Cloudflare, Inc. Q3 FY2024 earnings call

• Pleased with Q3 results, exceeding expectations for revenue, operating margin, and free cash flow. - Reached an inflection point in the rebuild of the go-to-market organization. Sales productivity improved and is back to good levels. - Added a record number of large customers. - Highlighted customer wins like a rapidly growing AI company signing a $7 million pool of funds contract for Workers AI, and a rapidly growing technology company signing a $2.4 million contract for R2, Workers, and Application Security. - Mentioned work in the public sector, including providing free service to election officials in many states.

In the third quarter, Cloudflare achieved revenue of $430.1 million, up 28% year-over-year. It added a record 219 new large customers (paying over $100,000 per year), with 3,265 large customers in total, up 28% year-over-year, and large customers contributed 67% to revenue. Dollar-based net retention was 110%, down 2 percentage points quarter-over-quarter. Gross margin was 78.8%, operating profit was $63.5 million with an operating margin of 14.8%, and free cash flow was $45.3 million. Geographically, the U.S. represented 50% of revenue, up 22% year-over-year; EMEA was 28%, up 31% year-over-year; APAC was 14%, up 38% year-over-year. Paying customers totaled about 221,500, an increase of 22% year-over-year.

• Fourth quarter revenue expected to be in the range of $451 million to $452 million, up 25% year-over-year at midpoint. Operating income expected to be $57 million to $58 million, effective tax rate 16%, diluted net income per share $0.18. - Full year 2024 revenue expected to be $1.661 billion to $1.662 billion, up 28% year-over-year. Operating income expected to be $220 million to $221 million, effective tax rate 13% for 2024, diluted net income per share $0.74. Free cash flow expected to be consistent with prior guidance of approximately $160 million to $164 million for the full year.

• Macro-economic uncertainties that could impact future operating results. - Sales team changes may have impacted the short-term cadence of some larger deal cycles. - Uncertainties regarding product launches and market acceptance.

Q: Hi. Thanks for taking my question, guys. Congrats on the results. Matthew, maybe I'll start with you. In the past, you've talked about sort of the crystal ball nature of Cloudflare. And I guess I'm wondering, when you look into that crystal ball now, what is it telling you about the external business environment? And then perhaps could you give a bit more color on -- maybe even the quantity of the U.S. based slip deals?

A: Yes. Matt, first of all, thank you for the question. I am not shy about talking about what we see or talking about macro concerns that are out there. I don't think that we see anything that is worse than in fact, I think we see an environment that maybe is ever have slightly improved. We saw real strength actually in Europe. I know a number of other companies haven't seen the same, but we executed well there and continue to see strength there. Asia has performed very well. And actually, from everything we've seen in the crystal ball, North America is -- has leveled off to slightly improved. I think we're where we have room to improve ourselves and where I'm optimistic looking forward is around our own internal execution. It has nothing to do with the macro. And the good news is that with our team in Europe, which has seen the most consistent sales productivity over the last eight quarters, I've had sales productivity increased by 22% year-over-year in Q3. They are running the playbook that we're running now in North America. There's a smaller team, so it's faster for us to be able to make those changes, but that's work. Same thing in Asia where they saw actually a sales productivity bump of 40% over the past 3 quarters. and they had the highest productivity of any region this year. So I think the macro -- I don't think there's anything about the macro that gives us more pause today than before. If anything, I think it's improving. And what I'm very optimistic about is that the places where we've already gotten through our improvement of our go-to-market team, we're seeing the benefits of that. And now we're rolling that out to our largest market, and we see that in Q1, you see a dramatic increase starting in the number of ramped reps and that gives me a lot of confidence and the consistency of the macro also allows us to invest with confidence.

Q: Okay. Good afternoon and congrats on the nice quarter. I want to start with a question on your AI. So you mentioned that a number of conversations with customers began to shift this quarter from AI training to AI inference, and I think you signed a large workers AI deal. Just give any more color on the AI landscape and some of the feedback you're hearing on Workers AI?

A: Yes, Andy. Thanks for the question. I'm really amazed at how quickly the AI platform that we launched is taking off and how many people are getting real value from it. And so as we mentioned, one of the leading AI companies signed a $7 million one year contract with us to move their inference to our platform. What they saw was that they were able to get significantly better performance while also being able to run at a much higher ROI on the investment that they made over what they were seeing, trying to manage it themselves through hyperscale public cloud. That's a story that is playing out over and over again. I think it's a story that is accelerating. And in order to support that, we have made the investments to increase not only just the number, but also the power of the GPUs that we're deploying around the world. What I think is unique about Cloudflare is two things. One, we are actually able to deliver inference incredibly close to where anyone is on earth because we've deployed the inference capabilities across at this point, nearly all of our network. But in addition to that, we've actually done the work to get higher utilization out of those same GPU resources where what we see when we survey customers that are trying to manage this themselves, through hyperscale public cloud is that they're getting utilization rates that are sort of in the 5% to 10% range of the resources that they're buying. We're able to deliver much higher utilization. And in the process of that, that means that we can actually pass on the effective savings to our customers. So they not only save in not having to maintain their own team to manage these virtual machines and containers, but they also save because we can just do more with the same GPU resources that are being deployed. So I'm incredibly excited that this is something which I think we have sort of started -- we're starting to shift to people who have built their models and how they actually want to deploy them in customer-facing ways. And when they do that, I think Workers AI is the most powerful platform to be able to deliver inference tasks at a global level.

Q: Thank you very much. I'll add my congrats, and I agree with Andy that I think CJ is just an incredible hire. Matthew, it seems like you're capable of adding about 100,000 new developers per month, I believe, onto the platform. I think you crossed 2 million or 3 million developers. And now you have vectorized, you have hyperdrive. There's so many new products. The stats out there, there are 30 million to 100 million developers depending on how you define it. How many of those do you think are viable candidates for Cloudflare? And what do you think is attainable over time? And then I have a quick follow-up.

A: Yes. I mean, I think all of them are viable candidates for Cloudflare. And we want to make the platform support any of their needs. That doesn't mean that every application is going to make sense to run on Cloudflare. If you have a legacy application, if you're trying to run SAP HANA, we're not the right place to do that. But if you're the company that's building the thing that's going to disrupt SAP HANA, then we're absolutely the place to do that. And so if you look across the AI ecosystem, if you look across the sort of blockchain and cryptocurrency ecosystem. If you look across anywhere where someone is able to start with a blank slate, we're seeing adoption rates in the top start-ups, top companies in those spaces that are well north of 50%, and in some cases, well north of 25% of the industry. So what we think the excitement around the platform is palpable, and it has again taken off much faster. I think our secret is that customer zero for everything that we do at Cloudflare is Cloudflare ourselves. And that's been a great formula. If we build things that our own developers want it turns out a lot of other developers want to develop the same way that Close does. And that's driving, I think, a lot of excitement and a lot of interest in the platform.

Q: Thanks. Good afternoon. Matthew, just on the go-to-market changes. There have been questions just in terms of when you talk about the pushouts, we always see this and you've seen this in past quarters. Was this quarter more pronounced on the pushouts? Or is this just something you're commenting, hey, made some sales changes this is the natural side effect. I think was kind of just curious about the magnitude of that push. Was that greater or kind of equal to what you've seen historically in past quarters?

A: I think that it was -- I think that what we saw this quarter that was a little bit different as we started to see the capacity held it back at some level. And that we had had to, especially in North America cut deeper than I think we initially expected. And Mark, I think, did a great job with performance management coming in and continue to do the hard work, finding the really great people on our team and make sure that they were taken care of, but also finding people that weren't going to be up to snuff and move them off the team. What I think is the big change, though, is I think we see the inflection point for that, and we've crossed it, we're really starting in Q1 the capacity. And we know that that's going to tick up because those are people who are already on the team. They're just ramping, right? And we know what the ramp rates are. We know how that builds. The capacity starts to really tick up in Q1. And assuming we're continuing to be able to hire the plan, which we expect we'll be able to given the caliber and quality of the candidates that we get, that continues to tick up over the course of 2025. So I don't think there was something that was dramatically different. I do think that we have made the productivity gains we've seen the success in other regions, and now we're bringing that to what is our largest market, which is North America. And we see again that inflection point in the not-too-distant future.

Q: Thank you. Just one moment, we are having connection problem with the operator.

Q: Thank you. Thanks for the question. Matthew, love to get an update from you on the public sector. Obviously, you've got [indiscernible] certification. You've seen some very good customers there. I just love to hear what's happening there. And then also as it relates to that, where they are, do you think they are in their adoption of inference? That would be really helpful.

A: Yes. I think that public sector has been -- was really an area of strength for us in 2023. We have not -- it has not -- it continues to perform, but it hasn't I would say, been in 1 of our standout star. I think that, that is because we've been nurturing relationships, and I think that you'll see it reemerge as a real driver of growth for us going forward. But I think it has not been much of a standout as it was last year. I also -- what is -- I'm constantly reminded of is how the people who work in governments are almost by definition, mission-driven and they really appreciate the work that we do. And so the number of notes that I've gotten from very senior people across the U.S. government, thanking us for what we did around the election, making sure that any time there was a problem they knew that they could call on our team that we had people available 24 hours a day to help with any county official in any state, anywhere in the country that we're seeing some type of an attack. And I'm proud of what we've done with that. That is the most effective marketing that we can do for our public sector business. And what we find time and time again is that as we do those good works, it turns into significant deals for us going forward. And so我 think that it will be a very big -- it will continue to be a big and growing part of our business. And we have the pieces in place now that there are really no roadblocks from us winning more federal business.

Q: Hi, good evening. Just wanted to get a little bit more color from some of the product side of things and particularly those around sort of the data orientation. Can you maybe give us a sense of how R2 and D1 are faring within your customer base? And whether these products are helping drive some of the growth around AI and sort of the inference modeling as well?

A: Yes. I think that R2 definitely is -- the magic continues to be that if you have a large data set and you need to move it to wherever there is excess GPU capacity that R2 is an ability to do that. And so I think that, especially in training workloads, we're seeing be something that is often the gateway into using the rest of Cloudflare. And then that is helping us win more and more of the AI workloads, especially on the inference side. I think D1, there is less that's driving in the AI space directly. It is more of a traditional SQL database. But I think these components together -- have come together where now people are building full applications on top of platform workers. So you need a database, you need an object store, you need all of these primitives and these primitives together are allowing us to win much more complicated applications, much more complicated workloads, and that's important. And we continue to innovate in that space. I think what we did with HyperDrive some of the announcements we had around Birthday Week, with Durable Objects and Durable Databases are really very unique primitives that you can only get on Cloudflare. And I think you're going to start to see applications that just would have been prohibitively difficult to build in the past, especially around synchronization worldwide. A lot of game companies are starting to use some of these primitives to be able to think their player states and things that were in the past, extremely difficult to build. That is something that I think you're going to see more and more applications that just couldn't be built anywhere other than Cloudflare. And that's -- I think that's incredibly exciting for the space.