Well, I guess we'll get started here. People trickling in. For those on the webcast, we have Thomas Seifert, CFO of Cloudflare here. They'll be, you know, keep in mind everything about Safe Harbor, everybody, just to be safe, Jason here, as well. Thanks for joining us, Thomas. Appreciate your time.
Thanks for having us.
You know, Thomas, after last quarter, you know, something you and I have talked a lot about, as well as Matthew kind of emphasizes around these waves or acts, waves one, two, and three.
Yep. Yep.
You know, is there a way? I know you don't wanna get into the specific products, but, you know, Cloudflare does a lot of this bundling and so forth.
Yeah.
Is there a way to think about the bookings trends between kind of these wave one versus wave two versus wave three products, just given kind of the strength that you've talked about, like, with Zero Trust, which I'd put into, like, the wave two bucket?
Yeah. Yeah. You know, there are never easy answers when it comes to that. I got this question a couple of times today. When we launch products, when we push, so to speak, a new wave, you know, we are rarely ever revenue focused. And because of that, booking is probably not the KPI you would look at. You know, when you talk about wave two products, wave two is something we would consider today Zero Trust. Cloudflare Access, the Gateway, Browser Isolation, email would fall in that category.
The KPIs we watch for and how we measure our progress, success, our momentum are much more how many seats did we sign up in a given quarter, you know, how is the growth rate from a seat perspective, paying customer count for that group of products. You would expect to see momentum already this year. We do. We see significant growth rates from a seat perspective, from a paying customer perspective, account perspective for wave two products, as you would see. Revenue is to come. We are big about adoption and disruption, and worrying about, you know, the dollars that are associated with it, not right out of the gate.
If we think about pricing products, it's always about, you know, what is the most disruptive move we can make in the market. Then product introduction strategy follows. Just for those in the audience that are less familiar with us, wave one would be where we started, where the company was built on protecting infrastructure. You know, this is the firewall products, routing, DDoS mitigation, load balancing, falls into that category, bot mitigation. Wave two is what we now has this neat name of Zero Trust. Moving from protecting infrastructure to protecting people. Wave three are what we call our Magic Transit products, where you go after the MPLS spend and then, you know, then comes Workers and the storage products.
Got it. Makes sense. One thing also we talk about a lot of, you know, luckily for Cloudflare, we really don't have to worry about the supply chain outside of the CapEx kind of investment in terms of getting servers and all of that. A lot of the history here has been about replacing hardware solutions.
Yeah.
Is there a way to think about, you know, when you go into a competitive deal, how much of it is replacing those hardware solutions versus competing against some of your software pure plays out there?
You know, the installed base of on-premise hardware or to what we call band-aid boxes, right? Band-aids to patch up the internet to do what it was not designed to do from a performance and from a security perspective is, you know, where we go after. This doesn't necessarily mean it's a rip and replace, right? You would often find us in front of existing on-premise hardware, and then over time, upgrade dollars or expansion dollars shift to us, right? Rip and replace happens sometimes more often, but it's not the normal go-to-market for us. We literally sit in front of an on-premise load balancing infrastructure or an on-premise firewall infrastructure, and then as I said, budget dollars shift to us over time. We call this winning the war of attrition.
That's how Matthew coined it. I think it's a quite appropriate description that also is, I think, part of the explanation why we have this steady and paced growth momentum that we've seen now for a couple of years in succession, but not this, you know, jump to 200% because we rip and replace complete infrastructure.
Got it.
Yeah.
Would you say, though, in terms of that hardware kind of competition, has that mix shift changed at all that you're coming up against more like replacing actually software-focused vendors or?
That's how it happens and it happens more and more often.
Okay.
This is what gets hyped up, of course, by everybody including folks like you. Well, I understand that, and we're excited about that too. Don't misunderstand me. The opportunity is the install base. It's going after the on-premise hardware for us and companies like us. We bump into each other more and more often, especially when it's about sophisticated installations, when it's about cloud native customers.
Got it.
Yeah.
You know, one thing that's been coming up more, especially since, you know, springtime was.
Yeah
around elongating sales cycles.
Mm-hmm.
Um, and-
Yeah
You know, you guys obviously have a mix between enterprise and commercial customers.
Yeah
you know, a decent international exposure. I guess.
Yeah
You know, to this point, what are you seeing with that top of the funnel? And has that changed in terms of how you approach, you know, customers or customers approach you in terms of that self-serve model with wave one, wave two, or even wave three products?
Well, you know, we gave quite a lot of color in our last earnings call around that motion, and nothing has really changed. It hasn't improved, it hasn't gotten worse, but it, you know, it is where it was. Sales cycles are extending. They are extending in the big buckets, so north of $500 million of ACV, people measure twice before they cut. That has not changed. Because of that, landing new logos in that bucket takes longer, I guess. I don't think we are the only company seeing that. We adjusted our go-to market. You know, expansion is still is an easier motion for us in an environment like that, and we adjusted to that. We've become...
I remember when we had our first Testing the Waters roadshow, and we showed our DBNR number, and I think at the time it was 110% or 111%, and people dinged us for that, I think rightfully. We have spent significant amount of time sophisticating our expansion motions and the playbooks we have using a lot of data at hand in order to address that. Where does the customer come from? What is the most likely land product? If that is the land product, what is the second or third product a customer is most likely to buy? Expanding existing customers has become easier in a recessionary environment, I think to a large significant extent because ROI is just much easier to show for an existing customer, right?
We can have a customer that is a load balancing customer, and you can say, "You know, do you know," I think I mentioned this already once today, "that 40% of your traffic is malicious traffic? So if we switch on bot mitigation, not only does your security posture become better, but you eliminate 40% of your bandwidth costs. So like let me switch it on for five days so just so you see." These motions are easier with existing customers and, you know, in a recessionary environment where ROI becomes a bigger topic, that's something you would lean into.
Got it. You know, you actually went directly where I wanted to go next, which was around your net retention rate.
Yeah.
which, you know, has been, you know, mid-120s%, let's say the last couple of quarters.
Yeah.
You know, you have this now goal of roughly 130 I think that you've talked about.
Yeah.
In your enterprise net retention rate, when you look at that cohort, it's a bit above that.
Yeah
Of course, that's gonna help move that as that mix shift happens. Is there a way to think about, I don't wanna say cohort analysis or what, that you see between years, you know, one versus two versus three in terms of that expansion opportunity? Does it even matter in this type of environment?
Yeah
where the macro is just challenging?
As I said, it's an important metric for us. We've built a team around it, a strategy around it. There's a ton of data science we throw at that problem. You know, it has shifted over time. If you understand where we come from, our first customers were what we call pay-as-you-go business. People give us a credit card, we charge them $20 or $200 a month. If you go back, even back to the S-1 and you look at our early customer cohort, that what you buy is an all-you-can-eat plan, so to speak, and there's hardly any chance for expansion. Those cohorts are flat. Flat is good because that means there's no churn.
They are hard to expand or almost impossible to expand, but they have extremely high retention rates. When we report on DBNR, it's an all-in KPI, so it includes those early cohorts and the revenue we generate from this pay-as-you-go business. You know, in a way, that's why DBNR for us is a lagging indicator because it's always diluted by these cohorts. Their percentage share of enterprise continues to grow, gets bigger and bigger, that track becomes less of an issue. That is a natural way how to explain that. The second thing which I think is really unique to us, the amount of products and innovation and features we put out every quarter, every year, is even to me after these many years, quite astonishing.
You know, we have more than tripled the TAM that we attacked in the short time since we've become a public company. It's hard to put a ceiling on DBNR because there are constantly new products that can be sold, that can be expanded into from a customer perspective. We said we want to be the benchmark in our peer group in the not too distant future. I think with the amount of product that we put out, that is a very achievable.
Target. Yeah, I would agree with you on the innovative side. It's almost annoying from my seat of like, okay, what's the newest product out of Cloudflare this week? It's Birthday Week or Cloudflare One week or whatever. Actually speaking of that, it was a couple months ago you guys talked about the Cloudflare One partner program for the first time.
Yes.
You know, indirect is a small part of the business, and, you know, when you think about especially the Zero Trust world.
Yeah
... your main competition there is selling through the channel.
Yeah.
This is a major step for you guys. I guess first off, you know, how big could the indirect business actually get to with this in place? Why is Cloudflare gonna beat out the Zscaler, the Palo Alto Networks for that indirect seat grab?
Yeah. For a long time, you know, even till the end of last fiscal year, channel and partner revenue was maybe in the 10-ish percentage points of overall revenue. The main reason for that was if you look at what we just called a minute ago our first wave of products, was that there was little a partner or a channel could offer in terms of value add implementing a product. I mean, this is what made us famous, right? Coming from this pay-as-you-go business, you know, you want to protect your blog or your website as a critical journalist or just as, you know, a normal individual. It takes you less than 5 minutes to be behind our network, you know, five steps.
We onboard the largest financial institution in North America on their DDoS attack, it takes us a couple of hours, right? Not weeks. There's no professional services involved and no Cloudflare employees that go on site. This efficiency on even the most complex products didn't offer room for partners to offer value. That's why our channel share was so low. This has changed with the second and third wave of products with Zero Trust and especially with what we call our SD-WAN products, where you literally go after the MPLS spend because onboarding is more difficult. The partners can develop onboarding strategies and packages by vertical, by country, by use case. So that makes it attractive for us to go to a partner. There are, as I said, 10% was the share last year.
If you look at some of our competitors, they derive up to 80% of their revenue from that part of the go-to-market aspect, so there's plenty of room for us. What makes it attractive for us, for partners to work with us is, for us, our second and third wave products are highly margin-accretive products. That's just how the infrastructure of the network was built. They generate hardly any additional cost from a launch perspective. We have a lot of margin to share with partners for selling us through. We attack that segment not by lowering prices, but by moving value to the partner. The margin allows us to be coming back to what we discussed in the beginning, to find the most disruptive path forward.
That's why you've seen quite significant momentum over the last two quarters, signing up partners here in the U.S., but also internationally.
One of the hot topics that came out of last quarter was annual versus monthly, and the fact that we're, you know, starting to look at more annualized contracts.
Yeah.
Is there a way to think about how much of Cloudflare today, how much of the install base or even just the enterprise base is actually, annual versus monthly at this point?
I think there's some color we can give. I mean, you know, going back to where we started, credit card, monthly billing, that was driving the business. Our pay-go business today is a monthly business, and you can argue whether, you know, you can offer incentives to change that. On the enterprise side, that just rolled over. I would say 20%, about 20% of our revenue last quarter was annual, 80% was still billed monthly. There's a lot of room for us to improve. I often get asked, how fast can you do that? We want to be diligent, right?
You know, it's easier to do that with new customers, because it's, you know, all of our peer groups have annual or multi-year billings and contracts. It's actually quite easy from a new logo perspective. More touchy are the customers that are existing customers and, you know, you touch them through the renewal cycle, and just depending on where they are, how important they are, it's a conversation that needs to be had. If we measure ourselves in, I think we say 20-80 today, 20 annual, 80 monthly, our peer group is probably looking just the reverse of that. Over time, this is where we want to be, and there are no good reasons why it shouldn't look like that.
Got it.
Yeah.
You know, your peers typically will have like a billings to revenue ratio of like 1.1 to 1.2. Is that something that Cloudflare could actually get to from where it's roughly at today around, I think, 1.05?
Within ranges, yes. There's, you know, what happens to our pay-go business or pay-go share is that of overall revenue, so there's some gives and takes. There is no reason why, at least for the enterprise business, the contracted business, we couldn't look like our peer group.
Got it. By the way, audience, if you have a question, feel free to raise your hand and I'll call on you. One of the other exciting parts to think about that's GA here real shortly is R2.
Yeah.
How should we think about what that business could look like? I mean, S3 at Amazon's a $10-$15 billion business, depending on who you want to talk to. You know, obviously, we're gonna talk a little bit smaller today, but, you know, are we off to that running start, come Q4?
Well, you know, we repeated how we started. You think about product launch and revenue. We don't. You know, when we think about what we want to do, this mission of building a better internet, we take this very literal. Eliminating friction, eliminating charge points, eliminating inefficiencies is just a part how we think about this universe. R2 was born from the idea that there are a lot of interesting use cases, large logos, large customers that move data a lot, right? R2 is not for somebody who stores petabytes of data and never looks at it, but archives it. You know, the heavy transaction interaction between storage, where those customers generate incredible amounts of egress.
We thought that is a charge point that can be disrupted. You know, we're in open beta now. There are very large logos in the open beta. There are very large storage use cases that are being looked at, and the momentum is good. But we will not measure it in revenue for the first half. We'll talk about, you know, who do we sign on, you know, of what interesting use cases, what can we learn. There will be revenue, but you know, but we think it's gonna be an integral part of our business model moving forward. You know, it comes back to what I, after all these years, find most exciting, is that the architecture allows you to have this completely fungible storage and compute capacity.
This whole network surface is something that we can work with, you know, how you shift customers, how you shift workload, how you underutilize parts of the network because some part of the world is asleep. We are running our open beta now without investing $1 into additional storage space, right? It's just using what we have at this point, and I find this super fascinating. That doesn't mean that we need to invest moving forward, and find creative solutions to that, but it gives you an idea, what the elasticity of this network is from a compute capacity and the storage capacity perspective.
Makes sense. Go ahead.
No, you couldn't expect that, right? Do you go from who buys load balancer to who buys Zero Trust. The personas we need to address are changing. We're adapting to that. You know, that's why our Area 1 acquisition was so important, not because it only added an email product, but it is the door opener on a C-suite from a CISO perspective, especially for very large logos. You know, sophisticated, persistent phishing attacks are the attack surface that gets the most focus currently from an attacker perspective. Having a product there that is so superior to anything else that is out there is good, but it also opened the door.
It also allows us to show off the huge amount of threat intelligence we have and find a platform to talk about that. The personas are changing. We're adapting to that. It has been a learning process, you know. It doesn't take away from the developer focus from a customer perspective. There are still people that take us from home to work. That happens quite often. I was just in New York in an RFQ with a financial service institution. I was part of sponsoring the meeting, and there were four people on the other side that were wearing Cloudflare T-shirts. That is a really nice start into an RFQ.
It doesn't take away from the fact that the personas are changing, and we need to adapt to that.
Time for one last one, otherwise I can ask, Money.
Well, first of all, we are not a CDN, so that helps. You know, all this traffic that doesn't provide value, where it just move a byte from A to B, where we don't have any Disney and Netflix and HBO, that is a highly commoditized service. You know, you get auctioned off at the end of every quarter, and we don't do that. We happen to have the fastest CDN in the world because this is what you need to deliver security and performance services at the edge of the network without adding a flip from a latency perspective. The network was designed for speed to deliver security and not to deliver content. That is one. We don't have this margin dilution in the revenue.
We don't have the volatility of consumption-based revenue either, so that helps. The most important part is, however, what I said before, is the uniqueness of the architecture of the network, right? If you have a network where every product and every service we offer can run on every server in every city, then this complete network surface becomes your degrees of freedom, how you manage costs. This is hard to replicate. I would argue it's our biggest competitive moat, because it needs significant scale in order to get there. It's highly defendable because, you know, literally every product we add adds more degrees of freedom. Every server we add, regardless of where in the world, gives us more degrees of freedom.
This is where I think to the largest extent, the superiority of the margin performance is.
I think you timed that almost to the second there in terms of that. I wanna thank you for joining us, everybody, and especially to you, Thomas, for all your insights.
Always a pleasure. Thank you.
Thank you. Thanks, everyone.