Cloudflare, Inc. — Q3 2020 Form 10-Q
Reporting period: Three and nine months ended September 30, 2020. Financial statements are unaudited. Cloudflare provides a global cloud platform focused on network security, performance, and reliability.
Financial performance and liquidity
| Metric | Q3 2020 | Q3 2019 | Nine months 2020 | Nine months 2019 |
|---|---|---|---|---|
| Revenue | $114.2 million | $73.9 million | $305.1 million | $203.1 million |
| Gross profit / margin | $87.2 million / 76% | $57.9 million / 78% | $233.1 million / 76% | $157.9 million / 78% |
| Operating loss | $21.3 million | $41.1 million | $82.0 million | $78.0 million |
| Net loss | $26.5 million | $40.9 million | $85.3 million | $77.7 million |
| Operating cash flow | $2.0 million | $(17.8) million | $(8.3) million | $(30.3) million |
| Free cash flow | $(17.9) million | $(33.6) million | $(68.6) million | $(72.7) million |
- Q3 revenue grew 54% year over year; nine-month revenue grew 50%. Growth reflected new customers and expansion among existing customers. Q3 revenue included a $1.9 million one-time customer-renewal true-up.
- Q3 GAAP operating margin was (19%), versus (56%) a year earlier; non-GAAP operating loss was $4.5 million, versus $18.1 million. Nine-month non-GAAP operating loss was $28.4 million, versus $52.9 million. Non-GAAP measures exclude specified items, including stock compensation and acquisition-related costs.
- Paying customers reached 100,968, up from 80,986 a year earlier; customers exceeding $100,000 in annualized revenue rose to 736 from 451. Dollar-based net retention was 116%, down from 121%.
- At September 30, cash and cash equivalents were $112.0 million and available-for-sale securities were $939.3 million. The company reported $1.05 billion combined, before restricted cash, and said these resources should cover working capital and capital expenditures for at least 12 months.
- Accumulated deficit was $386.5 million. Management expects operating losses and negative operating cash flow to continue for the foreseeable future.
Debt, commitments, and notable balance-sheet items
- In May 2020, Cloudflare issued $575 million of 0.75% convertible senior notes due May 2025, receiving $562.5 million net proceeds. The balance-sheet carrying amount was $374.5 million after accounting for the debt discount and issuance costs; disclosed fair value was $774.0 million.
- Debt discount and issuance-cost amortization drove $9.6 million of Q3 interest expense related to the notes, including $8.2 million of discount amortization. The company purchased capped calls for $67.3 million, intended to reduce dilution or excess cash payments on conversion, subject to a cap.
- Contractual obligations totaled $726.2 million, including note principal and interest, operating leases, bandwidth and co-location commitments, and purchase agreements. The notes’ $575 million principal is due in 2025 unless earlier converted, repurchased, or redeemed under specified terms.
- The January 2020 acquisition of S2 Systems had $17.7 million purchase consideration. Cloudflare also recorded $20.3 million of acquisition-related compensation arrangements, subject to continued service for the unrecognized portion.
Changes versus prior period, outlook, and risks
- Revenue growth and customer additions were strong, while gross margin declined by two percentage points year over year, to 76%. Cost of revenue rose faster than revenue, reflecting network and co-location costs, depreciation, software amortization, and support headcount.
- Nine-month GAAP net loss increased year over year, despite a lower operating loss, primarily reflecting substantially higher interest expense from the convertible notes. Q3 net loss improved year over year.
- Management provided no quantified revenue, earnings, or cash-flow guidance in the supplied filing text. It expects continued investment in infrastructure, research and development, and sales and marketing; profitability timing remains uncertain.
- COVID-19 increased Internet traffic and shifted usage geographically, while creating hardware provisioning delays, longer sales cycles, lost pipeline opportunities, and customer requests for payment concessions or termination rights. Management said it did not then anticipate a material adverse impact, but emphasized significant uncertainty.
- Cloudflare reported outages in April 2020 (about 4.5 hours at a core facility) and July 2020 (about 30 minutes in certain areas), attributed to maintenance and configuration errors, respectively; neither had a material financial impact. Future disruptions could affect service commitments, customer retention, and results.
- The OFAC voluntary disclosure concerning potential sanctions violations remained under review, and a possible loss was not estimable. Disclosures to the Census Bureau and Bureau of Industry and Security were completed without penalties. The filing also cites content-related litigation, including adverse rulings in Italy and Germany, and potential regulatory, reputational, and financial exposure.
- Other important risks include competition, customer retention and expansion, cybersecurity and network reliability, dependence on co-location and ISP relationships and hardware suppliers, international and China operations, evolving privacy and content laws, and the ability to service or settle convertible debt.
Important facts for investors to verify
- Whether customer growth and expansion can sustain revenue growth as net retention declined to 116% and the Q3 result included a one-time $1.9 million true-up.
- Whether gross margin can stabilize while network capacity, co-location, bandwidth, and depreciation costs rise.
- How operating cash flow, free cash flow, and investment spending develop; nine-month free cash flow remained negative despite improvement year over year.
- The potential dilution, cash-settlement needs, and future interest expense associated with the convertible notes and capped calls.
- Developments in the OFAC review, customer-content litigation, and any resulting penalties, restrictions, or reputational effects.
- Whether COVID-19-related customer concessions, sales-cycle changes, and hardware delays persist or materially affect operations.