Cloudflare S-1 Analysis — Do they have an edge?

CDN provider Cloudflare recently filed its S-1 with $100M as a placeholder for the offering. Similar to recently IPO-ed Fastly, Cloudfare offers edge cloud platform that enables businesses to build, secure, and deliver digital experiences. It protects and accelerates applications online without adding hardware, installing software, or changing a line of code. In CY18 Cloudflare had 67.9K customers generating $193M in revenue. Founded in July 2009, Cloudflare has ~1,069 employees and is headquartered in San Francisco, CA.

Cloudflare’s S-1 emphasized the movement from on-premise “band-aid boxes” providing network functionality to modern cloud solutions. The company posits that the network latency, support complexity, and cost of overhead makes stringing together multiple band-aid box solutions untenable. Cloudflare provide services such as VPN, firewall, routing, traffic optimization, load balancing, and other network services by replacing on-premise, band-aid boxes with a scalable, global platform.

Their network solution was built to be flexible, scalable, and more efficient. It is “serverless” in the sense that it can deploy standard, commodity hardware, and product developers and customers do not need to worry about the underlying servers. There is a coordination software that ties together thousands of machines into a single global network that allows it to efficiently route traffic to different physical locations and to individual machines. In turn, Cloudflare can maximize hardware utilization and provide different service levels to different customers. Furthermore, they’ve embedded encryption chips into the motherboards of the servers to prevent anyone else from running unauthorized software on the equipment. Finally, the API-driven platform allows a customer to change custom configurations and have them rolled out globally.

One product growth driver the filing highlights is Cloudflare Workers, which allows developer customers to write code and deploy it to the edge of their network. Today 20% of Cloudflare’s new customers adopt Cloudflare Workers. Cloudflare highlighted Optimizely as a user of Cloudflare Workers. We’ve discussed Cloudflare Workers here.

Cloudflare’s network spans 193 cities in over 90 countries and interconnects with over 8K networks globally, including major ISPs, cloud services, and enterprises. This compares to Akamai’s ~2K points-of-presence (POPs) across 139 countries and Fastly’s 60 uniquely designed POPs across 21 countries. Over 20M internet proprieties use the Cloudflare platform today.

Cloudflare addresses multiple markets including VPN, internal and external firewalls, web security (including web application firewalls and content filtering), distributed denial of service (DDoS) prevention, intrusion detection and prevention, application delivery controls, content delivery networks, domain name systems, advanced threat prevention (ATP), and wide area network (WAN) technology. Based on IDC data, $31.6B was spent on those products in CY18, which is expected to grow to $47.1B in CY22, representing a compound annual growth rate of 10.5%.

There are numerous competitors across CDNs, cloud providers, and data center providers. Direct CDN competitors include Akamai, Limelight, EdgeCast (part of Verizon Digital Media), Level3, Imperva, Flastly, InStart, StackPath, and Section.io. Cloud providers offer compute functionality at the edge like Amazon’s CloudFront, AWS Lambda, and Google Cloud Platform. Traditional load balancing, WAF, and DDoS competitors include F5, Citrix, A10 Networks, Cisco, Imperva, Radware, and Arbor Networks.

Cloudflare is growing well. It achieved $192.7M in CY18 compared to $134.9M in CY17, 43% YoY growth. In contrast Fastly achieved $144.5M in CY18 compared to $105M in CY17, 38% YoY growth. For the six months ended June 30, 2018 and 2019, Cloudflare’s revenue increased from $87.1M to $129.2M, expanding 48% YoY.

Today, approximately 10% of the Fortune 1,000 are paying Cloudflare customers. Additionally, across the broader Internet, approximately 10% of the top million, 17% of the top 100,000, and 18% of the top 10,000 websites use at least one product on Cloudflare’s platform on a paid or free basis.

Cloudflare has multiple GTM strategies including free, self-serve, and enterprise. The S-1 underscores that once a buyer uses one product on its platform, they can easily add additional products with a single click. Over 70% of enterprise customers already leverage four or more products.

The number of customers who have annualized billings of +$100K increased from 184 in CY17 to 313 in CY18, up 70% YoY. In contrast, the number of “enterprise customers” who spend over $100K annually with Fastly increased from 170 in CY17 to 227 in CY18, up 33% YoY. Cloudflare has less customer concentration than Fastly.

Revenue is derived from both U.S. and international customers. International customers represented 52% of revenue the past two years. It was interesting that in the risks section Cloudflare mentioned its network presence within China is dependent on their relationship with Baidu. Business from China represented 6% of revenue in CY18.

The business’ dollar-based net retention rate was between 110.5%-114.4% in CY18, which is just OK. The dollar-based net retention rate (NRR) is total current period ARR divided by the total prior period ARR for the customer cohort. Our recent research found that the SaaS businesses achieving 110%-120% net dollar retention are in the middle of the pack.

Moving on to gross margin, which equals revenue minus the cost of goods sold that includes things like hosting costs and customer support. Cloudflare achieved an 77% gross margin in CY18, significantly above Fastly’s 55% gross margin and Akamai’s 65% for the same period.

Of each operating expense item, Cloudflare spends the most on S&M at 49% in CY18, above Fastly’s spend of 35% of revenue for the same period. The company has an OK magic number of 0.7. A magic number between 0.5–1 suggests some S&M efficiency but room for improvement.

In terms of net income margin, Cloudflare achieved -45% in CY18, worsening from -8% for the equivalent period a year earlier. Cloudflare’s negative net income margin last year was twice as much as Fastly’s -21%.

Below we show a chart contrasting Cloudflare and Fastly business metrics for CY18. Cloudflare has more revenue across 40X more customers growing at a faster rate at a higher margin than Fastly. However, it spends more R&D, S&M, and G&A as a percentage of revenue generating a net margin twice as negative as Fastly. It also exhibits worse sales efficiency than Fastly.

According to Business Insider, Cloudflare achieved a $3.2B valuation in its last investment round. Cloudflare has raised roughly $332M to date from investors, including Franklin Templeton Investments, Fidelity, Union Square Ventures, New Enterprise Associates, Pelion Venture Partners and Venrock.

Cloudflare’s IPO registration touches on a few trends: 1) movement to the edge, 2) platform plays that start as a toehold and then expand upmarket, and 3) product portfolio expansion through easy one-click deployments. The company exhibits good revenue and customer growth based on a broad portfolio. After over a decade of being private, it will be exciting to watch as Cloudflare goes public.