Cloudflare stock missed first quarter cash flow.


This year, cloud investors saw the reality of how market prices are rising in this category. For Cloudflare, increasing revenue is not an issue right now. However, revenue growth is meaningless in the current macro environment unless growth leads to healthier returns.

It is true that the cloud is deflation, and that is why companies in this sector can continue to grow in times of inflation. However, it is also true that growth must be balanced with stronger returns as cash becomes more and more expensive.

Product overview

Cloudflare has a strong customer base and an overwhelming share of the content delivery network market. According to data 81% of websites using W3Techs, CDNs, or reverse proxies rely on Cloudflare, which has a strong presence in small and medium-sized businesses (SMBs).

We discussed in a podcast on tech stocks last year that Cloudflare offers a strong, free entry-level service in the Small Business (SMB) category. Companies can benefit from converting their free customer base into paid services, and they can also use their free customer base to test new features before they are released. Cloudflare was able to upsell its products in the most recent quarter with a dollar-based net retention of 127%, up 400bps year-over-year.

Because data is not stored in one place, zero trust security is gaining traction as security threats increase. Secure Access Service Edge (SASE) is a cybersecurity concept that leverages zero trust to identify users and devices to provide secure access to specific applications or data.

Cloudflare One is the company’s flagship zero trust network service. Because SASE allows policy-based security regardless of the location of a user, application, or device, the need for it has grown with remote teams. Zero trust security is built on the premise that no one inside or outside the network can be trusted. In the existing security system, while the security system inside the network is reliable, it is difficult to access it from outside the network. With zero trust, you can use tools like multi-factor authentication to remove this trust assumption, granting access for a limited time and verifying, authorizing, and continuously verifying all data points to which access is granted.

Zero Trust has helped the company grow its overall addressable market from $32 billion in 2018 to $100 billion in 2024. The company is playing a key role in the transition from traditional hardware-based security approaches to modern zero-trust security.

At the end of September, the Cloudflare company announced its R2 storage product. From the beginning of October, you can see the deep purple line start to rise sharply. R2 storage allows developers to store unstructured data without the egress bandwidth charges charged when retrieving data from cloud providers such as AWS. Departure fees are essentially a valueless tax. Markup is up to 7900% in US Regions when calculating what AWS charges you. This is 80X bandwidth markup detailed here Managed by Cloudflare.

Primarily, Cloudflare hopes to attract developers to its worker products, serverless computing services that allow developers to build applications and deploy code at the edge. This eliminates the need for developers to maintain servers or spin-up containers. A cloud service provider (Cloudflare in this case) provisions, scales, and manages the infrastructure needed to run your code. Cloudflare wants its developers to choose over the larger cloud providers because they are located at the edge.

Cloudflare’s Q1 Earnings

At the time of the launch of the low-cost R2 cloud storage service, Cloudflare’s CEO stated “We are aiming to become the fourth major public cloud.” Big Tech has significant margins and significant cash on its balance sheet to build its cloud infrastructure. For this ambition to come true, not only will Cloudflare need to build more Points of Presence (PoPs), but the company will also need to reduce AWS in egress fees, for example, to remain competitive.

Network capex this quarter was 9% of revenue. Over the year, network capex is expected to increase from 12% to 14% of revenue. I think this is the main reason Cloudflare’s rating could be under pressure.

Note: We previously covered Cloudflare on Forbes. Cloudflare Stock: Ambitious Companies Must Prove Their Value

Here’s what the company said on the call:

What’s powerful as we build more POPs is that, counterintuitively, both the design of our network and the efficiency of the network Thomas and I just mentioned actually cut costs over time. Than to drive it. A certain amount of servers are required to handle a certain number of requests. So CapEx really depends on service usage among other things.

What’s strong is that in terms of networking and software, we’ve worked hard to make sure that any server can handle any request, anywhere. We work with various ISPs and eye networks around the world to cut costs on things like bandwidth, colocation and other variable costs that are part of our business.

For now, it doesn’t matter that Cloudflare has fairly solid revenue growth across multiple quarters. The company reported revenue growth of 54% beat expectations by 6%, along with an expected 49% growth rate for the next quarter. The company increased its annual revenue guidance in the mid-range to $957 million for growth of 46%.

There is additional evidence that Cloudflare’s growth will not be an issue, including a 57% year-over-year increase in residual performance obligations (RPO) and a 400bps increase in dollar-based net holdings. Customers paying $100,000 or more were 1,537, up 63% year-over-year. This surpassed the total customer growth rate of 29%. Specifically, the >$100,000 segment slowed from 71% in the previous two quarters.

Large customers contributed 58% of sales. Our customer base of $500,000 and up grew 68% year over year, and our customer base of $1 million and above grew 72% year over year.

The company’s gross margin is 77.80%, but its GAAP operating margin is (18.90%) and its adjusted operating margin is 2.30%. The key difference was stock-based compensation, which doubled to $34 million in the first quarter, up from $18 million in the same period last year.

As with the note on network capex, the company says its operating margin won’t improve in the short term. If cloud peers can improve their operating margins in the current macro environment, I think this could put pressure on valuations.

Here’s what management said:

We plan to address the tremendous opportunity ahead of us by increasing operating costs and reinvesting excess profitability into the business depending on the revenue that stays here or at breakeven.”

Free cash flow was negative $64.4 million (30% of sales) compared to negative $2.2 million (2% of sales) in the first quarter of 2021. Of this, $30 million was due to unique withholding tax payments in the most recent quarter. This shows a significant decrease in free cash flow compared to the last quarter, when the market was particularly sensitive to cash flow. The company reported positive free cash flow of $8.6 million for the fourth quarter of 2021, the first positive free cash flow quarter since the company went public. Management said the post-COVID-19 network investment and physical office redesign will result in positive cash flow in the second half and negative free cash flow in the first half.

The company had approximately $1.7 billion in cash and available-for-sale securities, of which $152 million was in cash.

conclusion:

Cloudflare is showing strong customer growth, and steady revenue growth helps prove that the cloud is indeed deflationary. Squeezing the hearts of the market, CapEx will be the fourth cloud provider. Management confirmed that operating margins would not improve as soon as the company plans to reinvest and the company’s recent quarters show a decline in free cash flow. The I/O fund has closed stocks to focus on companies with better cash flow margins and higher confidence.

Royston Roche contributed to this article.

Note: I/O funds conduct research and draw conclusions about a company’s portfolio. We then share that information with our readers and provide real-time transaction notifications. This is not a guarantee of the performance of the stock, nor is it financial advice. Consult with your personal financial advisor before purchasing stock in any of the companies mentioned in this analysis. Beth Kindig and I/O Fund have closed their Cloudflare positions and do not own Cloudflare at the time of writing and have no plans to enter the stock within the next 72 hours.

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