Business Breakdowns
· Sam Eden
[00:00:00] S1: My view is that it's a strengthening position. Say with Act 2, Zscaler has that incumbent advantage and that trust with very large enterprises. But it's a huge market and Cloudflare can, like their other products, start at the smaller end and work up to the enterprises. And it's starting to do that. What really benefits them is having that global network of all the products. They can use their Act 1 strength to prove their product, encourage adoption of their Act 2 products. One example of that would be, let's say you're using Zscaler for internal security. You send a request, it goes to Zscaler's machines and then to a website. But that website is going to be likely using Cloudflare. So it ends up going to a Cloudflare server anyway and then back. And so Cloudflare is in a really strong position. It's like, "We're processing all of this traffic anyway. Why don't we process it on the way out as well as the way back in? And that will improve your latency." Another difference would be just on their peering networks. So it's very hard for another company to have all these partnerships with all these ISPs around the world. Zscaler took a different approach where they peered directly with the apps, which is great for dense cities, but in certain markets, it doesn't work as well. And maybe an example just to highlight some of these differences would be Canva. So, thousands of employees around the world – Canva, the web design company. They employ a lot of contractors to help out with the design templates and things like that. And a lot of those contractors are based in Southeast Asia. Canva uses their Cloudflare Act 2 products to help with the access, because Cloudflare uses what's called an in-line service. So you don't actually have to install an agent or anything onto the machine, which is really important when you're working with contractors. You can give these contractors access to all of the corporate apps that they need without having to have them install anything. Because a lot of these contractors are based in markets where other competitors won't have direct peering relationships, Cloudflare can say, "Look, we've been improving the speed of this area for years.
· Sam Eden, Matt Reustle
These contractors can sign on, be secure, and interact with your product with low latency that's not going to slow anyone down." And that's a really strong value proposition that a lot of other companies can't speak to. [00:00:00] S0: Are there any other risks that really stand out to you just from a business perspective and the organization and some of the external factors sitting around it?
· Sam Eden
[00:00:00] S1: Two risks to call out. One is that second mover in Act 2 that we were just speaking about. They are playing a bit of a catch up, but there is a long runway to go and they're a solid contender there. So I think all the trajectory is very positive when you look at their product positioning, their channel partner growth and all that. But it's worth just calling out, just because they are the second mover. The other risk to call out is just their AI inference strategy and AI in general, because it is new and it does slightly diverge a little from their previous strategy. So that always adds some risk there. Because I mentioned earlier that all of their other services can run on all hardware, whereas GPUs are specialized for inference. With the ROI of their other products, it was split across all of their services. But the ROI of their GPU component, that's just from the AI inference. So it's a more concentrated ROI risk. Also, there's a slight difference in how the AI inference product came about, from their other products. A lot of their other products, they kind of emerged from what Cloudflare was doing internally. With the Act 3, they had to build these services themselves. They never planned on launching a developer product, but they saw the value in that and they released it. Similarly with Act 2, they saw that during the day, not many people are on websites, there were underutilized servers, so they could work with corporate security that was used during the day. And then during the night, there's all their website security. So they kind of saw these opportunities and built for them and went into them. Whereas the AI inference, I think they just saw the importance of the market and decided to go after it. It's still that single global network, but there is a bit of top-spin of difference in strategy versus their other product launches. That's worth calling out.
· Matt Reustle
[00:00:00] S0: Thank you for calling that out. I do want to get your general framework for valuation. I find software businesses – heaven forbid, 75% to 80% gross margins relative to the 90% that some of these software businesses boast. But how does the market approach it? How do you think about valuation? And just anything that you would comment on that topic would be useful to hear.
· Sam Eden
[00:00:00] S1: It's no secret that Cloudflare is a highly valued company. I think at the start of the year, they were 25 times the next 12-month revenue, which is one of the highest in the industry. From my perspective – I love Michelle and Matt as the operators of Cloudflare – but valuation, it's always a constant battle, even though it's such an impressive company. And importantly as well, it's a capital intensive business, so the free cash flow margins and earnings will start to matter more and more in, say, five years’ time. And they'll likely have lower free cash flow margins than what we've seen in best-in-class software. But I think what gives confidence to the bull case for Cloudflare is that there's numerous growth levers that can support sustained high growth. And they've sustained it in that 29%, 30% or higher range. And the markets that they operate in have a lot of runway and they're continually adding products and features that support that sustained high growth rate. So that's a distinguishing factor for them. But to get comfortable with the valuation, you have to model out two things. You have to model out the Act 2 – how quickly they can catch up and perhaps surpass the incumbents in that space. And the trajectory is very solid there. But also, you need to model out what the Act 3 scenarios could look like. Like how important will they be for AI inference? How big will the inference market be? We believe that it can be a very large business, and you have to believe that. And just quickly on margin structure – sales and marketing, 35% of revenue today – there is room for operating leverage. They've guided to 25% free cash flow margins plus. We think they can exceed that. So then you can model that out over the years and still make money on the stock. But it's important to call out that there's effectively no margin for execution error. It's priced for pretty flawless execution, which they've done, but you just have to build confidence that'll continue.
· Matt Reustle, Sam Eden
[00:00:00] S0: Well, that's a very intellectually honest approach to it. At 25 times sales – I saw the SpaceX IPO headlines today, which implied I think 100 times sales. It's all relative in this market. [00:00:00] S1: Yeah, it makes it look cheap. [00:00:00] S0: Yeah, exactly. And the growth number on revenue, they must be sandbagging because it wasn't that material. Nonetheless, this has been fascinating. I really tried to scrape out as much on the technology. So thank you for keeping up with that. We like to talk about the lessons that you could take away, maybe bring it up a notch to think about frameworks and pattern recognition. What would you point to from Cloudflare that really stands out?