Cloudflare, Inc. Q1 FY2023 Earnings Call

Good afternoon, ladies and gentlemen, and welcome to the Cloudflare Q1 2023 Earnings Conference Call. Please be advised that this call is being recorded. And now I'd like to turn the call over to Mr. Phil Winslow, Vice President of Strategic Finance, Treasury and Investor Relations. Please go ahead, sir.

Thank you for joining us to discuss Cloudflare's financial results for the first 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 uncertainties, 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'll 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 MoffettNathanson's inaugural TMT Conference on May 17 and Jefferies 2023 Software Conference on May 31. Now before wrapping up, we are excited to host our Investor Day on Thursday, May 4, 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 with that, I'd like to turn over the call to Matthew.

Thank you, Phil. Q1 was a quarter of contrasts. We achieved revenue of $290.2 million, up 37% year-over-year. Our gross margin was 77.8%, again, above our long-term target range of 75% to 77% and up from 77.4% last quarter. During the quarter, we added 114 new large customers, those that pay us more than $100,000 per year, and now have 2,156 large customers, up 40% year-over-year. Our dollar-based net retention fell to 117%, down 5% quarter-over-quarter. Importantly, we did not see elevated churn across our broad customer base. Instead, we saw a slower expansion from existing customers. Throughout this quarter of contrast, we saw tailwinds and headwinds. The reacceleration of our new business pipeline during the second half of 2022 continued again this quarter, and we meaningfully exceeded our pipeline plan for the second quarter in a row. Our win rate against the competition remained at record high levels, and renewal rates were consistent with the high levels experienced over the previous four quarters. Those were all positive signs. On the flip side, the quarter saw new challenges: macroeconomic uncertainty, which intensified over the course of Q1 with every failing bank, resulted in a material lengthening of sales cycles, a significant decline in close rates, even as win rates held strong and an extreme back-end weighting to the quarter. To give you some sense, almost half of the new business closed in the last two weeks of the quarter, which is very nonlinear for us. All of these factors put pressure on growth. The quarter most reminded me of Q1 of 2020 when businesses were paralyzingly nervous about the impact of COVID-19. I think this parallel shows how with uncertainty in the economy, companies are closely watching their own businesses before committing to new spending. Thankfully, we continue to be a must-have, not a nice-to-have. And most of the deals we expected to close did, just later than we expected. I'm proud of our team's ability to sail through the rough seas that characterized Q1. Although the current economy poses uncertainty for nearly every business in the near term, as Mark Hawkins and our Board likes to say, when the going gets tough, the tough get profitable, and we are tough. We have our hands firmly on the tiller of our business and are able to adjust to rapidly evolving market conditions in order to deliver operating profit of $19.4 million, representing a record operating margin of 6.7%. Furthermore, in spite of tougher collections in the quarter, particularly in the month of March, we generated $13.9 million of free cash flow, representing a free cash flow margin of 5%. We continue to be on track to be free cash flow positive for 2023. As we navigate through the challenging macroeconomic seas facing our industry, this period of external uncertainty presents us with a perfect opportunity to be internally reflective, identifying areas of improvement within our business and taking proactive steps to create an even more successful and productive organization. As I take stock, we are not limited by the size of our market for our products, we are not limited by our ability to innovate, we are not limited by pipeline opportunity, and we are not limited by sales capacity. So what are we limited by? As I said last quarter, Marc Boroditsky, our new President of Revenue, has dug into retooling our go-to-market efforts and identified significant opportunities to improve the efficiency and performance of our sales teams. Although we've won one-third of the Fortune 500 customers, if we're honest with ourselves, we saw a lot of our success with our enterprise customers because our products were so good and solved real problems that every big company faces. That allowed many on our sales team to succeed largely by just taking orders. When the fish are jumping right in the boat, you don't need to be a very good fisherman. But at the risk of mixing metaphors, as the tide goes out, you get a clear view of who's not wearing shorts. The macroeconomic environment has gotten harder, and we're seeing that some on our team aren't dressed for work. Digging in with Marc, we've identified more than 100 people on our sales team who have consistently missed expectations. Simply put, a significant percentage of our sales force has been repeatedly underperforming based on measurable performance targets and critical KPIs. That's obviously a problem. But it's one in this environment with a particularly available and actionable solution. We are now in the process of quickly rotating out those members of our team who have been underperforming and bringing in new talent with salespeople who have a proven track record of success, grit, and a strong cultural fit. To give you some sense, these 100-plus people contributed approximately 4% of annualized new business sold over the last year. So we're optimistic we can make this team upgrade without significantly impacting sales capacity. While team upgrades are always hard, this is a uniquely good time for us to do this. A year ago, the tech labor market was extremely tight. Today, there is an abundance of talent eager to work at Cloudflare. In Q1, we received more than 250,000 applicants, approximately 40% of which were for sales positions. That's more applications than we received in all of 2021. In addition to the volume, the caliber of the applicants we're receiving is higher than we've seen at any point in our history, especially for go-to-market positions. While other companies are laying off, we're going to be bringing on great people with proven track records to raise the capability of our enterprise go-to-market team. We've always had a culture of high performance at Cloudflare. However, with the value of hindsight, I think we and most other businesses got a bit soft during the COVID crisis around performance management. That was understandable at the time, but that time is over. The work we do is vitally important for the healthy functioning of the Internet. The opportunity ahead of us is massive. We have amazing people on our team who are executing every day to realize that opportunity, and we have an incredibly long line of other proven talented people looking to step in to fill the positions where some of our current team aren't living up to expectations. Our pace of innovation is not slowing down. Now more than ever, it's paramount we continue to innovate and develop unique offerings that deliver value to our customers and differentiate us from the competition. We are great at that. I want every dollar we put into Cloudflare to be more productive at driving revenue, profit, and shareholder value. Innovation is a long-term competitive advantage, but productivity is too. Taking action to address inefficiencies in our go-to-market organization now will enable us to better capture new opportunities and expand our customer base and do so even more productively, profitably, and predictably than before. While I've talked about our team that's underperforming, that's only half the story. Our top salespeople are terrific. On average, the top 15% of our sellers have achieved 129% of quota over the last four quarters. They're incredibly consistent at bringing in new logos, expanding current customers, and delivering results, and approximately 27% of them started within the last 18 months. We know that if we hire the right people, they can ramp quickly and be successful with a full bag of products we handle. In that spirit, let me tell you about some of the deals our top performers closed this quarter. A Fortune 500 media company expanded their relationship with Cloudflare, signing a three-year $840,000 deal and bringing their total annual spend to $2.1 million. A customer of our application performance and security services since 2017, this company expanded into our Zero Trust portfolio with access and browser isolation for thousands of its contractors, displacing two Zero Trust competitors and even turning down three licenses from one of them. Cloudflare's products not only performed better than the competition during evaluation, but we were the only company that could deliver on the complex requirements needed. This contract is only the tip of the iceberg with the customer, which plans to potentially roll Zero Trust out to all their tens of thousands of employees. Responding to our descaler campaign, a leading e-commerce technology company in Europe expanded their relationship with Cloudflare, signing a three-year $780,000 deal. The company is going all-in on Cloudflare One, Gateway, Access, CASB, DLP, and Magic WAN. They were drawn to Cloudflare's platform as a unified pane of glass to consolidate their security modernization and network transformation needs, with Magic WAN as a key competitive differentiator versus first-generation Zero Trust competitors. A global industrial machinery manufacturer expanded their relationship with us by signing a three-year $648,000 deal. The company was looking to modernize their security infrastructure and is also going all in on Cloudflare One with Access, Gateway, Area 1, and Magic WAN, displacing multiple competitors. They appreciate being able to consolidate vendors, reduce costs, and increase flexibility with Cloudflare's platform. A Fortune 1000 SaaS company expanded their relationship with Cloudflare, signing a three-year $8.4 million deal. The company recognized Cloudflare's unique position as a neutral super cloud to manage and strengthen their application security posture and accelerated SaaS platform performance across AWS, GCP, and their private data center environment. Additionally, no other solution could compete with our data localization suite to simplify the customer's global regulatory and compliance requirements. A leading IoT security company expanded their relationship with us, signing two three-year deals for a combined $4.2 million, one for its commercial business and a FedRAMP one for its government business. The company has been a Cloudflare customer since 2020, using core application services and Cloudflare Tunnel for IoT devices. Drawn to our pace of innovation, this customer bought into the Cloudflare platform vision, now using over 25 products across core application services, Zero Trust and our developer platform, including R2, our object store and durable objects, to combat high egress fees from AWS. They plan to use Cloudflare's FedRAMP authorization to scale operations on both commercial and federal sides of their business and increase their security posture. A Fortune 1000 retailer signed a $1.3 million 46-month contract for Cloudflare's core application services to displace their existing vendor. They also added R2. The company has been dissatisfied with the unpredictability of their bills and bot-related issues from the current vendor and wanted to switch to Cloudflare, knowing our universal approach to protecting all traffic and our platform ease of use were top of the industry. A leading gaming company expanded their relationship with Cloudflare, moving from a pay-as-you-go customer spending $200 a month to a contracted customer signing a one-year $388,000 deal for R2, Workers, and application services. The company was looking for a more scalable platform for storage and outperformance that would support their exponential growth. The customer realized that by moving to R2, they could eliminate egress fees they were incurring from the competitor, easily integrate with S3 APIs, and centralize management. In particular, they were impressed with R2's lower latency and better throughput as well as how R2 tightly integrates with Workers and our core application services. Traction among developers continues to be strong. We now have 4.92 million Workers applications running on our platform, up 146% over the last six months. 33,000 paying customers have activated R2 and are storing more than 7 petabytes of data, up 25% quarter-over-quarter. AI companies, large and small, continue to build on Cloudflare at a breakneck pace. When we ask them why, they cite our neutral position, rapid innovation, and modern, nimble development environment. One last month called us 'The first cloud infrastructure company built for the age of AI.' I like the ring of that. And I'm extremely excited about our upcoming announcement at Developer Week next month. We'll announce a lot around how we support AI and make any developer more productive. We are the best in the industry at innovation, and we're making the changes we need to make and investing in our team to be the best in the industry of sales too. As I step back and think about what was a challenging quarter, I'm struck by our opportunity. We are not limited by the market for our products. We are not limited by innovation. We are not limited by pipeline opportunity. We are not limited by our ability to recruit. And we are not even limited by sales capacity. Instead, we are limited by our go-to-market performance. That's something we can fix, and we are committed to turning the current macroeconomic headwinds into a catalyst for positive change in growth at Cloudflare by investing in our top talent, refocusing on performance management, and elevating the productivity of our team to seize the opportunity we have ahead, which we all know is massive. With that, I'll turn it over to Thomas to walk through the financials. Thomas, take it away.

Thank you, Matthew, and thank you to everyone for joining us. In the first quarter, we continued to witness a challenging business environment, which deteriorated significantly in March when negative headlines emerged related to SVB, the broadening banking crisis, and the worsening macroeconomic outlook. With intensifying business uncertainty, companies became increasingly cautious and more deeply scrutinized deals, which impacted numerous areas of our business, including a material lengthening of sales cycles, delays in collections, and the significant back-end weighting in the linearity for the quarter. For some further context, technology, e-commerce, and financial services are our largest end customer verticals by revenue. Also, these headwinds to revenue growth that impacted Cloudflare were outside of our control; we remain committed to controlling what we can control, and that is to focus on building great products that customers need while also maintaining our strong commitment to being fiscally responsible and remaining good stewards of investors' capital. As such, we delivered a record quarter in terms of operating profit and operating margin and significantly outperformed on free cash flow. We also continue to prudently allocate capital with a focus on maximizing shareholder value. Turning to revenue. Total revenue for the first quarter increased 37% year-over-year to $290.2 million. New pipeline growth remained strong in the first quarter, exceeding our internal plan for the second consecutive quarter and continuing the trend of accelerating growth in new pipeline generation for a third consecutive quarter. However, the significant incremental caution exhibited by customers resulted in a pronounced decline in our close rate and an extreme back-end weighting of ACV bookings during the first quarter, both of which were primarily impacted by the aforementioned longer sales cycles. More specifically, our average sales cycle during the first quarter was 27% longer than the average of the previous four quarters. Sales cycles increased most significantly in expansion deals with our contracted customers, which were 49% longer than the average of the previous four quarters. However, our win rates against the competition remain high. From a geographic perspective, the U.S. represented 53% of revenue and increased 37% year-over-year. EMEA represented 27% of revenue and increased 40% year-over-year. APAC represented 13% of revenue and increased 31% year-over-year. Turning to our customer metrics. In the first quarter, we had 168,159 paying customers, representing an increase of 13% year-over-year. Turning to large customers, we ended the quarter with 2,156 large customers, representing an increase of 40% year-over-year and an addition of 114 large customers in the quarter. Our dollar-based net retention rate was 117% during the first quarter, representing a decrease of 500 basis points sequentially and a decrease of 10 percentage points year-over-year. We've not experienced elevated churn rates as renewal rates in the first quarter were consistent with the levels experienced on average over the previous four quarters, which was an all-time high for the company. Instead, similar to the fourth quarter of last year, the decline in dollar-based retention was again primarily driven by delayed expansion with our larger customers. Moving to gross margin. First quarter gross margin was 77.8%, representing an increase of 40 basis points sequentially and a decrease of 90 basis points year-over-year. Network CapEx represented 5% of revenue in the first quarter. For fiscal 2023, we continue to expect network CapEx to be 11% to 13% of revenue. Turning to operating expenses. We understand that a crucial aspect of our success is our commitment to being responsive to near-term changes in market conditions and adjusting our operations accordingly without compromising the long-term opportunity ahead of us, which we all know is massive. We again took proactive measures during the first quarter to improve operational efficiency and effectively manage spending. As a result of these actions, first quarter operating expenses as a percentage of revenue remained consistent sequentially and decreased 5% year-over-year to 71%. Our total number of employees increased 23% year-over-year, bringing our total headcount to approximately 3,390 at the end of the quarter. We will continue to pace hiring for the year based on market conditions. Sales and marketing expenses were $120.6 million for the quarter. Sales and marketing as a percentage of revenue increased by 1% sequentially and remained consistent at 42% compared to the same quarter last year. Research and development expenses were $51.3 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 $34.6 million for the quarter. G&A as a percentage of revenue remained consistent sequentially and decreased to 12% from 15% in the same quarter last year. Operating income was $19.4 million compared to an operating income of $4.9 million in the same period last year. First quarter operating margin was 6.7%, an increase of 440 basis points year-over-year. These results highlight 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 $27.2 million, or a diluted net income per share of $0.08. During the first quarter, we initiated tax-planning strategies, and we were able to successfully reduce cash taxes related to previous tax liabilities and other taxes. As a result, tax expense for the quarter was $3.9 million. We ended the first quarter with $1.7 billion in cash, cash equivalents, and available-for-sale securities. Free cash flow was $13.9 million for the first quarter, or 5% of revenue compared to negative $64.4 million, or 30% of revenue in the same period last year. Remaining performance obligations, or RPO, came in at $959 million, representing an increase of 6% sequentially and 39% year-over-year. Current RPO was 75% of total RPO. Before moving to guidance for the second quarter and full year, I would like to begin with our expectations and the provisions we have factored into guidance. Last quarter, we highlighted our expectation for sales cycles to continue to lengthen for both the first quarter and full year 2023. However, the level of elongation experienced in the first quarter was unprecedented and far surpassed our forecast entering the year, pressuring revenue growth. As a result, for the second quarter, despite the continued reacceleration of our new pipeline generation and our high win rate against the competition, we've assumed sales cycles to remain at the elevated levels experienced during the first quarter and have, therefore, also assumed close rates remain at continued low levels. From a linearity perspective, we have assumed a continued back-end weighting of ACV booked and have, therefore, incorporated minimal in-period revenue recognition for the second quarter. Also, we believe that currently depressed close rates and elongated sale cycles are temporary in nature, but we cannot predict when the increasing caution exhibited by the customers during the first quarter will recover. As such, we have assumed these headwinds, which emerged in the month of March, will persist through the end of the fiscal year. Now turning to guidance. For the second quarter, we expect revenue in the range of $305 million to $306 million, representing an increase of 30% year-over-year. We expect operating income in the range of $14 million to $15 million, and we expect diluted net income per share of $0.07 to $0.08, assuming approximately 345 million common shares outstanding. Due to our aforementioned tax planning strategies, we expect an effective tax rate of 6%. For the full year 2023, we expect revenue in the range of $1.28 billion to $1.284 billion, representing an increase of 31% year-over-year at the midpoint. We expect operating income for the full year in the range of $73 million to $77 million, and we expect diluted net income per share over that period in the range of $0.34 to $0.35, assuming approximately 345 million common shares outstanding. We expect an effective tax rate of 9% for 2023. After having achieved positive free cash flow in the second half of last year and again during the first quarter of this year, we continue to anticipate being free cash flow positive for the full year 2023. For modeling purposes, we expect free cash flow to trend upward on an ongoing basis but anticipate near-term variability in our free cash flow generation with the second quarter anticipated to be lower than the first quarter due to the timing of capital expenditures and other payables. In closing, we remain confident in the enormous opportunity ahead of us as well as the elasticity and durability of our operating model. We are focused on becoming even more efficient and more productive, not just during the currently challenging macroeconomic backdrop, but also because operational efficiency is a long-term competitive advantage. I'd also like to thank our employees for their continued dedication to our mission, customers, and partners. And with that, I'd like to open it up for questions.

We'll go first this afternoon to Sterling Auty of MoffettNathanson.

I think the big question is around the guidance. I think coming out of last quarter, the perception was that the guidance was actually aggressive and you kind of alluded to the close rates that you had factored in. Now with the changes that you've seen and especially in light of the sales changes you're looking to make, what are the elements that investors can look to see the confidence in being able to deliver on the revised outlook?

Yes. Maybe I get started here. Remember, when we gave guidance during the last quarter, we actually said the first and second quarters are more challenging than the later half of the year. We looked at close rates and assumed that what we had seen in the third and fourth quarter of last year, elongation would continue. But the deteriorating environment surprised us. We saw sales cycles really elongate far beyond our forecast, up to 27% on average and then the expansion business, as I said before, close to 50%. So those were material differences in the assumptions we had at the beginning of this year. I think we took this into account and adjusted guidance now carefully also assuming that the linearity deterioration we've seen in the first quarter would continue for the second quarter. Specifically, we have assumed hardly any revenue recognition from in-quarter ACV generation. So this, I think, is prudent in light of what we have seen. You heard from Matthew that the salespeople that are impacted by this measure contributed very little in terms of our overall ACV generation to the current results. So we think there is more upside in this transition than there is downside in terms of performance and positive impact on sales capacity moving forward. The good thing to point out, however, is again, that the improvement in pipeline that we have now seen over consecutive quarters has continued in the first quarter. So as Matthew mentioned, it's not a limitation of opportunity; we will see sales cycles extend but not pipeline slowing down. So on that was a very encouraging time. But I think the results are prudently now reflected in the guidance and the deterioration we've seen in the first quarter, especially from a sales cycle perspective, had a material impact on how we think about the rest of the year.

Understood. And maybe one quick follow-up for Matthew. Can you just characterize for us the traction in the AI opportunity in particular to give us one example. But when you look at it as a whole, how are you seeing it track? And what should we think about the expansion opportunities from that customer base through the rest of the year?

Yes, Sterling. The AI is something that I think surprised us last quarter in terms of the positive impact, and it continues to surprise us. We've seen the revenue that's coming from AI companies just quarter-over-quarter have substantial growth north of 20% quarter-over-quarter growth from the large AI companies that use us. And it's not just one or two, but from large to small. What we're hearing from AI companies is that as they look to who they're going to use for their infrastructure and they can start with a clean slate, that Cloudflare is part of that and that we're helping them go fast, compete, get the most efficiency, and be able to protect themselves from some of the significant cybersecurity and fraud risks that they face. And that continues to be something that is delivering really positive results for us. I think you're going to see us during our Developer Week next month in May highlight some of these customer stories and highlight ways that AI companies are using Cloudflare in order to push that innovation forward. So I think that has continued to be a real positive for us, and that has only accelerated from even Q4.

We'll go next now to Thomas Blakey of KeyBanc.

Tom Blakey here from KeyBanc. It seems there is significant pent-up demand, no gross churn, and the pipeline is setting new records. This question is for Matthew. You mentioned that these are critical needs regarding access and security, not just nice-to-haves. What are these customers telling you about what they are waiting for? Are there any indicators on how long this pause might last, Matthew? That would be my first question.

Yes. Everyone is communicating to us that they want to continue investing with us. IT organizations are critically reviewing their budgets and determining which projects to delay and which ones require immediate investment. We are observing that when companies face challenges, deals are closing very quickly. However, new large projects, such as transitioning to a Zero Trust environment, are experiencing extended sales cycles compared to previous times. What sets Cloudflare apart is that, despite these longer sales cycles, our average sales cycles remain significantly quicker than our industry peers. In early 2022, we were among the first to notice the economic slowdown due to the lengthening sales cycles. Although they improved, they are now slowing down again, and we tend to recognize these trends before some competitors. We approach our business with caution, and while no one is reporting significant cancellations of projects, clients are noting tighter budgets and increased caution, leading to longer sales cycles than we've historically experienced. However, customers have not indicated that they are switching to competitors; in fact, they express a desire to invest with us but are being careful with their IT expenditures, resulting in more deliberate decision-making.

All right. That's helpful, Matthew. And maybe as a follow-up, a perfect segue actually to the conservativeness of this guide. It sounds like it's increasingly conservative. I'd love to hear, maybe from Thomas, in terms of maybe any indications of what he's seeing from numbers coming in, in April. It's been a month from the end of March, and just kind of trying to gauge in terms of when we could even get back to this 130% long-term governor would be helpful, Thomas.

The early indications for the second quarter do not suggest a significant change, either positive or negative. We are maintaining our current pace, with no signs of substantial improvement, but also no signs of decline.

We go next now to Brent Thill at Jefferies.

Matthew, regarding the sales aspect, what are your thoughts on the impact of the new head of revenue? How confident are you that the existing team won't face a lengthy transition period? What leads you to believe that this team is well-suited for their roles and that the focus is more on internal execution rather than external factors?

I believe it's a mix of several factors. The challenges in the macro economy have revealed some weaknesses among certain sellers on our team. During the favorable conditions of 2021, success at Cloudflare didn't require a high level of discipline in sales. Moreover, our reluctance to replace underperformers when the tech job market was hot contributed to the issue of having some team members who were not meeting expectations. However, Marc has excelled at pinpointing these individuals and initiating their exit from the team. On a positive note, our top sellers continue to thrive, with only about a 1% decline in productivity, whereas the lowest performers have seen a significant drop. This suggests that under Marc's new leadership, along with the talented individuals he is recruiting, we are in a strong position. Notably, 250,000 candidates applied to work with us in Q1, indicating a high demand for roles at Cloudflare. Our successful employees can achieve remarkable results in sales, and Marc is instilling a focus and discipline that will be beneficial. As we consider replacing certain team members, their contribution is relatively minimal, and any transitions will be handled with care and thoughtfulness for our current staff. We anticipate that these changes will not only boost our high performers but also attract new talent that significantly enhances our capabilities. I am very excited about the potential of the individuals we are hiring to fill these roles.

And just a quick follow-up for Thomas. It looks like, if I'm looking at this right, the number of net new enterprise accounts was the lowest you've seen in two years at 114 sequentially. So it seems like this trend was observed across both enterprise and SMB, indicating that no single sector remained stronger than the others.

I think that read is correct.

We go next now to Matt Hedberg of RBC Capital Markets.

Maybe a follow-up to that last question from Brent. A comment on the pay-as-you-go side of your business. Is that being impacted by macro sort of more or less the same as the enterprise?

I think we're observing overall weakness in the entire market. Pay-as-you-go makes up a relatively small portion of our business, accounting for less than 15% of our revenue, so it doesn't significantly influence our results. However, we are noticing a lower rate of upgrades. At the same time, downgrades are not declining either. I'm encouraged by the strong developer engagement we're experiencing in our business. We're nearing 5 million applications running on our platform, with most of them coming from pay-as-you-go developers, which continues to be a successful area for us. Additionally, we have a case where a customer who was paying us $200 a month was identified and upgraded to an enterprise customer, now spending hundreds of thousands of dollars annually with us. Therefore, pay-as-you-go remains beneficial. However, the cautious approach to budgeting is evident across the industry, with no significant differences between the lower and higher ends of our business.

Got it. Thomas, with the revised outlook for 2023 at 31.5%, which is below the implied $5 billion target you discussed a few quarters back, what are your thoughts on whether this environment alters your approach to reaching that $5 billion goal in five years? Or do you have any updated insights on that?

As Matthew rightfully pointed out, the market is not limiting. It's limiting us, and the opportunity is not limiting us. There are some headwinds now. They will be temporary in nature, but they don't take away from the enormous opportunity that is in front of us. So it doesn't change our thinking around where this journey is going to take us.

We go next now to Keith Weiss of Morgan Stanley.

I feel a bit confused about what happened in the quarter. When I consider the explanations provided, the banking crisis occurred in the first two weeks of March. Since your business tends to follow a linear model, I would have expected you to say that you only closed about 15% of your business in the last two weeks if that was the impact. Additionally, concerning the salespeople, if they hadn’t been productive for a while, there wouldn’t be anything really new to report. Matthew, you mentioned a weaker macro environment last year and were among the first to point out that it was an unfavorable situation, yet you managed to operate very effectively throughout 2022 and presented a strong ROI focus along with a compelling cost-value proposition. I'm struggling to understand what changed in Q1 and the timing of that change.

Keith, the most significant change we've observed is the length of the sales cycle, which has increased by more than 25%. This extension impacted many aspects of our operations during the quarter. Typically, we see about half of our business closing in the final month of the quarter. However, the uncertainty surrounding the banking sector led to heightened caution among purchasing departments, causing a notable pause in decision-making across various companies, not just those associated with SVB or Credit Suisse. As a result, much of our business was delayed until the latter half of March, and some did not close within the quarter at all. We are uncertain if March represents a new normal, which would prompt us to approach future business planning cautiously, or if the situation will improve swiftly. The early indicators suggest that conditions aren't deteriorating significantly, but we aren't observing substantial improvements either. Ultimately, the key change has been a material increase in the length of our sales cycles; while win rates have remained stable, close rates have indeed declined.

Got it. You guys mentioned that you saw that in both small customers and large customers. Were there any product families that sustained better or worse than others? Was there any variance on that side of the equation?

We continue to have a very fast close rate when clients are facing issues and need to address them. This has not changed from quarter to quarter for clear reasons. We respond quickly, and when someone is unavailable, we can quickly get them back engaged. Those deals often close within hours. During the last quarter, we saw promising developments with R2, as larger customers are increasingly transferring bigger data sets. However, across the board, clients requiring a larger IT commitment are being more cautious, leading to noticeable increases in sales cycles. What distinguishes us from many other companies is our ability to identify trends sooner. Even with a 25% increase in sales cycles, our sales cycles remain significantly faster than the majority of other SaaS companies. We notice changes earlier, but we are uncertain whether this indicates a fundamental shift in how procurement departments view IT spending or if it's merely a temporary effect stemming from anxiety in March about the banking sector. The next quarter will clarify the direction of this trend, but we aim to be very careful and prudent as we plan for the future.

We go next now to James Fish at Piper Sandler.

On gross margins, you are holding above your long-term average as well. And Matthew, you actually just talked about the fact that these larger commitments are taking longer. Is there a thought process here to maybe just try to get that and land a little bit smaller and maybe offer higher discounts kind of near-term to try to land smaller deals here?

I believe that finding various ways to access a customer's account has always been part of our strategy. Thanks to our diverse range of products, we can explore many different avenues. I believe we can maintain gross margins within our target range of 75% to 77%. It would be a mistake to significantly reduce that gross margin over time. However, we can bundle and discount our offerings to pursue smaller deals, thanks to our favorable margin profile, while leveraging our engineering capabilities to achieve the gross margins we expect. We are not altering our gross margin targets, and we are not losing deals due to pricing. We have remained highly competitive and are continuing to deliver a strong return on investment along with significant software gross margins.

Makes sense. And Thomas, I appreciate all the details around sales cycles lengthening. But on the close rates, is there a way to think about the magnitude difference you're seeing here? And how much worse could it get for you guys? Is this kind of the bottom potentially of close rates that you're assuming? Or could it get another step lower from here?

We always say we are cautious about discussing our guidance. For this quarter, we aimed to be careful. We considered what we observed in the first quarter and were deliberate in assessing the improvements or lack thereof in those factors. The nonlinearity we experienced this quarter was significant, and we have not factored in any considerable improvements. As I mentioned in the second quarter, we have not predicted any notable revenue recognition from ACV during this period. Therefore, we have been thoughtful in how we formulated the guidance.

We go next now to Joel Fishbein at Truist.

Matthew, just one for you and really appreciate the color on the change you're making in go-to-market efficiency, but I wanted to ask about some of the partnerships that you've established with some of the global SIs like Accenture and Shields Up, and to see if you've seen any change in that go-to-market. And maybe just give us an update on how those are factoring.

I believe we are still in the early stages of this, but it's promising. We secured a federal deal that continues to grow in collaboration with Accenture, which has instilled confidence in them to promote us in various other partnerships and global agreements. Marc has done an excellent job of emphasizing the importance of partnerships and considering which market segments we want to address directly versus those we aim to serve alongside partners. As we achieve these initial successes, it enhances our ability to secure more opportunities with large global systems integrators and other major partners. They are noticing the same trends we are. In discussions with them, they observe a general conservatism regarding IT spending, which seems less significant in the security sector. Consequently, there appears to be a greater willingness and eagerness to collaborate with us. However, when we engage with systems integrators and other major partners, particularly at the higher end of the market, they reflect the same cautious approach of measuring several times before acting that they are observing from their clients. This situation remains a significant opportunity, especially in the areas of Zero Trust and Workers, where we see potential for greater collaboration. I also think we have seen IT departments looking for ways to optimize their operations effectively.

Just as a quick follow-up. Are the deal sizes generally bigger than your normal size since you're landing it seems like to be larger organizations with these partners?

Yes. They tend to be larger than the average deal. But we land $10 million-plus deals on our own as well. I think over time, you'll see us, again, work more closely with those SIs and other partners to deliver some of the larger deals and make sure that we can make inroads into more accounts and use them as a way to help integrate larger solutions together. So again, I think it's something that is a priority for us. I think we have the early wins, but now we need to continue to scale those programs.

We'll take our final question today from Mark Murphy of JPMorgan.

Thomas, were bookings more heavily impacted on the CDN side of the business or the security side or perhaps elsewhere?

We never talk about CDN. I would say, I come back to what Matthew said. If customers are in difficult situations under duress, we onboard fast. Those products tend to be security products. And so, if there's a statement at all, product-wise is that security product suites are doing better than the application services.

Okay. Understood. And then, Matthew, when you look back on it, and I think Brent asked about this a bit earlier, but the change in Head of Sales position last November, the goal was to introduce more rigor and discipline. I think you acknowledged at the time that those changes can take time. I'm curious to what extent you might have actually seen disruptions from sales org changes, whether it be account mapping or territory assignments or commission structures or anything along those lines, which you could look at and say, well, this might actually stabilize a little later in the year.

Yes. I understand that, that would be handy if we could point to that. I don't think that that's what we're seeing right now. I think that we have actually seen our top sellers be more productive. I think that the changes that Marc is putting in place really are starting with these changes now. And that obviously does introduce uncertainties. We think we have our handle around that. I think we've planned that extremely well. And again, I think that as we look at the caliber and quality of the people who we can bring on board and how we can invest in our top performers today, just getting our sales performance to look much more like a normal distribution than what today is much more of a bimodal distribution is an extremely effective way for us to reaccelerate the growth that we have. And so the changes that Marc is making are the right changes. Our team, the highest performing individual contributors and managers on our team are leaning forward and emailing me every day about how great it is to have an additional amount of rigor and discipline. There may be bumps along the road. These transitions do take time. But I think we are on the right path. Marc is the right person. Across our team, the feedback that we're getting is extremely positive. And again, we're not limited by the market for our products. We're not limited by innovation. We're not limited by pipeline. We're not even limited really by sales capacity even as we transition people off our team. And so that gives me a lot of confidence going forward that while we will continue to see pressure from the macroeconomic conditions over the next year, I am really excited for as we have our sales engine match our innovation engine, what we're going to be able to deliver as a company.

Thank you. And ladies and gentlemen, that is all the time we have for your questions this afternoon. I'd like to turn the conference back over to Mr. Prince for any closing comments.

Thank you so much. Really appreciate everybody tuning in for the call. This has definitely been a quarter of contrast, but it is an incredible opportunity for us to continue to make Cloudflare a better company. I appreciate all of the hard work from all of our team. We are excited for the quarter ahead. I hope to see many of you at our Investor Day on May 4, and make sure to tune in the following week for Developer Week. There are a number of incredible announcements coming. Thank you so much.

Thank you, Mr. Prince. Ladies and gentlemen, that will conclude the Cloudflare Q1 2023 earnings call. Again, we'd like to thank you all so much for joining us and wish you all a great evening. Goodbye.