Business Breakdowns
· 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?
· Sam Eden
[00:00:00] S1: There's a few lessons from Cloudflare that I think can be applied generally. I'll call out four quick ones. So number one, I think founder-led companies – it's very important for companies to have that founder-led vision. It can be very powerful for setting that long-term strategy and setting bold visions and sticking to the company mission. Square Peg's origins are as a VC fund and then the global tech fund listed strategy – we still look for that founder DNA. And Matthew Prince is a great example of that. The second general lesson would just be looking for product simplicity, particularly for complicated industries. To the extent they can serve the whole long tail of the internet, despite having a very sophisticated technical infrastructure, that sets them up really well and it's a really positive signal. Applying that elsewhere, I think that applies to Snowflake as well. They have a very powerful engine under the hood. It's very hard to replicate. But when you look at the product, it's a very simple query interface. It's very easy to use and adopt. And similar with Datadog, very easy to get started and set up. But it's powerful enough and flexible enough to work with the world's largest companies as well as the world's smallest companies. So looking for that product simplicity, yet flexibility and power, is really important. Number three would just be looking for multiple levers of growth. So great companies, they have multiple levers of growth, and they find ways to solve more problems for more customers over time. Cloudflare, great example of that. They've expanded their product lines, expanded the customer archetypes within each market, and have done so in markets that all have tailwinds, particularly for AI. Fourth lesson would be that CapEx in software can be okay, provided that it has that very high ROI. That CapEx is used to build that defensibility for their business. Talked a lot about that earlier with that reinforcing cycle, it creates a moat that's very hard to replicate. And because they're stacking layers on top of that hardware, you can extract a lot of ROI from each individual purchase there. Those lessons, they fit very cleanly into what Square Peg looks for. We have a framework around theme, team, model, and moat.
· Sam Eden, Matt Reustle
In Cloudflare, they sit at the center of a critical theme of managing networks for speed, efficiency, and trust, particularly in the era of AI. The team, they're hungry, it's founder-led, very focused, and they can attract and retain some of the best talent in the world. I think it's an underappreciated, high-quality business model. So they can stack multiple revenue lines on top of their core capability. And all of these levers have that long duration that we look for. And finally, moat. Cloudflare, it's a business that gets better as it gets bigger. And that's really important. They use their scale to enhance their differentiation and create barriers to entry as well. [00:00:00] S0: CapEx can be okay is a good lesson. I think AI certainly has shifted the narrative in terms of the willingness to accept high CapEx companies out there in the market. Assuming that they're creating barriers to entry – we can debate where that falls in line for companies and whether that's true or not, but this has been fascinating. Sam, I appreciate you sharing all of the knowledge, getting into the nitty-gritty details here. You’ve given me a better appreciation of all that's happening on the internet behind the scenes. So I appreciate you joining us. [00:00:00] S1: Thank you. This has been a lot of fun.