Cloudflare's FY22 Q4 revenue was in line with expectations and was overshadowed by its better-than-expected guidance for FY23 revenue growth and PF operating margin.
The company's guidance seems to be prudently derisked, and while it is not immune to macro headwinds, it appears to be executing well. Despite signs of deceleration in metrics such as RPO, DBNRR, and customer growth, Cloudflare's deceleration rate seems less steep than that of software companies in related markets, which is encouraging given its innovative and price-disruptive offerings.
Some signs of deceleration
Although Q4 revenue growth of 41.9% slightly exceeded the consensus estimate of 41.6%, there are signs of deceleration in Cloudflare's business.
The company's PF operating margin of 6.1% was also ahead of the consensus estimate of 4.7%, while its FCF was strong at $33.7M, fulfilling its promise of positive cash flow in 2H22. However, revenue upside was minimal in Q4, indicating that some deals may have rolled over into Q1, and variable revenue may have been affected by macroeconomic headwinds. Cloudflare has also experienced deceleration in metrics such as RPO, DBNRR, and customer growth, reflecting caution among customers due to economic uncertainty.
Despite these challenges, Cloudflare's rate of deceleration is not as severe as that of other software companies in related markets, such as Azure and AWS, which is encouraging. Cloudflare's innovative and cost-effective offerings, which have less exposure to base-level compute, memory, and storage, appear to be the reason for this resilience.
Cloudflare's initial FY23 guidance calls for revenue growth of 37%, which is above the 35% consensus, and PF op margin guidance of 4.2%, which is above the 3.6% consensus. The company is also anticipating positive FCF in FY23 and beyond, including an anticipated 11-13% of revenue in network CapEx spend. While the company's pipeline has improved, Cloudflare has not factored in any improvement in the macro or benefits from new go-to-market initiatives and is assuming the elongated sales cycles seen in 2H22 continue into 2023, thus incorporating sales productivity and close rates below historical lows into its guidance. Cloudflare's grounded view amidst a higher cost-of-capital world seems sensible and is perhaps amplifying the response to its guide-above for FY23.
The potential for Cloudflare to benefit from AI is real but still in its early stages
During its 4Q22 analyst meeting, Cloudflare announced that it has replaced Cisco as the network security service provider for OpenAI and has taken over from Azure Front Door CDN to handle the significant workload generated by ChatGPT. Additionally, Cloudflare provides advanced services such as Workers, an application development platform, and R2, a server-less repository, which are used by numerous AI startups, including OpenAI.
However, during a recent interview, an industry partner suggested that Cloudflare's collaboration with OpenAI/ChatGPT would likely have a limited near-term impact on revenue, as it is focused on Application Services. However, the company sees a significant long-term opportunity with R2 and Workers. Cloudflare has a one-year, $1 million agreement with OpenAI, which was signed when OpenAI experienced a surge in usage and realized that Cloudflare's superior performance was necessary.
Cloudflare believes that the storage and computing capabilities of its edge network are particularly advantageous for AI companies, and it notes that its largest R2 customer is also an AI company. However, the company is realistic and emphasizes that AI is a long-term opportunity rather than a short-term one.
Nonetheless, Cloudflare's collaboration with AI has significant potential in the long run and investors should keep an eye on it.
Strong Progress in Zero Trust
Cloudflare reports that its Zero Trust product continues to make progress, with several F500 customers among its recent wins. Q4 channel partner revenue, an indicator for Zero Trust, increased by 66%, only a slight deceleration from Q3's 67%. According to Cloudflare, its biggest challenge is not beating competitors in win rates but rather raising customer awareness and expanding its partner network. Cloudflare is making good progress in this area
Great Company but beware of macro uncertainty
In summary, I think Cloudflare is a company that consistently disrupts the market by leveraging innovation to expand its customer base and product offerings across different categories. With Zero Trust gaining momentum in its next growth phase, I believe the company has potential for success. However, given the current challenging business environment and investor concerns around macroeconomic uncertainty, I may have to wait for a better price to consider accumulating again.
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