Hello, everyone, and welcome to the Cloudflare Q4 2022 Earnings Call. All lines have been placed on mute to prevent any background noise. After today's remarks, there will be a question-and-answer session. [Operator Instructions]. I would now like to hand the conference over to Mr. Phil Winslow, VP of Strategic Finance. Please go ahead, sir.

Thank you for joining us to discuss Cloudflare's financial results for the fourth quarter 2022. With me on the call, we have Matthew Prince, our Co-Founder and CEO; and Thomas Seifert, our CFO. Michelle Zatlyn, our Co-Founder, President and COO, is unable to join us on the call today as she is in Asia being with prospect customers. 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 Web site. As a reminder, we'll be making forward-looking statements during today's discussion, including, but not limited to, our customers, vendors, partners, operations and future financial performance; our anticipated product launches and the timing and market potential of those products, and our anticipated future financial and operating performance. These statements and other comments are not guarantees of future performance, and are subject to risks and uncertainties, much of which are beyond our control. Our actual results may differ significantly from those projected or suggested in any of our 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 SEC 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. You may find a reconciliation of GAAP to non-GAAP financial measures that are included in our earnings release on our Investor Relations Web site. For historical periods, a GAAP to non-GAAP reconciliation can be found in the supplemental financial information referenced a few moments ago. We’d also like to inform you that we will be participating in Baird’s 2023 Silicon Slopes event on March 2, the Morgan Stanley Technology, Media and Telecom conference on March 8, and William Blair’s 7th Annual Tech Innovators conference on March 14. Now before wrapping up, I would also like to invite you to join us for our Investor Day on Thursday, May 4, which is being held in conjunction with our user conference Cloudflare Connect in New York City. A live webcast will also be accessible from our Investor Relations Web site. Now with that, I'd like to turn the call over to Matthew.

Thank you, Phil. It's great to have you on this side of the table. We had another strong quarter in spite of continued challenging macroeconomic conditions. We generated $274.7 million of revenue, up 42% year-over-year. We achieved a record operating profit of $16.8 million, representing an operating margin of over 6%. While we continue to invest to capture the huge market ahead of us, we believe that during economic slowdowns, like the one we're in the midst of, it's important to show discipline and optimize for efficiency. We have our hands on the levers of our business and are adjusting them based on the macroeconomic conditions. Our free cash flow in the quarter was $34 million, representing a free cash flow margin of 12% and allowing us to generate $29 million of free cash flow in the second half of 2022. While there will be some variability in our free cash flow quarterly, we expect to be free cash flow positive in 2023 and in the years after that. We achieved a gross margin over 77% above our long-term target range of 75% to 77%. Our dollar-based net retention ticked down to 122%, while our gross renewal rates remain as high as ever, like others in the industry, we're seeing customers take longer to sign new and expansion deals with us. Procurement departments are definitely in the mode of measure two or three times before cutting one. We still see a clear path to dollar-based net retention over 130% as we ramp seat-based products, like Zero Trust and storage-based products like R2, and we won't be satisfied until we get there. We added 134 large customers, those who pay us over $100,000 per year, and now have 2,042 large customers, including 33% of the Fortune 500. Revenue from large customers…

Thank you, Matthew, and thank you to everyone for joining us. I want to take a moment to welcome Phil Winslow, our new VP of Strategic Finance, Treasury and Investor Relations to the team. As an influential equity research analyst who has been following Cloudflare even before our IPO, Phil brings a wealth of knowledge, expertise and relationships to his role at Cloudflare, and we are excited to have him on board. Turning to the fourth quarter. Economic uncertainty resulted in businesses being more cautious with their spending, leading to longer decision making processes and ultimately longer sales cycles during the quarter, pressuring revenue growth across the technology industry, including Cloudflare. However, we remain focused on controlling what is in our control, which is to maintain our commitment to the efficient unit economics of the business and to prudently allocate capital with a focus on maximizing shareholder value. As a result, we delivered a record quarter in terms of operating profit, operating margin and free cash flow. I'm particularly proud of our free cash flow performance during the fourth quarter, and we are committed to continuing to scale free cash flow generation going forward. Turning to revenue. Total revenue for the fourth quarter increased 42% year-over-year to $274.7 million. From a geographic perspective, the U.S. represented 53% of revenue and increased 44% year-over-year. EMEA represented 27% of revenue and increased 42% year-over-year. APAC represented 13% of revenue and increased 40% year-over-year. Turning to our customer metrics in the fourth quarter. We had 162,086 paying customers, representing an addition of roughly 22,000 paying customers in 2022 and an increase of 16% year-over-year. We were pleased to see retention improve in the pay-as-you-go customer base in the fourth quarter returning to the levels we achieved in the late 2020 through early 2022.…

Thank you, sir. [Operator Instructions]. We will take our first question from Matt Hedberg, RBC Capital Markets.

Great. Thanks for taking my questions, guys, and congrats, Phil, on your new role. Looking forward to working with you on that side of the table. I guess one of the questions I'm getting is around the conservatism in your '23 revenue outlook. Obviously, Tom, you talked about some of the levers of conservatism. But I guess with 37% growth for both Q1 and the full year, obviously, your comps ease as the year progresses. But is there something that perhaps kicks in during Q2 or the second half of the year, maybe like the price increase you announced last year, or maybe a large customer renewal that would drive linearity this year?

I think we stick to our rule of trying to be prudent and thoughtful how we think about the future, especially in a rather uncertain environment. I think that the important takeaway in the guidance that we put forward is that we did not assume any help from the macroeconomic environment. We did not plan that things would get better. And we have a lot of initiatives that will accelerate sales productivity and accelerate growth, things that we can control. But we've been rather conservative there too in terms of what we anticipated in the guidance we gave. So I think it was our goal in a world where there are a lot of variables that shift around to find some ground of stability from which where we can build on moving forward. But I think prudent is what we said during COVID and thoughtful is what we said during COVID, and I think we stick to that philosophy, keeping our hands on the steering wheel as Matthew would call it and work on what we can control.

Great. And then maybe just a quick one, Matthew. Within your security portfolio, you noted some nice wins in your prepared remarks. I'm wondering, can you talk about maybe just some of the win rates specifically on your enterprise-grade customers within Zero Trust deals, I guess, specifically against some best-of-breed customers that you noted on the call?

Yes. I think that we are really happy with our win rates. What I think our challenge is in the Zero Trust space is not winning customers that know about us, but making sure that customers that are in the market for Zero Trust services are aware that that's something we do. The frustration that I still have is when I’ll meet with a customer and oftentimes they'll literally say, you should build something that is in the Zero Trust space, competing with Zscaler or Palo Alto Networks. And so when we're in those deals, we find ourselves winning very often. I think we are especially successful with very technical rigorous companies that measure performance and care about making sure that they have the best possible end user and especially developer experience. But our challenge now, and what Brent and Marc are really focused on, is how in that space do we increase our awareness? And I think you're going to see a lot of us doing that. But when we're in the deal, we tend to have very, very strong win rates that rival what we see from our other products.

Great. Thanks, guys.

Next up, we'll hear from Sterling Auty, SVB.

Thanks, guys. So Matthew, I think it would be helpful for investors to understand. You had talked about the AI opportunity and the use cases, but help investors understand how the revenue opportunity with those types of customers actually ramped since you have that subscription model versus a consumption model.

Yes. So the way that we've been -- the way that it has sort of been the natural way that we thought companies like AI companies would consume Cloudflare would be looking at our security products. And those are products that, as you said, are subscription-based and there's some opportunity there, but there really aren't yet that many AI companies. So that opportunity is fine. But I don't think it's anything that we would get really excited about. I think what we're seeing though is in that cluster of AI companies, they have a real use case for the cloud which is somewhat different than what we see from some other companies. It is, I would say, more forward leaning and that is that they are constantly looking for wherever the best model or wherever the cheapest GPUs are to process their data. And so they are looking around across multiple different cloud providers, whether that's Google or Microsoft or AWS and they're always saying, what can we take advantage of and get as much out of that as possible. And what the challenge for them is, is the AI training sets or these big lumps of data that they then have to sort of bring to wherever the model or bring to wherever that GPU is. And in that case, a lot of the workers products and, in particular, our R2 product, are a very natural way that they can put the data in one neutral location and then be able to access it all around in other locations as well. And what we're seeing is that that neutral position of R2 is actually not just appealing for people in the AI space, but for anyone that has shared data that they want to use not in just one cloud but across multiple different clouds. And so I think by having a way to embed data into the network and store data into the network, that is an opportunity for us to service anybody who is trying to be multi-cloud, which is frankly what every big enterprise today is doing. And in that case, R2 is very much a consumption-based product. And so as AI data sets get larger and larger, we expect that we will be able to grow R2 revenue along with that. And actually, our largest R2 customers, as I mentioned in the prepared remarks, is an AI company and they're growing at just extraordinary rates as they put more data into their models.

And then just a quick follow up is, how much of that ramp is factored into the full year guide?

I think that we are not looking for anything exotic here. I think, again, prudence is very much the sort of word of the quarter for us. And I think that we're not sort of counting on something that is the new hot thing doubling down on Cloudflare. And so while we're very proud of what we have done with companies in the AI space, and we're excited about the ramp in products like R2 and the overall workers ecosystem, we still think of that more as a long-term opportunity than a short-term quarterly or even 2023 opportunity. And so I think that we're not relying on sort of an AI miracle in order to make the numbers that we put up.

Understood. Thank you.

Next, we'll take a question from James Breen, William Blair.

Thanks for taking the questions. Just one is a little bit of a runoff from that one. Just around some of the new products that you launched, the one full in the back half of last year, R2 being one. Could you just give us some commentary around how that's picking up and launching those into maybe more challenging sales environment as it helped keep the DDR a little more stable than otherwise could have been? And then just financially, Thomas, if you can just talk a little bit about the decline in operating income sequentially into the first quarter, the seasonality there and what's happening? Thanks.

Yes, Jim. So I'll start and then Thomas can take the second part. I think we're really happy with the ramps of these new products. Cloudflare, we've always thought of ourselves as stacking S curves one behind another. And so I always think of sort of our application services products as sort of our first act. We think of our Zero Trust products as our second act. And we think of our workers products as our third act. And so I think that they're maturing at rates that continue to make us very excited and happy and we're seeing more and more new use cases that are coming from that. I think some of the trade-offs around DNR have been interesting here. One of the things that we really talked about last quarter optimizing for was just on how we did cash collections and converting customers to paying upfront. And I think that one of the things that we made a trade-off on was at times saying we would optimize for getting more customers to be paying us upfront. And that might not allow us to expand those customers as much in this quarter. And I think that's the right thing for us to do. We want to optimize in these times, making sure that we can collect cash as quickly as possible, can be paid upfront as much as possible. That continues to be an ongoing effort for us. But I think that that was more of a drag on DNR. I think you'll start to see as those new products come online that those will be positive. But remember that DNR only starts to kick in for a customer that's been with us for an entire year. So for those products that are new, even if they are wildly successful, the expansion won't actually show up in our numbers until 12 months after the products were actually in the market.

All of last year was a year where we did very active management of our expenses. And we reacted really early to the slowdown in the macro environment by slowing down our hiring, especially the velocity of hiring. And we'll stay committed to this course during the course of this year and align our spending to the development of the business. So there were a lot of companies out there during the season's earnings calls that talked about efficiencies. I always like to point out that efficiencies in the DNA of the company of Cloudflare, that is something that Matthew and Michelle already wrote in the founder letter for their prospects for the S1. So this is what you want to expect from us, not only for the first quarter, but for the remainder of this year as long as the environment is what it is.

Great. Thanks.

We'll go to Shaul Eyal with Cowen.

Thank you. Good afternoon, guys. Congrats, Phil, on the new role. Looking forward to working with you. Actually two product-related questions for Matthew. So actually starting with workers, so earlier today, Shopify came out with a press release discussing speeding up their storefront in 2023. [Indiscernible] like it is based on Cloudflare workers. I think back in the summer actually, they also had a blog where they confirmed the shutdown of their internal project Oxygen opting now to Cloudflare. So can you talk to us, Matthew, about Shopify relations, maybe just a flavor on workers and an additional win rate?

Yes. So Shopify has been a terrific Cloudflare customer for a number of our different products, including workers. And I think, look, we've talked about in previous calls is that one of the most effective ways for us to sort of turbocharge the adoption of workers is to work with other great partners that have an existing developer ecosystem. And so we were proud that Shopify has really standardized around Cloudflare workers. We've worked with them to make sure that we are doing the right things for the overall community that we open source, for example, the run time of workers. And I think that as you see companies like that adopt workers for their developer platform that that's a real opportunity for us to, again, turbocharge what workers is and make sure that more and more developers are on top of it. And what's incredible is just watching how as again we get more reps with really talented and smart engineering teams like the team at Shopify, that's just making the workers platform better for everyone involved. And again, we're really proud to have them as a customer.

Understood. And maybe back to the security side of things. Matthew, in your prepared remarks, you talked about that big security win displacement. But I'm just curious whether it also involved the e-mail security kind of the Area 1 related product?

Yes. I want to be careful that I might misspeak, but I don't believe that Area 1 was included in that particular deal. So that's still an expansion opportunity with that customer. We do see that e-mail security is a terrific entry into getting people to move to our Zero Trust platform. The reason why is that Zero Trust one is the first challenges is enumerating how many people are within an organization, how many seats effectively does that organization make up. And if we can get somebody to use our e-mail security product, that inherently defines that in a very natural way. And so migrating somebody from sort of our application services portfolio to our e-mail security portfolio is one click. It's a simple DNS change. And they don't have to -- they can continue to use any of their existing e-mail vendors, and we effectively just proxy that traffic and are able to provide additional layers and enhancement of security as well. Once we've done that, it then makes it a very natural step to go from the e-mail security product to the rest of our Zero Trust suite. And so that is a standard play that we run. It's very successful. But in the case of this particular oil and gas company, it wasn't the reason that they adopted us for Zero Trust. But hopefully, we can go the other direction as well.

Thank you.

Next up is Joel Fishbein, Truist Securities.

Thanks for taking my questions. Congrats to Phil as well. Matthew, for you, I want to take a step back, notwithstanding the current economic situation, I would love to just talk about the barriers to entry for Cloudflare and your top priorities for the next three years in terms of growing the business?

And Joel, by barriers to entry, do you mean for competitors competing against us or what exactly do you mean by that?

Yes, exactly, Matthew. I think there's a little bit of -- in the investment community, there's a little bit of thought process that it's easy to do what you -- what Cloudflare does. And as you and I both know, that's not true. But I think it's important for you to explain that from the perspective of how difficult it is to provide the services that you do?

Sure. So I think the thing that is at the core of Cloudflare is our network, the reason that our ticker is NET and not CLOFLARE [ph] is because of the fact that we are fundamentally a network. And that network has taken us over 12 years to build. And it is not something that you can just throw money at and buy your way into, it's not something that even some of the large hyper-scale public clouds have. And so we hear regularly from companies like Microsoft that they're like, wow, you guys have something very special in the network you've built, and it is very different than anything else that's out there. But somewhat counterintuitive a bit about our network is that as we expand into further corners of universe, whether that's opening an additional data center in St. Louis or going into Djibouti, any of those things actually help us lower our costs because it drives down the cost of delivering all of our services. And the other important bit is that unlike some of the competitors that are out there, whether those are competitors in the application services space that have grown through a series of M&A acquisitions or even in the Zero Trust space, someone like Zscaler actually runs multiple independent networks to provide their various services. And that means that customers that are using those different services not only is it more inefficient for them to service those customers, but those customers experience very performance setbacks when they're delivering their services. And that's something that a lot of the customers that are switching from Zscaler to us note time and time again. What's different about us is we have relentlessly said that we run one single network. And every single server across our entire…

Really appreciate it. Thank you so much.

We will now hear from Andrew Nowinski, Wells Fargo.

Great. Thank you. Congrats on the great quarter and the really strong guidance for the year. I wanted to start with a question on that big Fed deal. I know you mentioned a lot of interesting deals. I want to dig into the $7.2 million five-year deal with the Fed. First, I guess, will that be recognized as revenue ratably over the next five years? And do they bake in any sort of expansions that might not yet be included in that $7 million? Because it seems like that's -- certainly a lot of your big competitors are very strong in that space as well. So I was just curious like how it will progress, how you want it and what might also be down the road in that deal?

Maybe I’ll get started and there’s no expansion baked into the deal. That's the deal we signed and that's the deal we announced. And if there is expansion opportunity, it will add to that opportunity. Revenue will be recognized ratably. It's a little bit more tricky. It's not necessarily linear over the contract period. It's the amount of entities that are signing up and how fast they are on our network. But for modeling purposes, to assume a ratable distribution over the lifetime of the contract is probably a good start.

Okay. Thank you, Thomas. And then it looks like your channel momentum has continued and I think the channel accounted for about 13% of revenue this quarter, which is the highest it's ever been. I guess where are you seeing that traction from? Is that more from the GSIs or the traditional resellers?

I think that channel remains a big opportunity for us, but we're proud of the progress that we've made and it's a real priority for Marc as he’s there. I think that we're seeing both the traditional resellers as well as some of the GSIs that are increasingly adopting Cloudflare. And I think the big opportunity here is really with those act two and then to some extent, those act three products. And so we're seeing that in act two products, those are very much products that oftentimes we are winning in cooperation with a channel partner. And those initial wins help unlock future wins going forward. And then the second thing that we're seeing is that in our act three products, a lot of times, we're seeing as customers are coming to their partners to say, we're looking to consolidate vendors, we're looking to save money on some of our cloud spend that we're seeing more and more that Cloudflare is a solution that is in the toolkit for people who are trying to figure out how they can save money. So moving from an S3 to an R2 is a substantial savings. And we're seeing that even with some nontraditional partners. So someone like Palantir we announced a partnership with, they were driving a lot of their customers to their cloud solution. They saw how much money was wasted in some of the public clouds and so built a tool to help people understand what their cloud spend was. And they came to the conclusion that oftentimes, if customers could move more of their workloads to Cloudflare workers, that was a real money saving for them. And again, that's been -- it's early days but we think that that's definitely saving money, consolidating vendors. Those are all going to be trends throughout 2023, and we're very well positioned to be able to help partners as they work with their customers to take advantage of those trends.

Okay. Thank you, guys. Congrats, Phil.

Alex Henderson, Needham is up next.

Thanks for the great print and welcome to have you on board, Phil. I was hoping you could talk a little bit about the word at the end of the year here about how many coders are currently working on your platform and give us an update on that? I think that is the major positive strategic advantage that you have going to an earlier question.

Yes, I think that we announced at the end of last year that we were -- that we crossed through 1 million developers that were building on Cloudflare workers. I don't know what the latest numbers are on that, but the growth rates have continued to drive more and more developers to that. And again, partnerships with companies like Shopify that have their own developer ecosystem just further accelerate the number of people who are using Cloudflare workers. And we're doing more and more. I think one of the exciting things that we announced yesterday was a very small team on our side, wanted to see if they could get Mastodon which is sort of the open source Federated, Twitter client to run on Cloudflare. And that's a fairly sophisticated application. And they built not only a way for them to deploy that for any developer to be able to deploy that on Cloudflare workers, but then it scales just beautifully where if you wanted to build kind of the next generation Twitter that just scales and scales and scales, they have proven that that can be done on top of Cloudflare workers. And so I think we are starting to see more and more sophisticated applications like that get built on workers, and that's an exciting development for us.

The second question I wanted to address was your strategy around pricing. I know back in November, you raised prices for the first time and it was at a decade, which is amazing in and of itself. But can you talk about the magnitude of the pricing lever as we look at the full year for '23 and whether that is broader than just the low end entry fees?

Yes. I think that we were very hesitant and a little bit nervous about raising pricing. Cloudflare is fundamentally infrastructure for our clients, and we want to be reliable and predictable for them. And so we thought about this a lot. The primary goal of the price increase which was really only for our pay-as-you-go business, which is well less than 20% of Cloudflare revenue. But the primary goal was to shift that business from what was mostly a monthly payment business to one that was paid upfront and annually. So if you pay us upfront annually, you can keep the same price that we've had historically. And we were -- we obviously did all the work talking to users, figuring out what the tolerance was, but you have to sort of hold your breath and see what happens. And we've seen a handful of examples where I think with Slack, I think with Shopify, they’ve had price increases that have gone over well. And we've seen a handful of price increases from companies where there's really been pushback that they've received. And I'm really happy that our customers, if anything, I think we were very pleasantly surprised how many of our customers said, over the course of the last 12 years, Cloudflare has added so much additional value that they want to pay us more. And so we've seen a substantial number of convert already to the annual billing, which is great because it's helped us pull forward some cash, which is important. And then the second is that those people who -- we had price increases for, and it was about a 25% price increase, that actually -- so it went from $20 to $25, so not 25%. That's misspeaking. But that was well received and we have not seen elevated churn as a result of that. It went about as smoothly as we could possibly have hoped.

Operator, we have time for one last question.

And our final question today will come from Trevor Walsh, JMP Securities.

Great. Thanks for squeezing me in and taking my question. Matthew, thanks for the color around the SLED business and congrats on hitting the FedRAMP certification. You've indicated that you thought 3% was I think low at only 3%. So just curious around that public sector business, kind of what you think the kind of the opportunities and maybe what held you back on that up to now? And if your sales and marketing, your new leaders there have kind of any plans to kind of help expand that part of the business. Thanks.

Yes. I think we have had some business around --

We just lost Matthew. I’ll step in until he gets his line back. The Federal business, as you know, is a very local business. So getting all the certifications in place across the globe was one of the big targets. And we have made great progress both in Europe and now finally also here in the U.S. And as the certifications have been coming in and the products and the data centers get certified, we have been building up the teams in parallel, not only here in the U.S., but also outside of the U.S., especially in Europe, and we expect business to grow with it. And I would shy away from giving a concrete target or number for this year. But as you heard from Matthew, we think we have an overwhelming opportunity in front of us and now with the certifications in place and the team that gets hired, we are quite excited about this space.

Great. Thank you.

I wanted to -- I think Alex was cut off on his last question. I think you wanted to find out how much of the price increase was baked in, in our guidance. I think it's fair to assume, and you can draw that conclusion from Matthew's comments, for this year it's probably more a tailwind to cash flow than it is a tailwind to revenue. Most of the customers have opted in to convert to annual billing and lock in the historic prices for one more year. So less of a tailwind for revenue, but more a tailwind of free cash flow for this year, at least.

And apologies. My cell phone provider doesn't use Cloudflare it turns out. So my call dropped. That's a first. But I'm sure Thomas’ answers were exactly right.

And that does conclude our question-and-answer session. Did you have any closing remarks?

Yes. Sorry about the technical snafu. I really just wanted to end by thanking all of our customers, partners and especially the Cloudflare team. We have proven that we can do more even in very difficult economic times. I'm proud of all the work that we're doing to keep the Internet safe, secure, reliable for all of our customers around the world. So thank you for helping us deliver the quarter, and it's going to be a great 2023. I appreciate everyone being on the team.

And everyone that does conclude today's conference. We would like to thank you all for your participation today. You may now disconnect.