1,535. For the full year 2020, we anticipate revenue in the range of $404 million to $408 million, representing an increase of 41% to 42% year-over-year. We expect operating loss for the full year to be in the range of $55 million to $53 million. We believe we are well-positioned to execute despite these challenging times.

Thanks for taking my questions and congrats on a really strong quarter. What really stood out to me is your growth in large customers, which was 65%. Given these trends seem to be accelerating, does this typically mean you’re displacing a legacy on-prem vendor, or is it just greenfield wins for new cloud workloads?

Thanks for the question. We’ve been really happy with our ability to close larger and larger customers. I think we see a number of different scenarios that drive customers to us. Our belief is there are no new dollars in the world, so we don’t think of it as merely greenfield opportunities, rather we are typically replacing existing on-premise hardware-based solutions as part of the digital transformation that enterprises are going through, whether they were planning on doing that in 2020 or not.

Can you talk about how your go-to-market is changing and what you’re seeing from more traditional channels and integrators, particularly between landing new customers versus expansions?

The channel is an area where we see a lot of opportunity for growth. We continue to move upmarket and work with partners that assist in that growth. With products like Workers, we’re seeing channel partners that can provide real value and develop IP on our platform. Also, our Teams suite, has been an extra tool for those channel partners.

I’m trying to get a sense of your guidance this quarter compared to the prior quarter. Last quarter, the guidance seemed more conservative due to pandemic uncertainties. How do you assess the need for prudence in your guidance now?

We would characterize our approach as prudent. This quarter, we have more data points and less uncertainty from what we can control. We've seen significantly less headwinds from concessions and bad debt, allowing us to lean in a bit more. However, uncertainties still remain in the current environment.

We are focusing on doing right by our customers and for the long-term. We will optimize our forecasts cautiously as we continue to assess the overall economic landscape.

Thank you. And there are no further questions at this time. And I’ll turn it back over to the speakers for any closing remarks.

Just wanted to say thank you to our entire team Cloudflare. It’s been amazing to watch everyone adapt to a remote working environment. I’m really proud of how productive everyone has remained. Thanks to everyone as a shareholder. We’re going to keep going forward. And Michelle likes to say, we’re just getting started. Thank you.