Corporations of all sizes are increasingly relying on data to make business decisions. But some applications cannot be easily integrated with other systems, thus making the tech-stack architecture a daunting task.
Software-as-a-service company Cloudflare (NET -1.41%) is a flexible cloud-based security tool. More specifically, Cloudflare's solutions cover the entire spectrum of cloud security, which includes fraud prevention, application programming interface (API) management, threat intelligence, and data localization, among others.
Although there are a number of niche solutions in these verticals, Cloudflare and Big Tech are the only companies to cover all of these needs. The company's primary competitors are Microsoft, Alphabet, and Amazon, and it's doing a great job fending them off.
Cloudflare just released results for its first quarter, ended March 31. Following the earnings call, the stock dropped over 20%. Was the sell-off warranted? Let's dig in.
The first quarter at a glance
For the quarter ended March 31, Cloudflare reported $290 million in revenue, which represented 37% growth year over year. For reference, when Cloudflare reported fourth-quarter 2022 earnings in February, the company's first-quarter revenue guidance was $290 million to $291 million.
It's clear that the company achieved its guidance, albeit at the lower end. Perhaps more concerning is the company's full-year 2023 outlook. Per the first-quarter press release, Cloudflare is expecting total 2023 revenue to be in the range of $1.28 billion to $1.284 billion. Back in February, the company expected total 2023 revenue to be $1.33 billion to $1.342 billion.
It's clear that Cloudflare is facing some challenges on the sales frontier. Yet despite the weak guidance, the company's financial health is actually better than one might think. But more on that later. Let's dig into why the first quarter was so challenging.
Image source: Getty Images.
Why is Cloudflare's guidance low?
During the earnings call, CEO Matthew Prince addressed the numerous challenges the company faced in the first quarter. Prince talked about the current volatility of the macroeconomic environment, alluding to the uncertainties around lingering inflation and the potential for a recession and how those might affect corporate budgets.
Prince also pointed to the banking crisis and the collapse of several financial institutions directly affecting sales cycles. Given that many prospective customers likely had capital at risk at some of these banks, Cloudflare witnessed prolonged sales cycles and lower close rates.
Perhaps the most eye-opening passage from the earnings transcript came from chief financial officer Thomas Josef Seifert. Talking about future guidance, he stated:
From a linearity perspective, we have assumed a continued back-end weighting of [annual contract value] booked, and have therefore incorporated minimal in-period revenue recognition for the second quarter. Also, we believe that currently depressed close rates and elongated sales cycles are temporary in nature. We cannot predict when the increasing caution is exhibited by the customers during the first quarter will recover. As such, we have assumed these headwinds, which intensified in the month of March, will persist through the end of the fiscal year.
There is a lot to unpack here. Effectively, Seifert is saying that the current trends indicate that the majority of net new revenue will be booked toward the end of each quarter. In other words, Cloudflare will be spending most of its time trying to close deals during the quarter, leaving little time to implement its software at new clients. For this reason, the company will not be recognizing as much new revenue on the books in the current quarter during which these deals close.
While this is a bit sobering for investors to process, I view it as the conservative and appropriate thing to do. At the end of the first quarter, Cloudflare had $239 million of deferred revenue on its balance sheet compared to just $219 million at the end of December.
Deferred revenue is an accounting concept that quantifies when a company is paid for services that are not yet delivered. It is booked as a liability on the balance sheet. Given that deferred revenue increased from the fourth quarter to the first, investors can see that Cloudflare is likely building up a material backlog and not delivering services at the rate at which it would like.
What is the financial health of the business?
Let's face it: So far, there has not been a ton to celebrate about Cloudflare's first-quarter results. But I believe there is more than meets the eye, and that the stock may be trading at a reasonable valuation.
As of March 31, Cloudflare had $180 million of accounts receivable on its balance sheet, compared to $149 million at the end of December. The increase in receivables implies that collections were challenging during the quarter.
And for the quarter ended March 31, Cloudflare generated operating cash flow of $36 million compared to negative $35 million a year prior. This positive trend in operating cash flow contributed significantly to the company's free-cash-flow profile. Cloudflare reported free cash flow of $13.9 million for the first quarter of 2023, compared to negative $64 million in the first quarter of 2022. What's more, management expects the company to continue generating positive free cash flow for the entirety of 2023.
Despite the slower collections and barely meeting its first-quarter revenue target, the company's improving cash-flow profile directly impacted its cash position, which increased by more than $50 million since December.
While revenue growth is likely going to face near-term headwinds, the company is still able to generate positive cash flow and strengthen its financial position. This increase in cash flow should provide Cloudflare with some much-needed financial flexibility.
The challenges that it faces will not last forever. Long-term investors should be thinking about the company's ability to double down and make strategic investments fueled by its growing cash position. The most prudent action for investors is likely to assess future earnings reports, particularly for the second quarter. Should management revise guidance downward again, it could be a cause for concern.
But if the company can generate positive free cash flow and at least hit its new, lower guidance, Cloudflare could be worth a small position in your portfolio as a hedge to big-tech investments in particular.
