Business context and reporting period
Cloudflare, Inc. filed this unaudited Form 10-Q for the quarter ended March 31, 2020. It operates a global cloud platform providing network security, performance, and reliability services. Revenue is primarily subscription-based. International customers generated 52% of quarterly revenue.
Financial and operating performance
Amounts in millions of dollars unless otherwise noted.
- Revenue: $91.3, up 48% from $61.7 in Q1 2019. Growth reflected new customers and expansion among existing customers.
- Gross profit and margin: $70.4 and 77%, compared with $47.4 and 77% a year earlier.
- Operating results: Operating expenses rose 65% to $106.5. GAAP operating loss widened to $36.1 from $17.1; operating margin declined to -40% from -28%. Non-GAAP operating loss was $14.4 versus $16.1, and non-GAAP operating margin improved to -16% from -26%.
- Net loss: $32.7, compared with $17.1; net loss per share was $0.11 versus $0.20. The lower per-share loss reflects a substantially higher weighted-average share count following the 2019 IPO and related share conversions.
- Cash flow: Operating cash use was $14.3 versus $9.7. Free cash flow, a non-GAAP measure, was negative $30.6 versus negative $22.1; free cash flow margin improved to -34% from -36%. Capital expenditures were $11.4 and capitalized software costs were $4.9.
- Liquidity: Cash and cash equivalents were $109.1 and available-for-sale securities were $478.8 at quarter-end, totaling $587.9; restricted cash was $8.8. Current assets were $647.6 and current liabilities $108.3. Management believed cash, equivalents, and securities would cover working capital and capital expenditure needs for at least 12 months.
- Debt and obligations: The balance sheet shows no material borrowing balance; a $0.2 note payable assumed with S2 was repaid during the quarter. Operating lease liabilities totaled $50.8. Contractual obligations, including lease payments, purchase agreements, bandwidth/co-location commitments, and acquisition holdback, totaled $108.8.
- Key metrics: Paying customers increased 21% to 89,223; customers with annualized revenue above $100,000 rose to 556 from 336. Dollar-based net retention was 117%, versus 118%.
Material changes versus the prior comparable period
- Revenue grew 48%, while gross margin remained unchanged at 77%.
- Operating expenses increased from $64.5 to $106.5, notably reflecting higher hiring and stock-based compensation, including RSU expense. Stock-based compensation was $12.9 versus $1.1.
- Bad debt expense rose to $2.2 from $0.3; management attributed $1.2 of the increase primarily to COVID-19 impacts.
- Cash used in operations and free cash flow use increased. Cash, cash equivalents, and restricted cash ended the quarter at $117.9, down from $145.6 at the start of the period.
- Cloudflare adopted lease accounting standard ASC 842 on January 1, 2020, recognizing $50.0 of right-of-use assets and $52.8 of lease liabilities at adoption. Prior-year lease figures were not restated.
Outlook, commentary, risks, and unusual items
- Outlook: The filing gives no numerical revenue or earnings guidance. Management expects operating expenses to increase in absolute dollars as it invests in sales and marketing, research and development, personnel, and network infrastructure. It expects operating losses and negative operating cash flows to continue for the foreseeable future; profitability timing is uncertain.
- COVID-19: Management reported longer sales cycles, more lost prospective-customer pipeline, requests for payment concessions and termination rights, and possible slower collections. Internet traffic increased and shifted geographically, while hardware delivery and installation faced delays. Management had not identified a specific event requiring a financial-statement estimate revision as of May 8, 2020, but emphasized uncertainty about the pandemic’s duration and effects.
- Customer and network measures: Cloudflare made Cloudflare for Teams free through September 1, 2020, and announced free services for state and local governments through that date. An April 2020 outage at a U.S. core co-location facility lasted about 4.5 hours and occurred after quarter-end; the company said it did not materially affect reported results.
- Acquisition: Cloudflare acquired S2 Systems in January for $16.9, including cash, shares, and a holdback. It recorded $12.3 of goodwill and $5.6 of developed technology. Separate employee compensation arrangements related to the acquisition totaled $21.1, with $6.5 recognized at acquisition and $1.4 additional expense in the quarter.
- Contingencies and risks: Voluntary disclosures to OFAC and the Bureau of Industry and Security concerning potential sanctions/export-control violations remained under review; possible loss was not estimable and no accrual was recorded. The Census Bureau disclosure was completed without penalties. The company also faces litigation concerning customer content and copyright claims; management did not identify a pending proceeding likely to have a material adverse effect, while noting outcomes are uncertain.
- Other: The company remained loss-making, with an accumulated deficit of $333.9. Management cited competition, customer retention and collection risk, network reliability and security, supplier and co-location dependencies, international and regulatory exposure, and the dual-class voting structure. Disclosure controls were assessed as effective at a reasonable assurance level.
Important facts for investors to verify
- Whether COVID-related sales-cycle lengthening, customer concessions, pipeline losses, and higher bad debt persist or worsen.
- Whether customer growth and expansion can offset rising operating expenses, continuing losses, and negative free cash flow.
- The sustainability of the 117% dollar-based net retention rate and growth in large customers, noting the company changed its key-metric calculation from a billings-based to a revenue-based methodology.
- The impact of stock-based compensation and acquisition-related compensation on GAAP results, dilution, and future expense.
- Developments in the OFAC and Bureau of Industry and Security reviews, and any resulting penalties or business restrictions.
- Execution of network capacity plans amid hardware and installation constraints, and the effects of the April outage and other service disruptions.
- Liquidity relative to lease and other contractual commitments, and management’s stated expectation that available resources cover at least the next 12 months.