Life on the Edge is Pretty Great
How Cloudflare emerged to be one of the cornerstones of the internet and the paradigm of SaaS companies
Covid-19 forced billions of people to conduct most of their lines online. Working from home has accelerated the need for strong website and app security and performance. The last year or so has seen SaaS companies take off from lack of human togetherness, and Cloudflare has been one of the top performing, most innovative, and most critical of the group. I’m extremely bullish on the company for the long term, and to better educate myself and articulate why I’m so excited about it, I wanted to put my thoughts to paper and share (disclaimer, I’m an ~investor~, lol).
So what is Cloudflare? Cloudflare, per their website, is a company “on a mission to build a better internet.” It’s one of the world’s largest internet network providers, empowering those on the internet to use sites and apps quickly and securely. In simple terms, Cloudflare makes apps and sites more secure and high-performing by acting as a sort of funnel for servers, which prevents them from crashing. Let’s explore that a bit.
The internet used to work by having computers request data and webpages from servers, and then that server would send back the data or webpage requested. This is shown by the arrows in the middle of the image below. If the server received too many requests, it would crash and the data or webpage wouldn’t load for anyone trying to access it.
(Source)
Cloudflare eliminates this problem by serving as an intermediary and offering an edge network that provides content and services close to the requestor, which shares the data as quickly as possible. While Cloudflare is known for its content delivery network (CDN) offerings, that’s just the tip of the iceberg. CDN edge servers are composed of computers spaced out around the extremes (far ends) of a network, also known as the edge. These can also include devices as simple as routers. Pages you load from Amazon or Google are routed to CDNs so your request doesn’t have to go all the way to their data centers. They make your browsing fast and secure thanks to proximity. They also minimize bandwidth issues (i.e. the server problem) for app or site hosts.
The goal of Cloudflare’s CDN is to be as close to the computer doing the requesting as possible, which reduces latency (time from action to response) and load times. This web of combined machines enables network providers to share the transit of data outside their own network capabilities. Having a CDN on the edges of different networks enables a bridge between them, supporting the quick and efficient pass of information. Without CDNs, there is risk of the trombone effect when information is sought. This means that even if requesting information from a device across the street from you, a connection might have to go to a whole other country and back. Information doesn’t travel in a straight line, and that ends up causing latency.
CDN edge servers are often placed at the internet exchange points (IXPs) to help pass data between networks. IXPs are the locations where different internet providers connect so that they can give each other access to traffic originating on separate networks. This is extremely important for websites and apps to meet the user demand for high speed, secure information transfer. Without these edge servers, we would abandon pages, stop using apps, and have distaste for certain companies that are running their products over the internet. As we’ve seen internet and data consumption skyrocket, the need for CDN edge servers has moved correspondingly. Jen Taylor, SVP and Chief Product Officer at Cloudflare made note of the growth trend when talking to Businesswire.
Covid has helped accelerate this trend, but I think the data usage is here to stay, especially given that 99% of the world’s internet users fall within immediate reach of their edge servers. Those internet users have access to information at breakneck speeds thanks to Cloudflare, and the companies providing that information, who are reliant on Cloudflare, have a full suite of available products at their disposal. Not only that, but they have pricing tiers that range from “Free” (for simple sites) to “Business” ($200/month for companies needing more advanced security and support). They also have “Enterprise,” which is more custom and, I would guess, notably more expensive. All of the products below are offered a la carte and can be added to the monthly pricing.
Cloudflare also has a similar-ish model to the Shopify success funnel, in which the free tier is a funnel for the pro tier, which is a funnel for the business tier, which is a funnel for the enterprise tier. As long as your company becomes successful, which Cloudflare can help you achieve, Cloudflare will reap the additional revenue as you need to upgrade. Looking deeper into revenue…
The annualized revenue CAGR for the last four years is growing at a 50% clip. This shows that the rate of growth in each of the last four years has been massive and continues to expand. That growth has similarly translated into YTD growth post Q3 with revenue climbing to $305M. Potentially even more encouraging has been the 68% CAGR in >$100,000 AR customers, presumably constituting most if not all of those Fortune 1000 customers mentioned on the left. What’s also encouraging is the fact that 48% of Cloudflare’s revenue comes from outside the US.
An interesting metric pointed out later on in the investor presentation is that Cloudflare has maintained a Dollar-Based Net Retention of 115% or higher for the last 10 quarters. This represents the percentage of revenue retained from customers, when you take into account upgrades, downgrades, and churn over a period of time. An NDR of 115% is a fantastic indicator of growth because it shows a positive growth rate even without new customers and that the churn rate < growth rate.
Cloudflare has maintained gross margins consistently above 76% across years and quarters thanks to its products. Its server-less architecture, software stack, partnerships with ISPs, and network usage contribute to its strong margins. While Cloudflare is still operating at a loss, their expenses are decreasing YoY and positive revenue is within reach. Cloudflare’s operating margin has been improving from -30% in 2018, to -25% in 2019, and -4% in Q3 2020. Keeping at this rate and looking at their projects, profitability could be in their near future.
Cloudflare’s TAM continues to grow everyday as more users are connected to the internet, essentially providing Cloudflare with nonstop growth potential. Investors recognize this growth potential, which is part of the reason that Cloudflare is trading at a multiple of almost 47X NTM revenue. While I’m happy that I got in on the earlier side, there is obviously some risk investing in a company with such an enormous multiple yet no profitability. I think Cloudflare’s runway for its industry and TAM is incredible, and the upside is evident. Long Cloudflare.
Update: Cloudflare actually posted their 2020 Q4 Earnings today and absolutely crushed it yet again. FY 2020 earnings of $431M, a 50% YoY increase (Q4 2020 earnings of $126M, also a 50% jump). FY2020 operating margin improved to (24.8)%, getting closer to that 0% line towards profitability. Lastly, their NDR improved to 119%, continuing to grow, showing that Cloudflare isn’t done with their customer upgrades and funneling just yet.