Cloudflare: Badly hurt by macro

$Cloudflare, Inc.(NET)$ 

Cloudflare's Q1 revenue results were largely in line with expectations, but its revenue guidance for FY24 was below expectations due to macro uncertainty leading to longer sales cycles and backend-weighted linearity, with security products performing better than its applications. Cloudflare results will likely create significant overhang on shares over the near- and medium-term as investors weigh the prospects for Cloudflare and software generally for the remainder of the year. Based on the current pre-market trading, Cloudflare is already down 25% after its result.

Key Q1 earnings call takeaway

Cloudflare's Q1 revenue came in at $290.2M, or 37% growth, on the low end of the $290-291M guidance and roughly in-line with consensus of $290.9M. Cloudflare said that intensifying business uncertainty led to a material and “unprecedented” lengthening of sales cycles (increased 27% in total and 49% for expansion deals with existing customers than the average of the previous four quarters), delays in collections, and significant backend weighting of linearity in the quarter with almost half of the new business closing in the last two weeks of the quarter. Reflecting these trends, DBNR slowed 5pts sequentially to 117% and >$100K customer sequential growth slowed to 5.6%, with both metrics at levels comparable to Q1 2020. Cloudflare attributed the negative developments to the collapse of SVB in mid-March, the broadening banking crisis, and the worsening macro outlook, stating that uncertainty worsened “over the course of Q1 with every failing bank.”

As such, Cloudflare reduced its FY24 revenue guidance from $1.336B previously, or 37% growth y/y, down $54M to $1.282B, or 31.5% growth y/y, representing a 5.5% reduction to the full-year growth rate. Cloudflare assumes that sales cycles remain elevated and close rates maintain their low levels consistent with Q1 for the year, and that linearity remains backend-weighted, with expectations of “minimal” in-period revenue recognition from ACV generated in Q2.

Focus on profitability and FCF

Cloudflare emphasizes profitability and FCF generation amid a more challenging macro environment via efficiency initiatives. Q1 PF OPM comes in at 6.7%, ahead of consensus 4.2%, while FCF lands at $13.9M vs. consensus $(12.6)M despite collections headwinds. Cloudflare announced initiatives to improve sales productivity, including identifying 100+ underperforming salespeople who contributed only ~4% of annualized new business over the last year to be rotated out, which should improve sales productivity without overly negative impact on business generation in the near-term. Cloudflare guides FY24 PF operating income to improve $19M from $56M (4.2% margin) to $75M (5.9% margin) and maintained its target of being cash-flow positive for the year, which are important developments as it navigates revenue deceleration.

Despite the macro headwinds, there are some positive developments for Cloudflare. The company notes that the re-acceleration of its new business pipeline seen during the 2H22 continued into Q1 and win rates maintained at record levels, as did renewal rates. Security remains strong, and AI continues to be a rapidly expanding space.

Conclusion: Higher MOS for added risk

Cloudflare still remains in respectable growth territory based on its 30%+ revenue growth guidance for the year despite the ongoing macro headwinds as it continues commitment to innovation and disruption.

However, given its high valuation and the added risk posed by macroeconomic challenges, I think investors do need significant margin of safety before considering Cloudflare as an investment now. This is especially true because Cloudflare previously confidently projected figures above market expectations after Q4, only to later issue guidance below those expectations approximately 90 days later. Things can change very quickly.

@TigerStars @Daily_Discussion