Cloudflare, Inc. — Q2 2020 Form 10-Q
Reporting period: Quarter and six months ended June 30, 2020. Unaudited results; filed August 10, 2020. Cloudflare provides cloud-based network security, performance, and reliability services through subscription plans.
Financial and operating performance
Amounts are in U.S. dollars; financial statement amounts are in millions unless stated otherwise.
| Metric | Q2 2020 | Q2 2019 | Six months 2020 | Six months 2019 |
|---|---|---|---|---|
| Revenue | $99.7 | $67.4 | $191.0 | $129.2 |
| Gross profit | $75.6 | $52.6 | $146.0 | $100.0 |
| Gross margin | 76% | 78% | 76% | 77% |
| Operating loss | $(24.7) | $(19.8) | $(60.8) | $(36.9) |
| Net loss | $(26.1) | $(19.7) | $(58.9) | $(36.8) |
| Net loss per share | $(0.09) | $(0.23) | $(0.20) | $(0.43) |
- Q2 revenue increased 48% year over year, primarily from new paying customers and expansion in existing accounts. Paying customers reached 96,178, up 24%; customers with annualized revenue above $100,000 numbered 637 versus 387. Dollar-based net retention was 115%, down from 122% a year earlier.
- Q2 operating expenses were $100.3 million, up from $72.4 million. GAAP operating margin was (25%) versus (29%); non-GAAP operating margin was (10%) versus (28%). Non-GAAP measures exclude stock compensation and related payroll taxes, acquired-intangible amortization, and acquisition-related and other expenses.
- Stock-based compensation expense was $12.4 million in Q2 and $25.3 million in the first half, compared with $1.0 million and $2.1 million in the respective 2019 periods. This materially affects comparability of reported expenses and losses.
- Q2 operating cash flow was $4.0 million, compared with cash use of $2.9 million in Q2 2019; Q2 free cash flow was negative $20.2 million versus negative $16.9 million. For the first half, operating cash flow was negative $10.3 million and free cash flow negative $50.8 million.
Liquidity, debt, and balance sheet
- At June 30, cash and cash equivalents were $314.0 million and available-for-sale securities were $755.1 million; together, $1.069 billion. Current assets were $1.132 billion and current liabilities $120.7 million.
- In May, Cloudflare issued $575 million of 0.75% convertible senior notes due May 2025, receiving $562.5 million net proceeds after issuance discounts and costs. The balance-sheet carrying amount was $365.9 million after accounting for the equity component and debt discount; the company reported a $677.3 million fair value. It intends to settle the principal in cash upon conversion, subject to the note terms.
- The company paid $67.3 million for capped calls, intended to offset potential dilution or cash payments on conversion up to a cap price of approximately $57.58 per share. The initial note conversion price was approximately $37.43.
- Management expects existing cash, cash equivalents, and securities to fund working capital and capital expenditures for at least 12 months, while also expecting continued operating losses and negative operating cash flow for the foreseeable future. It stated additional capital may be needed depending on business and market developments.
- First-half capital spending included $30.6 million for property and equipment and $9.9 million for capitalized software. Contractual commitments totaled $716.9 million, including $575 million note principal, $21.0 million of note interest obligations, leases, and network and purchase commitments.
Changes, outlook, and notable matters
- Revenue grew 48% in both Q2 and the first half. Gross margin declined by two percentage points in Q2 and one point in the first half. First-half net loss widened to $58.9 million from $36.8 million.
- Management described COVID-19 impacts as mixed: increased Internet traffic and network reliance, but longer sales cycles, more lost sales pipeline, customer requests for payment concessions and termination rights, possible collection pressure, and delays or higher costs in obtaining and installing network hardware. The company said it did not then anticipate a material adverse impact, but emphasized significant uncertainty.
- Cloudflare offered Cloudflare for Teams and services to certain governments free through September 1, 2020, and made Workers available free through Project Galileo. The filing does not provide numerical revenue guidance or a quantified full-year outlook.
- Management expects continued investment in network infrastructure, sales and marketing, and research and development; it expects operating expenses to rise in absolute dollars and does not assure when, or whether, profitability will be achieved. Long-term gross margin was expected to remain generally consistent, with period-to-period fluctuation possible.
- The January acquisition of S2 Systems involved $17.7 million purchase consideration for browser-isolation technology, plus separate employee compensation arrangements. Goodwill rose by $13.1 million; acquisition-related employee compensation included $5.7 million recognized at acquisition and $2.8 million additional expense in the first half.
- The company disclosed a voluntary OFAC self-disclosure concerning potential sanctions violations that remained under review; the related possible loss was not estimable and no loss was accrued. Separate export-control and Census Bureau self-disclosures were completed without penalties.
- Cloudflare reported outages in April 2020 (about 4.5 hours at a core facility) and July 2020 (about 30 minutes in certain areas), as well as a route leak and outage in 2019. Management did not expect the cited outages to have a material financial impact, but warned similar future events could be material.
- Management reported effective disclosure controls and no material changes in internal control over financial reporting during the quarter. The filing identifies no pending legal proceeding management believed likely to have a material adverse effect, while noting litigation and customer-content liability risks.
Key investor verification points
- Track revenue growth alongside the decline in dollar-based net retention, large-customer additions, and any further changes in the company’s metric methodology.
- Assess whether gross margin stabilizes as network costs, depreciation, and infrastructure investment rise, and whether operating losses and free-cash-flow consumption improve.
- Review the scale and timing of stock-based compensation and acquisition-related charges when comparing GAAP and non-GAAP performance.
- Monitor COVID-19 effects on sales cycles, customer concessions, receivables, collections, hardware supply, and network capacity.
- Evaluate the notes’ conversion, cash-settlement, repurchase, dilution, and capped-call terms, alongside the company’s liquidity and contractual obligations.
- Follow the OFAC review, customer-content litigation, privacy and regulatory developments, and the reliability of network operations.