What Cloudflare Actually Does

Cybersecurity provider Cloudflare (NET 1.44%) recently burst onto the market, touting big-name customers like Shopify and the FBI, as well as plenty of impressive growth figures to boot. But all that glitters is not gold.

In this clip from Industry Focus: Tech, analysts Dylan Lewis and Joey Solitro explain what Cloudflare actually does, some of the most important numbers from its S-1, and the significant red flags that investors need to know about before getting too serious about this company.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

This video was recorded on Sept. 20, 2019.

Dylan Lewis: Our second company that has gone public in the last month is Cloudflare. This one's going to need a little bit more explanation, Joey. [laughs]

Joey Solitro: Even for me. [laughs] They're basically a cloud platform. They make sure all of your mission critical applications are operating as they should to prevent downtime for your website. In the increasingly digital world, outages can be the death of your company. We talked about the same thing with PagerDuty, where they would alert the exact person that you would need to fix a specific problem. These guys help you monitor everything and also they prevent cyber-attacks. I was looking through their S-1. They say they block 44 billion cyber threats from 20 million internet properties daily.

Lewis: Which is baffling.

Solitro: Yes. I thought that'd be an annual rate. 44 billion cyber threats are blocked from 20 million properties daily. And then, they have customers that include SaaS superstars, Adobe, HubSpot. Then you've even got big retail names like Shopify and Walmart. But then you've even got, they're doing this for the FBI, the U.S. Department of State. If organizations like that trust Cloudflare to do what they do, they must have a great product. They have 74,000 customers right now. They've added 7,000 this year. They've still got a lot of companies that can be added to this mix.

Lewis: Working with the government is generally a pretty good stamp of approval, huh?

Solitro: Especially the FBI and U.S. Department of State. That's no joke.

Lewis: For this company, all of that has materialized into a pretty good growth story, as you might imagine. The tailwinds here are very strong. I don't think those cyber-attacks are going anywhere. If anything, I think they're probably going to become more prevalent as we move forward. This was a company that actually enjoyed reaccelerated revenue growth. For the first half of 2019, revenue hit 48% year on year versus a 2018 growth rate of 43%. You love to see that acceleration.

Solitro: I love to see accelerating revenue growth. It definitely shows that either the business has been getting more attention from the companies that it should, or their marketing spend was going as they wanted. I always go back to our favorite statistic, the net dollar retention rate. That's been over 110% for the last eight quarters. Their existing customers are consistently spending more. And, they are adding a good amount of customers. That's when you get that beautiful cohort analysis, where they're adding more clients, existing ones are spending more. This accelerated revenue growth, while it might decelerate starting next year, it's still well over 40%. I think the compound annual growth rate since 2016 was over 50%. That's very impressive.

Lewis: When you can grow your business without having to add any new customers, that's awesome. And then, other new customers that are coming in are gravy. That shows you are building a product that people want, people are increasing their spend with you, and they're very happy as customers.

We teased this, but this company is losing money. It's because of sales and marketing. They are investing heavily, much like Smile Direct. That's kind of going to be the theme of today's show, is investing heavily because the opportunity is there for all these businesses.

Solitro: Exactly. There are some red flags that come with Cloudflare that I don't traditionally see with the SaaS companies that I follow. This is one of the reasons I did not purchase Cloudflare. I actually own Smile Direct, for full disclosure. But when it comes to Cloudflare, they've had two mass outages in the last year. For a company that is supposed to keep my company up and running and prevent outages, to have two outages in the last year? That's pretty bad. And then, they stated in the last week that they may have violated U.S. sanctions by providing services to terrorist organizations and drug traffickers. Their defense over this is, "Hey, we couldn't say this going to the IPO because we were in a quiet period." I think, well, how convenient for them.

And for them to not have known that ahead of the filing ... I feel like you should know your customer base better, or do your due diligence on them, and say, "We're going into the biggest liquidity event in our history. Maybe we should make sure we're not servicing some terrorist organizations."

Lewis: Yeah. The generous interpretation of that, just to dive into the idea of a quiet period for a second, is, when you have this filing out there, management cannot go out and make certain comments about the company. It's something that is part of the IPO process. If they were to have discovered it, truly, during this period, management would have been in a position where they probably couldn't have talked about it. But, I mean, yeah ... this seems like a pretty big deal.

Solitro: It's the ultimate "come on, man." I was on the fence about buying this one. As we've talked about previously, I buy a lot of IPOs on day one. I have a completely different investment strategy than most people and even most Fools here. But that was the one that pushed me over the fence, like, "Yeah, let's wait on this one."

Lewis: Yeah, I can understand that. [laughs] There's some red flags there.

Solitro: There's so many great tech companies out there, I didn't have to force this one.