Business Breakdowns
· Sam Eden, Matt Reustle
[00:00:00] S1: That's exactly the case. And they have over 55 revenue-generating products, so a long product sheet and customers with more than 10 products is the fastest growing revenue category. So that's exactly the case. [00:00:00] S0: Offering a freemium model seems to be ingrained in their DNA. How have they managed that over time, in terms of continuing to offer a product that attracts users and potentially gets them into the funnel over time? What does that look like?
· Matt Reustle, Sam Eden
[00:00:00] S0: Offering a freemium model seems to be ingrained in their DNA. How have they managed that over time, in terms of continuing to offer a product that attracts users and potentially gets them into the funnel over time? What does that look like? [00:00:00] S1: We spoke a lot about the freemium model for how they got started, and they've really kept that in their DNA for Act 2 and Act 3 as well. The way they do it as well, it's quite strategically different to some of their competitors. On Act 1, they don't really charge for volume. Their free users can actually get unmetered DDoS protection, free bandwidth for CDN. This is really generous. What they actually charge for is complexity. If you want specialized rules and special bot management setups. But that means if you're a website that constantly gets attacked with high volume, they're not going to charge you extra. They're not going to punish you for that. That's one interesting part of their different strategy, for at least for the Act 1 products. For Act 2, quite generous as well, up to 50 free users. But then Act 3, their freemium product as well, you can very realistically set up and build a sophisticated app without paying much at all. And that's actually what we have done at Square Peg internally. We've built some quite sophisticated AI products to ingest a lot of our research, create dashboards, and have a full AI interface, built on Cloudflare. And it generates an enormous amount of value. And our Cloudflare bills have been remarkably low.
· Matt Reustle, Sam Eden
[00:00:00] S0: Interesting that an investment firm can do that and fit into that category. Is there a way to capture what's subscription-based versus that – you mentioned the complexity, does that still fall under a subscription? I'm just trying to get an understanding of the contractual nature versus the usage-based nature, which I'll bucket complexity into that if it should be. They're not charging based on volume necessarily, but how do you split that up? [00:00:00] S1: It is slightly different per product group, but for Act 1, it is a contract. It's a subscription tier. So you pick a plan, pro tier, business tier, or custom enterprise tier. And you're paying that flat monthly rate for that tier. And it includes a bunch of things. You would upgrade a tier when you need more enterprise features – whether it's those complexity rules, special splitting of traffic and things like that. Not on volume for Act 1, at least. Act 3, those developer products, that is more usage-based pricing. No egress fees, but the usage-based pricing for how much you use their services. [00:00:00] S0: Putting it all together on a margin, however you would look at this, what do margins look like for Cloudflare?
· Matt Reustle, Sam Eden
[00:00:00] S0: Putting it all together on a margin, however you would look at this, what do margins look like for Cloudflare? [00:00:00] S1: They're a software business, so their non-GAAP gross margins are about 75% to 78%. This looks lower than maybe a top-performing software business that you'd expect to see. But you have to keep in mind that they own and operate their own physical infrastructure, and the depreciation of this equipment is included in the reported cost of goods sold. That naturally compresses their gross margin. If you did want to try to look at a cash-based gross margin to compare apples to apples, about 6% of their revenue is depreciation directly tied to equipment. So if you want, you could add that back in and compare gross margins on an 83%, 85% range. [00:00:00] S0: As it falls to the bottom line, whether it's EBITDA margin, free cash flow margin, what does that look like? Are there any major cost buckets that eat into that? [00:00:00] S1: The main one to call out is their CapEx, which is naturally a lot higher than a lot of software businesses. The CapEx has consistently been around 11% to 14% of revenue. That's going to bring your free cash flow margins down. And the free cash flow margins have been around 10% in recent years. The long-term guidance, at least from management, is to expand those to over 25% as operating leverage continues to expand. [00:00:00] S0: They'll get the majority of that off of the operational costs, labor, whatever it might be.
· Matt Reustle, Sam Eden
[00:00:00] S0: They'll get the majority of that off of the operational costs, labor, whatever it might be. [00:00:00] S1: Yeah. One big cost now is their sales and marketing costs. That's 35% of revenue. That has opportunity to come down and there's margin points available there as well. [00:00:00] S0: Capital allocation, with that in mind, it feels like a business that has reinvestment opportunities that would take up the majority of where that cash flow would go. Has that been kind of the policy? And how do you think about how they allocate the capital that they do have and their history for CapEx spend and ROI on that CapEx? [00:00:00] S1: The capital allocation, it's a really important part of the business. And they're very strategic about how they do it, such that they get a really strong ROI on their CapEx. We spoke earlier about just using commodity hardware, so that reduces the cost of the hardware. They often talk about investing behind the demand curve. So they see where the traffic is and what the demand is before they build. They're not just building for no reason. What's really important to understand with their CapEx is that all of their servers can run all of their products and provide all of their services. So that means the CapEx and the ROI is split across all of their product lines across Acts 1, 2, and 3. So the incremental ROI is more diversified and it's higher. So you're not building a separate network for each product. It's one network that can contribute to the return on each incremental CapEx spend.
· Sam Eden, Matt Reustle
[00:00:00] S1: The capital allocation, it's a really important part of the business. And they're very strategic about how they do it, such that they get a really strong ROI on their CapEx. We spoke earlier about just using commodity hardware, so that reduces the cost of the hardware. They often talk about investing behind the demand curve. So they see where the traffic is and what the demand is before they build. They're not just building for no reason. What's really important to understand with their CapEx is that all of their servers can run all of their products and provide all of their services. So that means the CapEx and the ROI is split across all of their product lines across Acts 1, 2, and 3. So the incremental ROI is more diversified and it's higher. So you're not building a separate network for each product. It's one network that can contribute to the return on each incremental CapEx spend. [00:00:00] S0: You've alluded a lot to legacy competition. Are there new competitors that are in the market? It does seem like a market that will only get more important over time. How do you frame the competition and does anybody have large comparable market share similar to what Cloudflare has?