Boosting Cloudflare’s Sales Productivity by Helping It Win $100,000+ ARR Deals Faster (NYSE:NET)

Introduction and investment thesis

Last time I wrote about Cloudflare (NYSE:NET) in May, where I upgraded my rating from “hold” to “buy.” My thesis was based on my belief that the sales created an attractive investment opportunity the company continued to do well to gain market share among enterprise customers while expanding its sales capability to pursue larger deals with greater momentum. Since then, the stock has climbed nearly 20%, outperforming the S&P 500 by more than three times.

Cloudflare reported its Q2 FY24 earnings in August, where revenue and non-GAAP income from operations grew 30% and 180%, respectively, from last year, beating estimates. The company continued to see strong momentum in the growth rate of its customers spending at least $100,000, while sales productivity increased by double digits year over year, allowing it to unlock operating leverage. In addition, management raised its full-year FY24 revenue and earnings guidance. In particular, when it comes to its expectations for non-GAAP operating income, management increased its guidance by 21% from prior levels, underscoring management’s confidence in its go-to-market strategy. While there are risks in the rate of expansion among customer cohorts, as well as facing tougher compositions, I think Cloudflare’s growth story is intact. Therefore, I will reiterate my “buy” rating with a price target of $105.

Benefits: Large enterprise customers over $100,000 ARR continue to grow, sales productivity accelerates, margins expand

Cloudflare reported its Q2 FY24 earnings, where revenue grew 30% year-on-year to $401 million, on pace with the previous quarter, as it continued to drive deeper enterprise penetration, expanding its the go-to-market organization to win large targeted deals. Compared to last quarter, its large customers paying at least $100,000 in ARR grew 5% sequentially and 30% year-over-year to a total of 3,046, indicating the company’s success in gaining market share in the enterprise segment, with the contribution to revenues from large customers contributing 67% of Total Revenue, compared to 64% in the same quarter of the previous year.

During the earnings call, management discussed that their investments in their go-to-market strategy are paying off as the IT buying environment continues to be challenging with vendor consolidation occurring among enterprises at scale. In my previous post, I discussed that the company has already added several senior market leaders, a new partner director, a new head of global sales and renewal, and several regional strategic account sales leaders as they focus their efforts. on gaining deeper market share by attracting large enterprise customers. We also discussed that the company had seen an improvement in sales productivity with an increased ACV per account executive, which we believed was the basis for their decision to invest in expanding their sales capability. In Q2, Cloudflare saw its sales productivity increase by double digits year-over-year, with improvements in close rates and sales cycle. At the same time, the company continued to expand its team by adding a new VP of Americas Sales, a new VP of Revenue and Operations, and a Global Head of Customer Success, while growing sales manager and AE hiring by 150% sequentially and 163% year-on-year to continue to drive with large enterprise customers.

Simultaneously, Cloudflare reached a total of 2.4 million active developers on the platform, up from 2 million in the previous quarter, along with Worker AI (launched in April to help developers tune and run their AI models on the network global Cloudflare) growing faster than expected. with developer accounts taking advantage of their AI features growing 67% QoQ. In fact, Stack Overflow recently polled a broad base of developers on what platforms they use, and Cloudflare came in fourth. Additionally, when developers were asked which platform they were most excited to work on, Cloudflare came in second, ahead of AWS (NASDAQ:AMZN), Google (NASDAQ:GOOG), and Microsoft Azure (NASDAQ:MSFT).

Shifting gears to profitability, Cloudflare generated non-GAAP operating income of $57 million, up 180% year-over-year, with margin expansion of 760 basis points to 14.2%. This was achieved by streamlining operating expenses which grew at a slower rate than overall revenue growth. Part of what offset the 15% increase in headcount was increased productivity leading to a higher ACV per employee as the company continued to see strong momentum in the growth rate of its $100,000+ ARR customers , thus allowing him to unlock the operating lever. .

Bad: Net dollar retention rate has fallen, expanding sales numbers could turn into a headache if productivity growth slows

Despite stellar top and bottom lines, Cloudflare saw its net dollar retention rate decline both sequentially and year-over-year to 112%. Management attributed part of the decline to slower net rates of expansion in large customer cohorts. But most importantly, management believes that DNR has been adversely affected by a large group of fund deals, which tend to be very large in nature, with the largest between $40 million and $60 million in total contract value. As it turns out, these types of deals are generally billed monthly as opposed to an initial annual billing cycle, impacting the form of revenue recognition, as well as deferred revenue and current RPO, especially for existing customers moving to this structure . As a result, the company now expects new customers to contribute a higher percentage of their overall revenue growth rates. Meanwhile, as the company expands its sales capacity to drive an accelerated pace of customer acquisition, we must also monitor the trend in sales productivity, as continued macroeconomic and competitive pressures may erode margins in the future, putting operations on long term. model at risk.

Revising my rating: Cloudflare remains a “buy”

Looking ahead, management raised its full-year revenue guidance by 0.5 percentage points to $1.658 billion, while expanding non-GAAP operating income by 21% over prior guidance to $197 million USD, which would represent a margin of USD 197 million. 11.9%. As for my long-term revenue growth assumptions, I’ll keep it the same as in my previous post, where I expect the company to grow revenue in the mid-20s region over the next two years through FY26, followed by an increase. rate in the teens through FY28 as it expands its sales team and builds its product roadmap to drive deeper enterprise penetration, resulting in more $100,000+ customers. In that case, Cloudflare should generate nearly 3.6 billion in revenue by FY28.

From a profitability perspective, assuming Cloudflare can grow its profit margins by 200 basis points each year over the next 4 years, it should achieve its long-term operating margin target of 20% by FY28 as streamlines its operating expenses while driving higher sales productivity to drive higher deals, resulting in non-GAAP operating income of $721 million, which will be equivalent to a present value of $511 when discounted at 9 %.

Using the S&P 500 as a proxy, where its companies grow earnings by an average of 8% over a 10-year period, with a price-to-earnings ratio of 15-18, I think Cloudflare should trade at 4-5x. multiple given its earnings growth rate over this time period. This will translate to a PE ratio of 70 or a price target of $105, which represents a 28% upside from current levels.

My final verdict and conclusions

Since my last post, the stock is up nearly 20%, outperforming the S&P 500 by more than three times. In my previous post, I pointed out that the share price decline presented an attractive investment opportunity as I was impressed by the company’s progress in gaining market share among enterprise customers with robust innovations, strategic partnerships and expanding sales capacity.

Additionally, I’d like to point out that the company has consistently beaten its earnings estimate over the past four quarters by an average of 49%, which is very impressive in my opinion and further solidifies management’s commitment to its operating model over the long term long.

While the overall upside has shrunk since my previous post, I believe Cloudflare’s growth story is still intact as it sees tremendous momentum in the enterprise segment, with the number of customers above $100,000 in ARR growing, according to total revenue. growth. Additionally, I like that management is prioritizing its investments in its go-to-market strategy, and as it increases its sales productivity, it should continue to capture market share while unlocking operating leverage. While there are risks that a slower expansion of customer cohorts will affect DNR rates and face tougher headwinds, I think the stock remains a “buy” at these levels.