Cloudflare, Inc. Q4 FY2021 earnings

Cloudflare has incurred net losses in all periods since inception. FY2021 year to date net loss widened to $260.3 million from $119.4 million in FY2020 year to date, and the company expects operating expenses to increase as it hires personnel and expands infrastructure.

The 2025 Notes are convertible at the holder's option until March 31, 2022, and from Q4 2021 through March 1, 2022 the company received conversion requests for $16.6 million in aggregate principal. In August 2021 it issued $1,293.8 million of 2026 Notes; cash settlement or stock settlement could strain liquidity and dilute existing stockholders, and adoption of ASU 2020-06 in 2022 may reduce reported diluted earnings per share.

Cloudflare faces intense competition from on-premise vendors such as Cisco and Palo Alto Networks, cloud security vendors such as Zscaler, and public cloud providers including AWS, Google Cloud, Microsoft Azure, and Alibaba Cloud. Larger competitors may bundle products, sell at zero or negative margins, or use greater resources to win large customers.

The ongoing COVID-19 pandemic has led to remote work, potential morale and attrition issues, and plans to reintroduce employees to offices in 2022. It could also decrease customer spending, cause customers to request payment concessions or termination rights, and negatively affect collections.

COVID-19 has caused slowdowns and shortages in network hardware supply chains, including delays in obtaining servers and other hardware and increases in hardware prices. These constraints have adversely affected provisioning of co-location facilities and could make network expansion more difficult and expensive.

As Cloudflare targets more large enterprise customers, these larger organizations may undertake more significant evaluation and negotiation processes, which could materially lengthen the sales cycle. The company also noted that COVID-19 contributed to an increase in the sales cycle for many customers in Q1 2020 and that an increase could recur.

The business depends on retaining and upgrading paying customers and converting free customers. Pay-as-you-go customers can terminate monthly at will, and contracted customers generally have no renewal obligation. Dollar-based net retention was 125% for the three months ended December 31, 2021, but the company warns this may decline or fluctuate as large customer concentration increases.

Cloudflare's growth strategy depends on large customers, and the number of paying customers with more than $100,000 of annualized revenue grew to 1,416 for the three months ended December 31, 2021 from 828 a year earlier. Larger customers have greater negotiating leverage, may demand price concessions, and could cause significant quarterly variability if they terminate or reduce usage.

Cloudflare is highly dependent on co-founders Matthew Prince and Michelle Zatlyn and other key personnel. It faces intense competition for cybersecurity and engineering talent, and post-IPO equity wealth may make it harder to retain and motivate employees.

Headcount grew from 1,270 at December 31, 2019 to 1,788 at December 31, 2020 to 2,439 at December 31, 2021, straining management and operational infrastructure. Failure to integrate and manage a rapidly growing, globally distributed workforce could harm product quality, compliance, and corporate culture.

Cloudflare has limited experience with pricing models for newer products and may face pressure to reduce prices, especially as it focuses on larger customers that may demand price concessions. This could adversely affect revenue, gross margin, profitability, and cash flow.

Use of Cloudflare's network by controversial customers such as The Daily Stormer and 8chan caused significant negative publicity, and actions to terminate those accounts also drew adverse feedback. The company is aware of potential customers that decided not to subscribe because of these customer-content issues.

Adverse economic conditions and reduced spending on network security, performance, and reliability could reduce sales, lengthen sales cycles, increase churn, and lower demand. The company notes that COVID-19 has already caused an economic downturn and increased market volatility.

Growth depends on value-added channel partners, referral partners, systems integrators, and managed security service providers, but many arrangements are short-term and can be terminated on 90 days notice. Competitors may incentivize partners to favor their products or partners may become competitive with Cloudflare.