Cloudflare, Inc. — Q3 2022 Form 10-Q
Business context and reporting period. Cloudflare provides cloud-based security, performance and reliability services. This unaudited filing covers the quarter and nine months ended September 30, 2022; comparisons are with the same 2021 periods.
Financial results and liquidity
| Metric | Q3 2022 | Q3 2021 | Nine months 2022 | Nine months 2021 |
|---|---|---|---|---|
| Revenue | $253.9 million | $172.3 million | $700.5 million | $462.8 million |
| Gross profit / margin | $191.9 million / 76% | $134.8 million / 78% | $535.7 million / 76% | $358.2 million / 77% |
| Operating loss | $45.9 million | $26.5 million | $150.5 million | $86.6 million |
| Net loss | $42.5 million | $107.3 million | $147.5 million | $182.8 million |
| Free cash flow (non-GAAP) | $(4.6) million | $(39.7) million | $(73.4) million | $(51.7) million |
Revenue grew 47% year over year in Q3 and 51% for the first nine months. GAAP gross margin declined 2 percentage points in Q3 and 1 point year to date. Operating expenses rose 47% in Q3 to $237.8 million and 54% year to date to $686.2 million. Q3 non-GAAP operating income was $14.8 million (6% margin), versus $2.2 million (1%) a year earlier; the company defines this measure to exclude stock-based compensation and related payroll taxes, acquired-intangible amortization, and acquisition-related items.
Q3 net loss was lower than the prior-year quarter largely because 2021 included a $72.2 million loss on extinguishment of debt. The operating loss increased in both comparison periods. Stock-based compensation expense was $53.8 million in Q3 and $142.5 million year to date, versus $23.0 million and $61.6 million, respectively, in 2021.
Cash, liquidity and debt. At September 30, 2022, cash and cash equivalents were $137.8 million and available-for-sale securities were $1.498 billion; the investment portfolio was investment grade, with an average AA rating. Current assets were $1.816 billion and current liabilities $339.3 million. Nine-month operating cash flow was $45.5 million, compared with $24.0 million; capital expenditure and capitalized software spending totaled $118.9 million, leaving negative free cash flow of $73.4 million. Cash, cash equivalents and restricted cash totaled $149.0 million at period end. Management said existing cash, equivalents and securities should meet working-capital and capital-expenditure needs for at least 12 months.
Convertible notes had $1.452 billion in aggregate principal outstanding: $1.294 billion of 0% notes due 2026 and $158.4 million of 0.75% notes due 2025. Their combined net carrying amount was $1.435 billion. The 2025 notes became convertible at holders’ option during Q4 2022 under the indenture’s stock-price condition; management said it currently intended to settle principal in cash. The 2026 notes were not convertible under the specified conditions during Q3.
Material changes and operating trends
- Paying customers increased 18% year over year to 156,000; customers with annualized revenue above $100,000 rose to 1,908 from 1,260. Dollar-based net retention remained 124%.
- Management attributed growth to new paying customers and expansion within existing accounts. International customers represented 47% of Q3 revenue, unchanged year over year.
- Cost of revenue grew faster than revenue in Q3 (65% versus 47%), while gross margin declined from 78% to 76%. Increased network capacity and bandwidth, customer-support and technical-operations headcount, depreciation, and acquired-technology and software amortization contributed.
- Operating cash flow improved year over year, but year-to-date free cash flow worsened, reflecting higher infrastructure investment and operating-asset needs.
Outlook, commentary, risks and unusual items
The filing provides no specific numerical revenue or earnings guidance. Management expects continued investment in network infrastructure, product development, sales and marketing, and personnel; it expects operating expenses to rise in absolute dollars and anticipates operating losses may continue. It expects gross margin to remain consistent over the long term, while acknowledging period-to-period fluctuations.
Management reported that in the first half of 2022 large-customer sales cycles lengthened, the prospective-customer pipeline slowed, and some collections took longer. In Q3, payment timing rebounded and the pipeline improved from the prior quarter, but large-customer sales cycles remained longer. Pay-as-you-go churn also increased in Q2 and Q3 as customers shifted to free plans. Management cited inflation, higher interest rates, currency movements, COVID-19 and geopolitical uncertainty as potential sources of pressure on customers, costs and demand.
- Acquisitions and accounting: Cloudflare acquired Area 1 for approximately $156.6 million and Vectrix for approximately $7.6 million in 2022. Area 1 added preliminary goodwill of $120.8 million; total goodwill increased to $149.1 million. Adoption of ASU 2020-06 changed convertible-note accounting and produced a $34.3 million cumulative adjustment to beginning accumulated deficit; it also reduced reported interest expense versus 2021.
- Regulatory contingency: The company’s voluntary OFAC disclosure concerning potential sanctions violations remained under review. No loss was accrued because a loss was not considered probable and the possible loss range was not estimable. The company disclosed potential fines, penalties and reputational or market-access consequences.
- Network and customer risks: A June 2022 configuration-related outage affected traffic at 19 facilities for about 1.5 hours; the company reported no material financial impact. Security incidents, outages, customer-content controversies, privacy and regulatory requirements, and dependence on colocation and ISP relationships remain material risks.
- China relationship: The company’s integrated network presence in China depends on JD Cloud & AI; the disclosed agreement was due to expire April 1, 2023, with no assurance of extension.
- Equity compensation and dilution: Stock-based compensation rose substantially. The CEO and COO co-founder performance awards had not received the required disinterested-stockholder approval as of the report date; the filing stated they would be forfeited if approval was not obtained by December 22, 2022. The dual-class structure gives Class B shares ten votes per share, concentrating voting control.
Investor verification priorities
- Track large-customer sales-cycle length, pay-as-you-go churn and customer collections against management’s Q3 commentary.
- Assess whether revenue growth can outpace operating-expense and network-investment growth, and whether free cash flow improves.
- Review the effects of stock-based compensation, outstanding equity awards and convertible-note conversion or cash-settlement obligations on dilution and liquidity.
- Monitor the OFAC review, any related outcome or disclosure, and the status of the JD Cloud & AI agreement.
- Reconcile non-GAAP measures with GAAP results; the filing cautions that non-GAAP measures have limitations and are not substitutes for GAAP measures.