Cloudflare vindicates our thesis on cloud security

Mark Temnikov — 9 August 2022

Cloudflare (a long-time holding and a top pick in our portfolios) rallied 48% last week thanks to positive results that vindicate our conviction on the entire cloud security sector.

Bottom line

Another quarterly report in which Cloudflare has shown that it is skillfully capturing the cloud disruption. The company remains a hyper-growth player, growing sales organically at ~50% YoY while remaining innovative with high R&D investments, and improving margins to finally become profitable.

This latest earnings report reiterates the company's growth story and our conviction about the cybersecurity industry. Despite a challenging macro environment, the sector proves to be resilient with the strong ongoing demand for its products and services. Our cybersecurity exposure concentrates on the most promising and technologically advanced companies that are becoming essential for daily life in the modern world, exactly like Cloudflare.

What happened

Cloudflare (part of our portfolio) has published its second-quarter earnings report beating the estimates, reporting much-coveted breakeven readings, and raising its annual revenue guidance. As a result, the stock ended with a blast (+27% on Friday) and an outstanding week (+48%).

Cloudflare's 2Q22 sales increased 54% YoY to $234.5mn beating the Wallstreet expectation of $227mn and announced adding 212 large customers to its now total 1749 “large” clients, i.e., a contract >$100K annually. Finally, as a cherry on the cake, the company increased its guidance from $958 to $970mn.

The company continues to outperform a target market that is still growing at a juicy 5y CAGR of ~17%.

Impact on our Investment Case

Cybersecurity is vital to protect an ever-increasing attack surface

The world is progressively moving to the cloud, the population is growing, and the number of connections, devices, and data complexity is skyrocketing. Cloudflare offers cloud, hybrid, on-premise, and SaaS platforms that provide advanced cybersecurity, performance optimization, and analytics and domain delivery services. The recent earnings report has reconfirmed Cloudflare's leadership in the segment and its ability to grow both its customer base and its customer penetration as companies have no choice but to invest in increasing security, resilience, and recovery. Indeed, new customer growth healthily remains in the mid-teens, and the retention rate remains solidly above 125% (with the company's long-term target being 130%).

The upgrade cycle is only starting

Public and private investment plans needed to modernize cyber-defenses have ignited a spending supercycle. Governments are pushing concrete investment plans in cybersecurity following the recent series of cyberattacks. The Cyber Resilience Act initiative in the E.U. and the Cybersecurity Act in the U.S. have been driving investments in cybersecurity. Cloudflare reported a record increase in the number of new logos in its client base (212 new large customers, to a total of 1’749).

Maintaining technological leadership matters

On the other side of the equation, cybersecurity companies are upgrading themselves, adding AI and machine learning for better automation, behavioral analytics, and lower analytics costs, fueling margin expansion and overall sector growth. Again Cloudflare results confirm this trend. As the undisputed leader in the field, it improved its gross margin by 90 bps (to 78.9%) and reached operational breakeven. The improving margins situation, along with the strong growth, maintain the company on its trajectory to become net profitable in 2022, a major catalyst.

Our Takeaway

Thanks to its strong competitive positioning, Cloudflare sits at the crossroad of key sector drivers, and confidently remains on the path to capturing a significant share of the targeted $310bn cybersecurity market, including cloud security, a large ~$50bn (2025e) segment growing at a 5y CAGR of 17%.

Our cybersecurity exposure concentrates on the most promising and technologically advanced companies that are becoming essential for daily life in the modern world. And our investment process focuses on achieving the highest risk-reward limiting the potential downside risk by focusing on profitable (or close to being profitable) firms with strong growth prospects and healthy balance sheets, with Cloudflare naturally making this shortlist.