Q3 2022 Cloudflare Inc Earnings Call

Okay.

Good day, everyone and welcome to the call Claire Q3, 2022 earnings call at this time I would like to hand, the call over to Mr. Jason Nolan. Please go ahead Sir.

Yeah.

Thank you for joining us to discuss <unk> financial results for the third quarter 2022 with me on the call. We have Matthew Prince co founder and CEO shelf that Lynn co founder President and COO and Thomas Seifert CFO .

By now everyone should have access to our earnings announcement this announcement as well as our supplemental financial information may be found on our Investor Relations website. As a reminder, we will be making forward looking statements during today's discussion, including but not limited to our customers vendors and partners operations and future financial performance anticipated product launches.

And the timing and market potential of those products the company's anticipated future revenue financial performance operating performance non-GAAP gross margin non-GAAP net income or loss non-GAAP net income or loss per share shares outstanding non-GAAP operating expenses free cash flow.

Tax expense dollar based net retention rate paying customers and large customers.

And that's and other comments are not guarantees of future performance, but rather are subject to risks and uncertainties some of which are beyond our control, including but not limited to challenging general economic conditions, including foreign exchange inflation rising interest rates and other impacts of the ongoing COVID-19, pandemic and Russia Ukraine.

Conflict.

Actual results may differ significantly from those projected or suggested in any forward looking statements. These forward looking statements apply as of today and you should not rely on them as representing our views in the future. We undertake no obligation to update these statements. After this call.

For a more complete discussion of the risks and uncertainties that could impact our future operating results and financial condition. Please see our filings with the Securities and Exchange Commission as well as in today's earnings press release, unless otherwise noted all numbers, we talk about today other than revenue will be on an adjusted non-GAAP basis.

All current and prior period financials discussed are reflected under ASC 606, you may find a reconciliation of GAAP to non-GAAP financial measures in our earnings release on our Investor Relations website for historical periods. The GAAP to non-GAAP reconciliation can be found in the supplemental financial information referenced a few moments ago.

I would also like to inform you that we will be participating in the RBC capital markets Global technology Internet Media and Telecommunications conference on November 16th and the Credit Suisse, 26th Annual Technology Conference on November 30th.

Now I'd like to turn the call over to Matthew.

Thank you, Jason we had a strong quarter, even if the economic environment has continued to be challenging we generated $254 million in revenue up 47% year over year.

Surprisingly the slowdown in the economy, we discussed on our last two earnings calls is starting to show up on our top line revenue numbers, even with those economic headwinds this quarter marked a milestone for us crossing through $1 billion in annualized revenue only 6% of public software company that achieved this milestone so we're proud to have.

Crossed it but nowhere close to finished we added 4197 paying customers for a total of 156000 paying customers for large customers those that pay us more than $100000 per year. We've added 159, new large customers for a total of 1908 up <unk>.

51% year over year large customers now account for 61% of revenue at our large customers keep getting larger the number of customers over $500000 in annual spend grew 88% year over year and customers over $1 million grew 63% year over year.

Even with inflation hitting some of our costs. Our gross margin held strong at 78, 1% still above our target gross margin range of $75 to 77%, we achieved a record operating profit up $14 8 million.

Representing an operating margin of five 8%. We are confident we can deliver meaningful operating margins over time, but continue to plan to hold them near breakeven as long as we're able to deliver exceptional revenue growth.

Our dollar based net retention in the quarter with 124% flat year over year and down from 126% last quarter. While there is some noise in that number based on when contracts renew we will continue to be dissatisfied Intel at over 130% and we believe that is still very achievable as.

We add seats and storage based product like zero Trust in <unk>.

We are proud to have cross through $1 billion in annualized revenue, but it hasnt thinking about our next milestones while there are economic challenges for every business in the near term, we know that the opportunity <unk> has the head to the long term is massive even as we achieved $1 billion, we have penetrated less than 1% of our identified market for products.

Already have available today.

That's why we're confident we're on the path to organically achieved <unk> 5 billion in annualized revenue over the next five years less than 1% of all public software companies reached the $5 billion milestone.

While todays global economy will continue to present headwinds in the quarters ahead as we look further out we are confident we have the products already in market to get us there.

Crossing the $1 billion milestone is also an opportunity to reflect on our team. It's a maxwell normal process gap different leaders for different stages in the company.

Earlier this year, Chris Merritt, who runs our sales team reach out to me and Michelle to say that while he wasn't in a hurry we thought it made sense for someone else to take the next milestone passed $1 billion.

Chris himself as a unicorn he started at class, they're almost 10 years ago as our first sales higher fee grew our revenue from zero to $1 billion.

I tried to count the number of sales leaders do accomplish that and have come up with fewer than 10 across all the history of software I wanted to give Chris the floor for a second to recognize and all he's accomplished and helped us build a cloud player.

Thanks, Matthew I remember meeting with Michelle all the way back in 2013 as cloud Flair was looking for someone to build that sales organization.

It was very clear from that very first meeting that the opportunity to cloud clear had was just incredible.

Fast forward to present day and I'm. So proud of the team. We've built that brings cloud players products to market to solve real problems for our customers. It is a truly world class organizations doing amazing work.

And as Matthew said I had a terrific run and I decided to $1 billion Mark was the right time for me to transition out and bring in another leader for the next phase of <unk> growth I worked closely with the team to help identify the great leader. We've found that do that and are continue to be involved to help with a smooth transition through at least the end of the year.

What a great 10 year journey, it's been always believed the cloud <unk> orange.

Back to you Matthew.

Thanks, Chris with Clinton have gotten here without you as Chris said he worked closely with us over the last several months to identify the right person to lead our sales team going forward to personally found is terrific.

Understand enterprise sales mid time as a senior leader at Oracle can help accelerate our zero Trust go to market based on his experience in the identity and access management space rocks the desire to developers as we turned workers into a massive goodwill and recently led sales for Twilio. Another software as a service company, which grew more than 50%.

Panic, we compounded during her tenure to a $4 billion annualized run rate Mark borer, Jetski is uniquely qualified to take us through our next milestone of beyond I wanted to give him the floor to talk a bit about why he joined <unk>.

Thank you Matthew.

And on the team now for a little over a week and I couldnt be more thrilled.

I was very fortunate to have 10 cloud players recent customer day in San Francisco in all my years at similar then I've never seen more engaged customers of all types are.

Eager to do more with us as a strategic partner.

Let me tell you, what's especially compelling about cloud flare is the breadth of solutions that are part of our platform today.

We don't need to go out and buy companies, we don't need to embed new technologies.

See a clear path to $5 billion in five years.

Really by selling what we already have in the bag to the customers that already knows that an.

An incredible opportunity and what compelled me to join the cloud layer team.

Thank you Matthew.

Thanks, Marc we are excited for you to build on the great team, Chris has put in place and further mature our go to market efforts as we sell more products to a larger and larger customers with that setup. Let me tell you about some customer wins last quarter.

A fortune 500 technology financial services company signed a one year $2 $8 million contract they face an increasing number of sophisticated cyber attacks.

Paradise, nearly all of our competitors, while the competitors tried to offer lower pricing. It didn't matter. This company with so convinced that we were the clear technical leader that they paid a premium for our services.

Value of our integrated approach and are now evaluating us to be their zero trust provider as well.

Fortune 500 pharmaceutical company expanded their relationship with cloud, where they signed an additional $915 three year deal, bringing their total contract over that period with up to $7 4 million Sir.

They are adopting our data localization suite powered by cloud car workers. This product allows customers to process data locally in the countries where their customers reside.

These features are unique in the industry to cloud flare and increasingly important to highly regulated customers like this one.

500, European Telecom signed a three year $1 $2 million deal the customer was moving more of their security services from on premise hardware to the cloud while they evaluated our security services as best of breed. This shows software for them again was our data localization suite, none of the other vendors they considered including the hype.

Scale public cloud at an equivalent pollution.

Seeing more and more EU companies adopting cloud player in order to meet the increasing data localization and data residency requirements, becoming law in the region.

A fortune 500 retailer expanded their relationship with Chrysler signing a $442000 deal and bringing their annual commitment to nearly a $1 billion, they're using workers to build highly scalable functions across their E. Commerce application Theyre also using cloud network to route traffic between different Hyperscale public cloud vendors.

Being multi cloud is the priority for them and class eight is the only vendor they see it being able to help them achieve their vision.

They've started experiments with <unk>, our object store and D won our first database while their spend is still modest we think theres an opportunity and they've expressed interest in making <unk> one of their strategic vendors going forward.

A fortune 500 life Sciences conglomerate signed a 745.

$1 three year deal they use a range of our products, including magic transit to better protect their on premise data centers handing traffic directly to our network completely replacing their ISP, we sign an MSA with them and believe there's a significant opportunity to expand across their other two subsidiaries.

A fortune 500 apparel company signed a three year $1 $1 million deal. They bought our full set of security services as well as cloud our workers a fun fact is that my cofounder Michelle had an opportunity to be this company as CEO as chief of staff out of business School instead, she chose to start Cloudware and know their customer.

A fortune 500 consumer products company expanded their relationship about signing an additional $292000 one year deal that brings their total spend with us to nearly $1 million per year, using our zero trust product and we worked with a large channel partner to win in service some of the customer a fortune 500 financial services company signed a 230.

$6 one year deal. We believe this will be another example of how we can land with one product kind of general MSA and then expand over time, you've been counting that's a lot of fortune 500 companies and we're actually up to 32% of the Fortune 500 now using us.

See a clear path to nearly every fortune 500 companies using us for something in the next five years and a big part of Mark and the team's job then.

And those relationships and then get them to use us for everything we aim to be the network for every fortune 500 company, but not just the fortune 500 in Q3, a large building materials manufacturer in Europe , and a $1 $2 million 31 mine expansion deal. They are broadly adopted our zero trust products across their 25000 employees.

They had been hit by a ransomware attack earlier this year that their existing E Mail security vendor failed to cash we included our area. One E Mail security product as part of their zero Trust solution something no. Other zero Trust vendor provides as a native integration.

During our POC, we got phishing messages with our other existing vendors Smith's they went from POC to live in two days and signed that deal a week later.

Small customer previously, but turned to us for an integrated solution. The minute. They had another network security need and we delivered.

Finally, a large software monitoring company signed a $3 $6 million expansion deal, bringing their annual spend to more than $5 million, they're a big user of popular workers processing seven trillion request just in September they are migrating more and more of their application from AWS to class our workers for our performance and easy.

Gail ability.

In a few weeks, we have our upcoming developer innovation week, where we'll be announcing some incredible new class of our workers milestones, but I couldn't resist sharing a few here now.

As of the end of Q3 were up to $2 2 million unique applications running on top of our workers' comp book.

Pages, which is a product within the <unk> portfolio is that the 367000 project and has doubled since may and September we announced that our two was that generally available along with our other generally available storage products workers kv and workers durable object, we're now growing over a petabyte of customer data and the.

Before the end of the quarter D won our first database products will be available in open beta.

Increasingly we're hearing about more and more startup companies that are skipping the hyperscale public clouds and building exclusively on workers, reflecting that trend in September we announced the workers Launchpad funding program in which 26 of the top venture capitalist collectively earmarked $1 billion to $5 billion in.

Funding for innovative new startups building on cloud for their workers with funding program came about because <unk> kept coming to us to do due diligence on companies. They were considering investing in when more and more of their tech stacks were powered exclusively by popular workers. So from the fortune 500 for the hottest new startups increased.

<unk> the future seems powered by cloud our workers.

I wanted to close by reminding everyone in the United States that we have an election next Tuesday.

That makes this time of heightened cyber security concerns for the country.

The cloud players Athenian project, we provide our services for free to any state and local officials, who help oversee election today election authorities and more than half of U S States and most of the so-called Battleground States are participants in the Athenian project. We're proud that we help cyber attack not be part of the story in 2020 electric.

And we have had our team standing by and there'll be available 24, seven over the next week to help ensure cyber attacks won't be part of the story for 2022, either so we'll do the thing we're about that you don't forget to vote with that I'll turn it over to Thomas Thomas take it away.

Thank you Matthew and thank you to everyone for joining us.

As Matthew mentioned, we achieved an important milestone in the third quarter, surpassing $1 billion revenue run rate for the FERC time.

This milestone is a testament to our enormous market opportunity our ability to land and expand larger enterprise customers and the durability of our subscription based revenue model.

Turning to revenue for the quarter.

Total revenue for the third quarter increased 47% year over year to $253 9 million.

Area, one the email security company, we acquired in April again contributed less than 1% of revenue this quarter.

While we are seeing foreign exchange headwinds and global economic uncertainty impact the business.

Continue to have traction upmarket and believe we are very well positioned in this environment.

From a geographic perspective, the U S represented 53% of revenue and increased 49% year over year.

EMEA represented 27% of revenue and increased 51% year over year.

APAC represented 13% of revenue and increased 38% year over year.

APAC performance has improved meaningfully from last year, but we are.

Seeing more price sensitivity and buying decision delays in the APAC region.

Turning to our customer metrics in the third quarter, we had 156000 paying customers.

Representing an increase of 18% year over year.

Similar to last quarter, we saw a higher level of churn in our pay as you go customer base, primarily due to more customers shifting down to our three customer tier.

We think this is a function of a more challenging macro environment. However, we are pleased to see these customers to remain on our platform.

Turning to large customers.

We ended the quarter with 1908 large customers, representing an increase of 51% year over year and then the addition of 159 large customers in the quarter.

We were pleased to see large customer revenue contribution increased again sequentially.

We're also encouraged to see the quality of <unk> continued to increase across the fortune 500, and a broad array of growth, including consumer retail healthcare life science pharmaceutical industrial a telco and financial services.

While the sales cycle, but the high end of the business have elongated we continue to see our 500000, plus and $1 million plus cohort, scoring prosper than topline revenue.

We also achieved a milestone of 75 customer larger than $1 million in the third quarter.

Increased 42 per cent you over a year, bringing our total number of employees to approximately 3100 and a T. At the end of the quarter.

We will continue to invest in the business. So as we mentioned last quarter. If we continue the pace hiring based on current market conditions.

Sales and marketing expenses for $103.5 million for the quarter.

Sales and marketing as a percentage of revenue decreased 3% sequentially and decrease the 41 from 45% in the same quarter last year.

Research and development expenses for $46.4 million in the quarter R&D as a percentage of revenue decreased 2% sequentially and decreased to 18 from 19% in the same quarter last year.

General and administrative expenses were $33.6 million for the quarter.

G&A at the percentage of revenue decreased by 2% sequentially and decreased 13 from 14% in the same quarter last year.

Operating income was $14.8 million compared to an operating income of $2.2 million in the same period last year.

Quota operating margin of 5.8% an increase of 450 basis points here over a year.

Overseas operating expenses benefited from the strengthening of the U S dollar, which contributed to the increase in operating profit.

Turning to net income in the balance sheet.

Oh and net income in the quarter was $19.1 million or net income per share of six cents.

Tex expenses for the quarter was $1.7 billion.

We ended the third quarter with $1.6 billion in cash cash equivalents and available for sale securities.

Free cash flow with negative $4.6 million in the third quarter of 2% of revenue.

Compared to negative $39.7 million or 23% of revenue in the same period last year.

Operating cash flow was $42.7 million in the third quarter or 17% of revenue compared to $6.9 million or 4% of revenue in the same period last year.

As stated previously we continue to expect to be pre cash flow positive in the second half of 2022.

[noise] remaining performance applications are up Yo came in at $831 million for it.

Presenting an increase of 9% sequentially and 52% yoga yeah.

<unk> 75 per cent of the total our appeal.

Before moving to guidance for the fourth quarter and full year I would like to reiterate our expectations in light of the uncertainty in the macroeconomic environment.

Why we saw a foreign exchange benefit to operating expenses. We also saw F X headwinds to revenue so you're all set.

Concessions to offset the strength of the U S dollar internationally.

In the quarter, we observed an increase in our sales cycle and expect similar sales dynamics to continue leading to longer lead time deal closures.

We are cognizant of the increasingly cautious environment and that factor this into our outlook.

No turning to guidance.

For the fourth quarter, we expect revenue in the range of 273.5.

$274.5 million, representing an increase of 41 42 per cent keel over yet.

We expect operating income in the range of $12 million to $13 million and we expect net income per share afford five cents, assuming approximately 343 million come in shape outstanding.

We expect a tax expense $1.9 million.

For the full year 2022, we expect revenue in the range of $974 million to $975 million.

Representing an increase of 48% to 49% year over year.

We expect operating income for the full year in the range of $31 million to $32 million.

And we expect net income per share over the period and the range of 11 to 12 cents.

Assuming approximately 342 million common shares outstanding.

We expect that texts expense of $6.1 million.

Also challenging to remain in the current environment. We are confident in the continued growth of our business and the durability of our subscription model.

Before closing I would like to let you know with the Chase Norland, Oh, I had a strategic finance and Investor Relations is leaving US. This is happy and sad news happy for him to pursue his first teeth all opportunity.

Ikea, a software company, but sad to lose such an integral member of the team I want to thank them personally for its leadership and partnership and wish them great success in his next chapter.

In closing I'd like to think logically employees for their continued dedication and delivering exceptional service to our customers Harkness and communities.

And that's Matthew mentioned now that we have reached a billion dollar revenue run right. We are setting our sights on the next milestones of $5 billion in five years with that I'd like to open it up for questions. Operator, please pull quick restaurants.

Thank you Sir I'm, having my nephew with like ask a question. Please spell star one on your telephone keypad.

Dar one if you would like to ask a question and we will go first to sell Linzo credit. Please.

Hey, Thanks for taking my question, one for Matthew than a follow up for Michelle and and Thomas Matthew Obviously, you've talked about the macro for a couple of quarters now when you look across cloud first portfolio. Obviously, it's broad zero Trust services network services applications services developer platform, where wherever you seen the most impact to the businesses and Conversely.

What is actually held up the most and then have fallen for Thomas and Michelle you talked about it being.

Yeah, you can keep your eye on hiring relative to revenue growth you what are the puts and takes that you're saying, they're trying to balance obviously, the longterm 5 billion dollar target, but also this where the near term realities.

Yeah, So I'll I'll start.

And then handed up to Thomas Thomas I'm, Michelle So I think that what what we have been seeing and I think we've been very transparent about talking about is that the velocity sail at large companies, especially in especially in getting new logos.

Is slowing down it feels like everyone right now is measuring twice to cut ones and you know I think we started to see that as we've talked about on previous calls in December of last year, and you're seeing some of that slowness in new business now.

Flowed through and hit hit our top line. What I think is is continuing to hold up extremely well right now in in in fact in some cases, we're seeing acceleration is in the security portion of our business. While it is worrisome that that.

Global conflicts that we are all watching in multiple parts of the world that is putting more pressure on companies to make sure that their security.

Is it a good place and so I think that Wow as I said last last quarter. The economy. The macro economy is challenging right now and we have said that I think consistently for for the last the last three calls we we do believe that we are very well positioned in.

I continue to say that I wouldn't trade places with any other C E O at any other company.

Great and then in terms of hiring about yes.

So you saw the door I'm, sorry, you're at 242% year over year in the quarter I think we've been very restrained when it came to corporate functions and TNA expenses.

We have made sure that we hire them or sales capacity in the article to market <unk> in a way that we are not Ah hindering our potential and opportunity that is in front of us. So we tried to be very balance wherever you slow down and we have been very strategic where we added <unk>.

In terms of numbers, but also in terms of footprints from a regional perspective.

Great. Thanks to take my questions.

Our next question comes from our Heartburn IPC capital market.

Great guys. Thanks for taking my question is Matthew and your prepared remarks. He noted economic headwinds that you've been talking about the last couple of quarters of showed up here I Wonder. If you are if marks in the room to can talk a little bit about perhaps what your sales force can do to kind of navigate. These headwinds is is it a different sales motion as a different way to to engage the cut.

Customer just sort of curious on how.

How how sales organizations adapt to the Chinese headwinds.

Yeah. So first of all I don't think there's anything that has dramatically changed this quarter and at this time versus what we are seeing earlier in the year and so I think the adjustments that we made in terms of our go to market strategy.

Are are actually things that we've we've made previously and we've seen positive benefits from those changes the nature of subscription businesses is that if you see slowdowns in the beginning of the year. They shop in your top line later in the year, but the things that we did that I think have been successful and will continue to be successful.

Is really focusing on how do we get to know the customers that already know us and trust us how do we sell more to those customers from the broad portfolio of products that we have and how do we make sure that they are getting all of the value from.

Cloudflare and one of the things that I think we are hearing over and over again is that as companies are thinking about how can they reduce their cloud span how can they rationalize ed how can they make sure that they are getting the most out of the <unk>. The I T dollars that they're deploying over and over and over again.

We are able to deliver services to help companies save money get better performance get higher reliability get more variability at multicloud environment and make sure that they are secure and so as we look at our customers based.

C S more and more as a strategic partner on making sure that they're getting the most out of every dollar they spent.

The.

Go ahead.

I just wanted to put in additional comment on it so that I can which was coming back from her customer trip in Europe .

<unk> the security products are holding up nicely nine and light upon the security and <unk> concerns, we we see out there leading half a year on on the intelligence. We have we just launched a sweat intelligence product locked for a cloud of course, a couple of weeks ago.

<unk> on this effort we have in terms of the intelligence and <unk> is helping us, especially with opening.

Dorothy.

That's super clear and then maybe Matthew obviously are too as early but but it's great to hear the success already with a pet by distorts you can you can you talk about what sort of customers you're seeing leverage. These are these some of your biggest strategic customers are they just just maybe a little bit of color on on where you are seeing that usage.

Yeah. So in the quarter that they usage was was mostly still during our beta period and so that the the the users of that product have primarily been developers that are that are using it to build new services or <unk>.

Paul teams within larger organizations, where I think that will see now that it is out of data at the very end of the quarter is that you'll see much more large companies who are looking to figure out how they can reduce their cloud spend and make sure that they can have a <unk>.

The cloud presence adopt are are two services and so we were talking to very large companies about moving more and more of their stored objects to where we where we can store that with our two and one of the benefits is not only can we help them save money on the <unk> fee, but it allows them.

Then use those objects across any of the different cloud platform, they're using so by being that neutral third party. We can let people adopt a little bit of Amazon a little bit of Microsoft a little bit of Google a little bit of SAS vendors and share that data across all of those different places it actually it they use case at <unk>.

<unk>, putting data in the network one of the things, which is is really valuable and I think you'll and quarters to calm the larger and larger companies adopt that as the objects door for their company.

Super helpful. Thanks.

Next up a bank account caffeine.

Matthew one of the key themes. We keep hearing is just seem a consolidation that you're using a lot of pockets organizations and many are saying that they they could consolidate do you feel over the next year you can use that your advantages or a C.

Oh sure an opportune, you're starting to see where you're getting you know water Weiner enterprise license agreements to to take to take on a more and more solutions.

Yeah, Yeah, I think that you know we are extremely well positioned to help companies ferret out any type of savings that they can find across across their their organization and the conversations that we're having are are very much around how can companies consolidate.

They're they're vendors into what are those critical vendors that provide services and how can they they really save money in the process of doing that the fact that we've got add broad portfolio products as we do means that what we're seeing is more and more companies or.

Are adopting the complete Cloudflare network and I think the way that that shows up in the numbers is the fact that you know our customers that are over $500000 a year spend over a million dollars a year span are growing faster than our overall revenue growth rate in our overall customer growth right and so I think that's a good indication that.

Are the customers are doubling down and using more of our services I think that's gonna make it a more challenging environment for those point cloud solution that are that are out there and that we will increasingly take share and help b that strategic vendor to become the network for our customers.

And can I, just quickly clarify with with Thomas.

Slow down that you're seeing did you see that more pronounced in small amid versus large or did you see it against.

Men and large.

I see you see.

And each one of the segments you mentioned, you'll see some impact you know, we we talked about pay as you go downgrading to free singer customer staying on the platform, but Ah downgrading, we see.

<unk> sales cyclists at the very high end.

Very large customer cohort.

And we see the expansion in our midst mark equipment slowdown of insurance. They didn't turn off of expansion was a bit harder. So it it really depends on the website when you look at.

Thank you.

Our next question <unk>.

Hey, guys. Thanks for the questions.

Matthew you highlighted that fortune 500, retail when with Cloudflare, it's kind of like glue between B Hyperscalers and you also said you see fortune 500 penetration getting to 100 per cent over time I guess.

Balancing that strategy of being that glue or fabric between the hyperscalers first being that full infrastructure as a service offering alternative to the Hyperscalers and how does that success of one or the other change your view our ability to hit that's 5 billion dollar golf five years from now.

Okay, I think I think that our approach is is very different than the hyperscalers. The hyperscalers sorta start from the inside and work their way out and we are starting from the outside and working our way at what I mean by that is fundamentally what <unk> is is a network and we want to be the best network to connect.

Anything online to connect cloud to cloud cloud home after a home office cloud the remote office cloud a branch office anything that is having to be connected by a network. We want to be that network. There are things that make a ton of sense to live in the network itself. So.

For instance, a shared object, if you're going to use across Google and Microsoft and and and they W. At so hurting that with our two makes a ton of sense, because we're not going to charge you. They egress tax to be able to access that across all of those those different platforms, you're also going to for some applications.

Want to make some parts of the application as fast and it's scalable and are as reliable as possible. So those parts can live inside of Cloudflare, but our our strategy is not to completely recreate every single thing that the hyperscalers do we want to be the best network with it is there and there will be <unk>.

This is at the margins, where we absolutely will compete with them and and again I think increasingly we're seeing that companies are able to build entire applications using the cloudflare stack in a way, which is much more modern and much more reliable, but we're never going to be the place that you can lift and shift S. A P. <unk> that's.

Just not the way we're building instead, what rebuilding is for those applications that need to live inside the network pretty did their performance reliability compliance requirements and the data they asked to live inside the network for those same reasons, we wanna be the network to be able to do that <unk>.

Regardless you know, we see with the products that we have in market today, a clear path to getting to $5 billion of revenue and that doesn't assume any M&A. We believe that that is through organic organically that we can get the $5 billion of revenue in the next five years with the products are that are in market today and so I.

I I I think that we we don't have to <unk>. The hyperscalers don't have to fail for us to succeed we actually see ourselves as much more of that glue between them and whether companies wannabe multicloud or not they all are and so that glue is is critically important and again I think we provide the only so.

<unk> as we see companies that are trying to struggle with reconciling that that increasingly multicloud world.

Thomas maybe for you is there any way to understand the impact or adoption of that monthly to annual conversion with enterprise specifically this quarter you know our customers actually looking for staying with shorter duration. It just gives me this macro uncertainty or are they alternatively looking to lock in for longer on your infrastructure.

<unk> thanks, guys.

You know a good Christian.

Uhm, let's reset in the past you know the moving from Matt from monthly billing and contracts or annual it's our biggest lever on all costs to delivering a free kind of slow.

In a world, especially outside of North America, where you can exchange rates are high customers are more resistant to log in and as you know, we we don't <unk> <unk>.

Discount too much in order to log in lower revenue in there and everywhere else off north difficult to exchange for it. So we have been more <unk> to customers and partners in general in this environment and have not pushed as hard.

You know moving forward in this transition, but you know it it is still there the biggest lever we happened it's an opportunity that is in front of us and it will materialize and or free cancel numbers I'm moving forward.

For next question will confirm shall I R. Kelly.

Thank you good afternoon, <unk>, Matthew Uhm on earlier one.

When you've acquired them I think you've indicated they can assist you.

You and taking deep.

Deeper into an entire community how does that coming along thus far.

Maybe any commentary about when rates versus the scanner, maybe even Palo Alto that you flagged in recent quarters.

Yeah sure. So uhm. So area. One team is is amazing and I think they brought to US three distinct things. The first is a product, which I think is a natural gateway to our overall zero Trust solutions. The second is a world class threatened <unk>.

<unk> team, which we are now turning into a product to.

To sell to our existing customers and also as a a great way to attract new customers in and create some of the marketing around the threat intelligence that we do and then the third is it a really a much deeper and more mature understanding of channel through some of their leadership that we that we have that we've.

Brought onboard and again I think had that has matured helped us mature what our channel strategy has been uhm I looking at area. One in particular, we're seeing particular strength in in Asia actually around around the area, one product and I think our sales team, especially in Japan has done a great job selling the area one product.

We're seeing a lot of it and that's that's the straight email security product and once we have got someone using the email security product. It's a very natural extension for them to turn to the rest of our our zero Trust product I think in addition to threaten intelligence team has helped us win larger and larger customers.

And being able to help customers understand if something goes bump in the in the middle of the night, what's going on it's been Tomatoes is the area of one team again has really helped us with and then again the channel or channel strategy, you're seeing more and more of our deal, especially in Missouri address space come through our channel or one way to get out.

When rates against Z scaler and in Palo Alto networks continued to be very strong our product in that space compete extremely well with them.

That's that is the challenge and the thing that I think we are continuing to work on it just increased awareness in the market and and that's that's something where as we were thinking about who has the right replacement for Chris Marx.

Mark's background and identity and access management, both an Oracle twilio, he really understands that market and I think it's gonna help us increase the awareness, it's there, but when a customer is considering going on there zero Trust journey, if we're <unk> and that consideration, we love our when rates in that.

And so our job is now just increase our awareness and go from the company that people I have known US. We're doing one thing today are much more sophisticated and much more broad portfolio and and I'm I'm excited add that that grows and I think that zero trust is very much is gonna be the story of the next few years to come.

Thank you.

We will take the next question time harmful side or while I'm working Stanley.

Hey, guys. Thanks for taking my question, Matthew and perhaps Ah Thomas as well I wanted to dig in a little bit around the net expansion point and you spoke a little bit about this already but just get more specific.

You know, we're hearing from a lotta cloud service providers around rationalization Matthew.

Matthew you spoke a little bit about how the cost there are getting you know too high but as it relates to cloud Fleur are you seeing any of that rationalization as it relates to your usage and expansion and obviously you have a very different pricing model as a subscription based company and this is kind of weird Thomas comes in.

How do you expect that to play out and mechanically over the next few quarters, we'd likely see these expansion rates continue to be impacted thank you.

Yeah, I think that if you are a usage based purely usage based model. It is and it is a place where people are looking for areas to to save money. Similarly, if if you are seats base model as you're seeing some companies you know do lay off.

<unk> and or at a minimum not expand their seats that that is something that is is is challenging and in the current environment. I think we are fortunate that today are are most of our revenue is not usage based and not seats based and so why.

We are adding products that are in both of those categories and and we think that over time that that will be an expansion driver for us that today, we're not seeing that downward pressure from people trying to rationalize or consolidate their bills I think the one place which Thomas reference.

Where we are seeing some pressure is actually with new accounts, because we we bill all in U S dollars <unk> that is putting some pressure, especially outside of the United States and we are making concessions in order to accommodate what are the foreign exchange pressures that that are that are there.

Uhm again, though <unk>, it's less about our existing customers trying to figure out how to use less of us in fact, if anything we're seeing that they are trying to say how can we use more of you instead of using what are some of the other consumption based alternatives, which are which are out there. So I think we have been last exposed to that downward pressure then.

Then some of the pure consumption based services that exist.

And it was a very completed I'm, sorry, nothing to us.

Yeah. Thank you for the clarity.

[laughter].

Okay.

The next step is Sterling <unk>.

Thanks, guys. So Matthew in terms of thinking about the threshold of keeping the margins basically flat within that context of growing to 5 billion is they're kind of like a threshold growth rate that you think about so as long as you're over 30 or 35 or 40, you'll keep it there otherwise.

You would reconsider kind of the margin profile.

I think I remember that we we have you know a specific specific guidance I've I've always personally and and and Thomas will probably slap me for saying this but I've always personally kind of found that sort of idea of the rule of 40 to be pretty pretty compelling and so and so I I think that we.

That we that we we like we like that and I think that that would if we're growing north of 40 per cent. Then I think that that's showing that we can continue to execute and deliver on the enormous opportunity that we that we have ahead and so so so again I think where we we want we know that we have the <unk>.

<unk> two when when it's the right time for us to be a business that delivers very significant operating profits, but while we see at total addressable market ahead of us that we only have you know less than 1% penetration on we think that it makes sense to continue to invest in in that market and continue to.

Drive drive growth going forward and and today you know we're still we're still living above the rule of 50. So so I think I think we've we've we've got some time to think about that.

Makes sense. Thank you guys.

Our next question today comes from John <unk>.

Thank you the question for for Matthew than a quick follow up for Thomas [noise], Matthew I, just want to make sure I understand your comments about acceleration and the security portion of your business.

Security businesses have so far anyway, generally held up well against the macro slowness it sounds like that's continuing or even getting stronger for you given your comment there, but I wanted to make sure.

And and that the the macro backdrop is really meant manifesting itself more broadly than the rest of your business is that correct.

Yeah. So so first of all you know I don't.

I think we have been consistent and talking about the macro pressures now for the last three quarters and and there isn't something that has dramatically changed since we started to to.

To warn that there were pressures and the macro space what I, what I think if we dig down a little further into the security business make especially in February of this year. When we saw Russia invade Ukraine, a lot of security company is expected, but that would be a tailwind to their business what I think.

Actually ended up happening was a bad tailwind did not materialize and that the threat that you know the Russians are coming turned out to not be something which which showed up outside of the Ukrainian theater.

However, in the last several months and especially in a Q3, we started to see an increase in cyber attacks coming out of both Russia and other parts of the world that drives increasing adoption of products like Cloudflare.

Its products.

At a very very very high velocity, so where will see clothes rates that you know you can often measure in hours or days and so I think that that expectation of the the war in Ukraine and other political conflicts around the rest of the world leading to more security business with somebody that I think a lot of the industry.

Expected would show up in Q1, and Q2, and we actually saw it show up more in Q3, uhm, but generally the overall macro environment hasn't changed substantially throughout this entire year based on what we're seeing and and and so I want to make it clear that we're not saying that we're seeing a big change we have seen that there.

Was softness in the macro economy since Q1, and we've been talking about it since Q1.

Yeah, and you've been very clear on that Matthew so thank thank you [laughter] Thomas <unk>, a quick it's sort of a follow up to what Matthew was just talking about you talked about when he gave the outlook and you've talked about your caution and that outlook I just Wanna make sure I understand what's implied in that outlook are you looking at sort of similar.

Sex due to the macro backdrop or are you expecting further deterioration.

<unk>, we are talking about the subscription based model. So a lot of the things we see the third quarter and we'll see in the fourth quarter or the impact. So that's when we started to talk about the macro climate going to change. So when we when we give guidance for the fourth quarter, it's less the the <unk>.

Packed up their business, it's just a flow through a court already has happened.

I understand that but do you are you do you expect to see the macro backdrop the effects on your business trip further deterioration, even if we can't see it although we kind of think we we try to anyway or do you expect it to sort of stay about where it is and the softness you've seen over the last couple of quarters I guess.

Why are we really of course sure not mm mm Martha assumed in improving the macro economic environment and <unk> with an hour <unk>, there's nothing that that that stigma that it's going to get better at anytime soon.

Okay. Thank you very much guys.

Next up we'll take a question from Andrew No Lynskey Wells Fargo.

Great. Thank you I just wanted to start with a quick sort of follow up to Johns question. I was wondering if you could just provide.

Provide any color around maybe your pipeline of renewals for Q4, because I assume Q4 is usually.

Pretty big in terms of renewals and I'm wondering if you perhaps changed how you're handicapping the likelihood of those renewals clothing in queue for given the lengthening sales cycles are saying and then I have a follow up.

Yeah, I I don't I don't think again, we have we have not seen an uptick in overall churn.

Across across the business that that has had continued to hold very very strong and so we haven't changed how we have handicapped the the renewal for Cassie.

Okay. Thank you and keep him and keep your mind to know most of our revenue still good spook My monthly and not annually. So we don't have this.

Massive renewal quarter and before four nine.

At least not yet.

Got it Okay I just want to also just dive a little deeper on the security and how security demand is holding up you know we heard obviously over the last few days <unk> talking about how they're seeing sort of more normal spending patterns from customers, where they're not ordering placing orders for firewalls 12 months in advance because of supply is starting to free up.

I suppose you could view that negatively is sort of a change in the overall security spending environment, but could you also view it as a positive for <unk>, because now customers aren't making sort of irrational purchase decisions and buying firewalls, whereas now they can actually evaluate and deploy a smarter solution like clubs are one just wondering how you kind of how you view that change.

<unk> the firewall vendors are talking about.

I mean, I I think that there's.

I I think that that you've had a series of head fakes from the hardware space for for quite some time going back to the Trump tax cuts that move forward a lot of incentives on capex spending the beginning of Covid, where everyone was just scrambling to keep the lights on and then the supply chain.

Crisis, which again made people place orders just to get in line for for for products that they they may not eventually even even want to to have so it is it is in the Grand course of history, you can't solve the problems of a distributed workforce you can't solve the.

Problems in the cloud by shipping a box or a virtual box. It. It just doesn't work and so I I think that that anything that get the market back to being rational without any kind of sort of artificial incentives to continue to invest in hardware is is definitely benefit.

<unk> for for Cloudflare and other cloud based security solutions.

Great. Thank you.

Next <unk>.

Oh, Thank you for taking my questions Marquee went for you and then Thomas wanted for you as well.

I wanted to ask you about eat pricing strategy pricing philosophy questions that we heard a lot in your preparing commentary about the downshifting of customers or or trade down from customers to some of your free <unk>, which of course is that R. T. C. L. In this environment I'm wondering what's the rationale for you.

You too.

Maybe not I guess raised the floor online. So you can hold on to the paying customers I'm. Just curious about how you started thinking about that game and I can add followed fans. Please.

First of all our our pay as you go business is a is a relatively small.

Portion of of our business, it's it's much less than 20 per cent.

Revenue and so and so I think that what we see as the value from that pay as you go business is that those those customers, whether they pass something or not end up being our biggest advocates and our biggest champions inside whatever large.

Organization that they that they operate out so if you look at who are our largest customers and you go down in the top 10 customers almost all of them came to US originally because some technical leader inside that organization used cloudflare pay as you go services fell in love with.

<unk> understood us and was able to adopt us as part of that and so I think that that benefit is is so substantial to us that we always wanted to make sure that we're treating those customers well and so is Thomas said, while they may go from paying $20, a month, just not paying or something because gas.

Prices went up that that that is something that we're trying to optimize for what we're trying to optimize for is that those customers love us they understand us and they take us to work and so as they do that's how we've been able to close so much of the fortune 500 behind almost every one of those fortune 500 wins.

Yeah. The pay as you go customer who advocated for us internally and that is you know our secret Salesforce.

Start off I appreciate you sticking to your email on that Thomas on the dollar Netflix expansion rate discussion I appreciate and kind of share something at a granularity <unk> you know some of the pressures are coming to narrow, but I'm curious from E product pillar of perspective.

If you can shed light on you know are you, saying expansion level moderate within the application services pocket or the network services stuck it just kind of curious to get a sense that you know what teacher functionality uhm across your portfolio are more prone to that expansion velocity dynamic. Thank you.

The I think the first statement to make us for US this is.

Very true number it's an all and number of covering our pay as you go business all of them at the market N O N.

Fries and this we just discussed over the last.

15 minutes different segments behave differently, which expand that talked about paigle customer churning, often becoming free customers that does something some of that hinders.

Across their cohorts expand should we have seen.

Exchange rate headwinds from a from a billing and contacting prospective and overseas are calling so if that is something that would be reflected in the next branch and number and then we talked about how long ago did the sales cycle. The very high end and they're very large cohorts and that is if you go back to the.

K P ice we sure it's where a lot of gross dynamics that happening those cohorts growing in general significantly faster than average.

<unk> broke right. So any movement, we have in terms of sales cycles in the in the very large cohorts is impacting dealers are in the current Barker.

Not take away from the opportunity that is in front of US ended its claws into the lottery that we always had when we talked about the <unk> you know, we we see a path forward ticket and also 530%, but there will be movement around that number it will not be a straight line that gets us there.

I appreciate that thank you.

Thanks to Timo, operator can we take a question from one last analyst. Please.

Absolutely Yeah, No question will come from James screen William Blair.

Thanks for taking the question can you just talk a little bit at the M&A environment. Yeah. I know you talk about getting a 5 billion organically.

It seems with valuations coming down and get into cash you have or are they gonna be opportunities out there to maybe add product or some scale on certain divisions around other coverage.

Yeah I you know I think are different companies are built in different ways and so if you look at at.

Cisco they were very much in M&A, an acquisition machine, whereas if you look at an Apple you know they do M&A, but it's usually for core technologies. It's not it's not for products. I think we are much more like an apple than we are then we are like a disco we've watched as some of the competitors in the states have really tried to himself.

Up in knots building, what is effectively a frankenstein type solution through a series of M&A and they don't get the same level of efficiency that we do and so I I think that you know we will always be biased against M&A and we will always have a very high hurdle rate.

To do any sort of a transaction, which isn't to say we won't do transactions. When we find great technologies, great teams, great ways to integrate like we did with area. One we will jump on that and add the valuations in multiples, especially in some of the private market continue to fall.

You know, we look at lots and lots of deals, but I don't think that that has changed that relative to other companies. I think we're gonna have maintained a very high hurdle rate, we have very much optimize around internal development and as Mark said in his his responses. We believe we can get the $5 billion without having to build or buy.

Any new products or companies that are out there. We think we've got the right products in the bag today and it's just a matter of us continuing to execute on the go to market side.

Great. Thanks.

So that does conclude our question and answer session I'd like to hand things back to Mister Matthew paints for any additional are closing remarks.

Just wanted to thank everyone on cloud players team for delivering what has been again another strong quarter. We're proud of the fact that we're protecting the U S elections, and we're standing by to make sure that they go off smoothly I also wanted to specifically thank Chris for nearly 10 years of services Cloudflare and appreciate.

All that he's doing to transitioning to get mark onboard and to wish Jason Good luck in his new role as at CFO , signing all of those S. E. C statements hopefully won't keep them up too much at night and I know that he's gonna do an amazing job going forward. Thank you all for being investors.

Look forward to talking again next quarter.

Ladies and gentlemen that does conclude this conference. Thank you all for your participation you may not <unk>.

[noise].