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spk01: functions and G&A expenses, but we have made sure that we hire our sales capacity and our go-to-market functions in a way that we are not hindering the potential and the opportunity that is in front of us. So we try to be very balanced where we slow down and we have been very strategic where we added headcount in terms of numbers, but also in terms of footprints from a regional perspective.
spk12: Great. Thanks for taking my question.
spk09: Our next question comes from Matt Hedberg, RBC Capital Markets.
spk05: Great, guys. Thanks for taking my question. Matthew, in your prepared remarks, you noted economic headwinds that you've been talking about the last couple quarters have showed up here. I wonder if you or if Mark's in the room, too, can talk a little bit about perhaps what your sales force can do to kind of navigate these headwinds. Is it a different sales motion? Is it a different way to engage the customer? Just sort of curious on you know, how sales organizations adapt to these headwinds?
spk02: Yeah, so first of all, I don't think there's anything that has dramatically changed this quarter and at this time versus what we were seeing earlier in the year. And so I think the adjustments that we made in terms of our go-to-market strategy are actually things that we've made previously and we've seen positive benefits from those changes. The nature of subscription businesses is that if you see slowdowns in the beginning of the year, they show up in your top line later in the year. But the things that we did that I think have been successful and will continue to be successful is really focusing on how do we get to know the customers that already know us and trust us? How do we sell more to those customers from the broad portfolio of products that we have? And how do we make sure that they are getting all of the value from Cloudflare? And one of the things that I think we're hearing over and over again is that as companies are thinking about how can they reduce their cloud spend, how can they rationalize it, how can they make sure that they are getting the most out of the IT dollars that they're deploying, over and over and over again, we are able to deliver services that help companies save money, get better performance, get higher reliability, get more variability in a multi-cloud environment, and make sure that they are secure. And so as we look at our customers, they see us more and more as a strategic partner on making sure that they're getting the most out of every IT dollar they spent.
spk03: The...
spk01: Go ahead. I just wanted to put an additional comment on it. I'm just coming back from a customer trip in Europe at a time where, as Matthew said, the security products are holding up nicely in light of all the security and threat concerns we see out there, leaning heavier on the intelligence we have. We just launched a threat intelligence product, Cloudforce, a couple of weeks ago. Leading on this asset we have in terms of the intelligence and the insight we have is helping us, especially with opening up doors at new logos.
spk05: That's super clear. And then maybe, Matthew, obviously, R2 is early, but it's great to hear the success already with the petabyte of storage. Can you talk about what sort of customers you're seeing leverage these? Are these some of your biggest strategic customers? Just maybe a little bit of color on where you're seeing that usage.
spk02: Yeah, so in the quarter, the usage was mostly still during our beta period. And so the users of that product have primarily been developers that are using it to build new services, or small teams within larger organizations. What I think that we'll see now that it is out of beta as of the very end of the quarter is that you'll see much more large companies who are looking to figure out how they can reduce their cloud spend and make sure that they can have a multi-cloud presence adopt our R2 services. We're talking to very large companies about moving more and more of their stored objects to where we can store that with R2. One of the benefits is not only can we help them save money on the egress fees, but it allows them to then use those objects across any of the different cloud platforms they're using. So by being that neutral third party, we can let people adopt a little bit of Amazon, a little bit of Microsoft, a little bit of Google, a little bit of SaaS vendors, and share that data across all of those different places. It actually is a use case that makes putting data in the network one of the things which is really valuable. And I think you'll in quarters to come, the larger and larger companies adopt that as the object store for their company.
spk04: Super helpful. Thanks, guys.
spk09: Next up is Brent Till, Jefferies.
spk14: Matthew, one of the key themes we keep hearing is this theme of consolidation that you're used in a lot of pockets organizations, and many are saying that they could consolidate. Do you feel over the next year you can use that to your advantage? a sales motion or an opportunity you're starting to see where you're getting wider enterprise license agreements to take on more and more solutions?
spk02: Yeah, Brent. I think that we are extremely well positioned to help companies ferret out any type of savings that they can find across their organization. And the conversations that we're having are very much around how can companies consolidate their vendors into what are those critical vendors that provide services and how can they really save money in the process of doing that? The fact that we've got as broad a portfolio of products as we do means that what we're seeing is more and more companies are adopting the complete CloudFlare network. And I think the way that that shows up in the numbers is the fact that our customers that are over $500,000 a year of spend, over a million dollars a year of spend, are growing faster than our overall revenue growth rate and our overall customer growth rate. And so I think that's a good indication that the customers are doubling down and using more of our services. I think that's going to make it a more challenging environment for those point cloud solutions that are out there. and that we will increasingly take share and help be that strategic vendor to become the network for our customers.
spk14: And can I just quickly clarify with Thomas, the slowdown that you're seeing, did you see that more pronounced in small and mid versus large or did you see it against mid and large?
spk01: I see you see in each one of the segments you mentioned, you see some impact. We talked about pay-as-you-go downgrading to free, staying a customer, staying on the platform, but downgrading. We see elongated sales cycles at the very high end in the very large customer cohorts. And we see the expansion in the mid-market segment slow down a bit. Sure, they didn't turn off, but the expansion was a bit harder. So it really depends on what segment you look at.
spk03: Thank you.
spk00: Our next question today comes from James Fish, Ticker Sandler.
spk12: Hey, guys. Thanks for the questions. Matthew, you highlighted that Fortune 500 retail win with Cloudflare is kind of that glue between the hyperscalers. And you also said you see Fortune 500 penetration getting to 100% over time. I guess, how are you balancing that strategy of being that glue or fabric between the hyperscalers versus being that full infrastructure as a service offering alternative to the hyperscalers? And how does that success of one or the other change your viewer ability to hit that $5 billion goal five years from now?
spk04: I think that our approach is very different than the hyperscalers.
spk02: The hyperscalers sort of start from the inside and work their way out, and we are starting from the outside and working our way in. What I mean by that is fundamentally what CloudFlare is is a network, and we want to be the best network to connect anything online, to connect cloud to cloud, cloud to home office, cloud to remote office, cloud to branch office. anything that is having to be connected by a network, we want to be that network. There are things that make a ton of sense to live in the network itself. So, for instance, a shared object that you're going to use across Google and Microsoft and AWS, storing that with R2 makes a ton of sense because we're not going to charge you the egress tax to be able to access that across all of those different platforms. You're also going to, for some applications, want to make some parts of the application as fast and as scalable and as reliable as possible. And so those parts can live inside of Cloudflare. But our strategy is not to completely recreate every single thing that the hyperscalers do. We want to be the best network that is there, and there will be places at the margins where we absolutely will compete with them And again, I think increasingly we're seeing that companies are able to build entire applications using the CloudFlare stack in a way which is much more modern and much more reliable. But we're never going to be the place that you can lift and shift SAP HANA. That's just not what we're building. Instead, what we're building is for those applications that need to live inside the network for either the performance, reliability, compliance requirements, And the data that has to live inside the network for those same reasons, we want to be the network to be able to do that. I think regardless, we see with the products that we have in market today, a clear path to getting to $5 billion of revenue. And that doesn't assume any M&A. We believe that that is through organically that we can get to $5 billion of revenue in the next five years with the products that are in market today. And so I think that we don't have to, the hyperscalers don't have to fail for us to succeed. We actually see ourselves as much more of that glue between them. And whether companies want to be multi-cloud or not, they all are. And so that glue is critically important. And again, I think we provide the only solution as we see companies that are trying to struggle with reconciling that increasingly multi-cloud world.
spk12: Thomas, maybe for you, is there any way to understand the impact or adoption of that monthly to annual conversion with enterprise specifically this quarter? You know, are customers actually looking for staying with shorter duration just given this macro uncertainty? Or are they alternatively looking to lock in for longer on the infrastructure side? Thanks, guys.
spk01: Yeah, good question. As we said in the past, moving from monthly billing and contracts to annual is our biggest lever on our path to delivering free cash flow. In a world, especially outside of North America, where exchange rates are high, customers are more resistant to log in. And we don't want to discount too much in order to log in lower revenue in a world of difficult exchange rates. So we have been more conciliant, I think, to customers and partners in general in this environment and have not pushed as hard, you know, moving forward in this transition. But, you know, it is still the biggest lever we have and it's an opportunity that is in front of us and it will materialize in our free cash flow numbers moving forward.
spk00: Our next question will come from Shaul Ayal Cowan.
spk11: Thank you. Good afternoon, guys. Matthew, on area one, when you've acquired them, I think you've indicated they can assist you in taking you guys deeper into the Thar community. How is that coming along thus far? And maybe any commentary about win rates versus Zscaler, maybe even Palo Alto? that you flagged in recent quarters?
spk02: Yes, sure. So Area One's team is amazing, and I think they've brought to us three distinct things. The first is a product, which I think is a natural gateway to our overall Zero Trust solutions. The second is a world-class threat intelligence team, which we are now turning into a product both to sell to our existing customers and also as a great way to attract new customers and create some of the marketing around the threat intelligence that we do. And then the third is a really much deeper and more mature understanding of channel through some of their leadership that we've brought on board. And again, I think that has helped us mature what our channel strategy has been. I think looking at Area 1 in particular, We're seeing particular strength in Asia, actually, around the Area 1 product. And I think our sales team, especially in Japan, has done a great job selling the Area 1 product. We're seeing a lot of it, and that's the straight email security product. And once we have got someone using the email security product, it's a very natural extension for them to turn to the rest of our Zero Trust product. I think, in addition, the threat intelligence team has helped us win larger and larger customers. And being able to help customers understand if something goes bump in the middle of the night, what's going on, has been something that the Area 1 team, again, has really helped us with. And then, again, our channel strategy, you're seeing more and more of our deals, especially in the zero trust space, come through our channels. Our win rates against Zscaler and Palo Alto networks continue to be very strong. Our product in that space competes extremely well with them. That is the challenge and the thing that I think we are continuing to work on is just increased awareness in the market. And that's something where, as we were thinking about who is the right replacement for Chris, Mark's background in identity and access management, both at Oracle, at Twilio, he really understands that market and I think is going to help us increase the awareness that's there. But when a customer is considering going on their zero trust journey, if we're in that consideration, we love our win rates in that. And so our job is now just to increase our awareness and go from the company that people might have known us for doing one thing to today, a much more sophisticated, much more broad portfolio. and uh and i'm i'm excited as that that grows and i think that zero trust is very much going to be the story of the next few years to come thank you we will take the next question from hamza faderwala morgan stanley hey guys thanks for taking my question um matthew and perhaps thomas as well
spk16: I wanted to dig in a little bit around the net expansion point, and you spoke a little bit about this already, but just to get more specific, we're hearing from a lot of cloud service providers around rationalization. Matthew, you spoke a little bit about how the costs there are getting too high. But as it relates to Cloudflare, are you seeing any of that rationalization as it relates to your usage and expansion? Obviously, you have a very different pricing model as a subscription-based company, and this is kind of where Thomas comes in. How do you expect that to play out mechanically over the next few quarters as we likely see these expansion rates continue to be impacted? Thank you.
spk02: Yeah, I think that if you are a purely usage-based model, it is a place where people are looking for areas to save money. Similarly, if you are a seats-based model, as you're seeing some companies do layoffs or at a minimum not expand their seats, that is something that is challenging in the current environment. I think we are fortunate that today most of our revenue is not usage-based and not seats-based. And so while we are adding product, that are in both of those categories, and we think that over time that that will be an expansion driver for us, that today we're not seeing that downward pressure from people trying to rationalize or consolidate their bills. I think the one place which Thomas referenced where we are seeing some pressure is actually with new accounts. Because we bill all in U.S. dollars, That is putting some pressure, especially outside of the United States, and we are making concessions in order to accommodate what are the foreign exchange pressures that are there. Again, though, it's less about our existing customers trying to figure out how to use less of us. In fact, if anything, we're seeing that they are trying to say, how can we use more of you instead of using what are some of the other consumption-based alternatives which are out there. So I think we have been less exposed to that downward pressure than some of the pure consumption-based services that exist.
spk04: That was a very complete answer. Nothing to add. I was going to say, yeah, thank you for the clarity.
spk09: Next up is Sterling Audi, Moffitt Nathanson.
spk06: Thanks, guys. So, Matthew, in terms of thinking about the threshold of keeping the margins basically flat within that context of growing to $5 billion, is there kind of like a threshold growth rate that you think about? So as long as you're over 30 or 35 or 40, you'll keep it there? Otherwise, you would reconsider kind of the margin profile?
spk02: I don't know that we have a specific a specific guidance. I've always personally, and Thomas will probably slap me for saying this, but I've always personally kind of found the sort of idea of the rule of 40 to be pretty compelling. And so I think that we like that. And I think that if we're growing north of 40%, then I think that that's showing that we can continue to execute and deliver on the enormous opportunity that we have ahead. And so, again, I think we know that we have the levers to, when it's the right time for us, be a business that delivers very significant operating profits. But while we see a total addressable market ahead of us that we only have less than 1% penetration on, we think that it makes sense to continue to invest in that market and continue to drive growth going forward. And today, we're still living above the rule of 50. So I think we've got some time to think about that.
spk04: Makes sense. Thank you, guys.
spk09: Our next question today comes from John DeFucci, Guggenheim.
spk15: Thank you. I have a question for Matthew and then a quick follow-up for Thomas. Matthew, I just want to make sure I understand your comments about acceleration in the security portion of your business. Security businesses have so far, anyway, generally held up well against the macro slowness. It sounds like that's continuing or even getting stronger for you, given your comment there, but I wanted to make sure. And that the macro backdrop is really manifesting itself more broadly in the rest of your business. Is that correct?
spk02: Yeah. So first of all, I think we have been consistent in talking about the macro pressures now for the last three quarters. And there isn't something that has dramatically changed. since we started to warn that there were pressures in the macro space. What I think if we dig down a little further into the security business, I think especially in February of this year, when we saw Russia invade Ukraine, a lot of security companies expected that that would be a tailwind to their business. What I think actually ended up happening was that that tailwind did not materialize and the threat that the Russians are coming turned out to not be something which showed up outside of the Ukrainian theater. However, in the last several months, and especially in Q3, we've started to see an increase in cyber attacks coming out of both Russia and other parts of the world. That drives increasing adoption of products like Cloudflare's products at a very, very, very high velocity. So where we'll see close rates that, you know, you can often measure in hours or days. And so I think that that expectation of the war in Ukraine and other political conflicts around the rest of the world leading to more security business was something that I think a lot of the industry expected would show up in Q1 and Q2, and we actually saw it show up more in Q3. But generally, the overall macro environment hasn't changed substantially throughout this entire year based on what we're seeing. And so I want to make it clear that we're not saying that we're seeing a big change. We have seen that there was softness in the macro economy since Q1, and we've been talking about it since Q1.
spk15: Yeah, and you've been very clear on that, Matthew, so thank you. Thomas, just a quick sort of a follow-up to what Matthew was just talking about. You talked about when you gave the outlook and you talked about your caution in that outlook. I just want to make sure I understand what's implied in that outlook. Are you looking at sort of similar effects due to the macro backdrop, or are you expecting further deterioration?
spk01: You know, we are talking about a subscription-based model. So a lot of the things we see in the third quarter and we'll see in the fourth quarter are the impacts of when we started to talk about the macroclimate going to change. So when we give guidance for the fourth quarter, it's less the in-quarter impact of the business. It's just the flow through of what already has happened.
spk15: I understand that, but do you expect to see the macro backdrop, the effects on your business, show further deterioration, even if we can't see it, although we kind of think we try to anyway? Or do you expect it to sort of stay about where it is in the softness you've seen over the last couple of quarters, I guess?
spk01: Well, we have for sure not assumed an improving of the macroeconomic environment. And with an outlook in Q4 and Q1, there's nothing that signals that it's going to get better anytime soon.
spk04: Okay. Thank you very much, guys.
spk09: Next up, we'll take a question from Andrew Nowinski, Wells Fargo.
spk07: Great. Thank you. I just want to start with a quick sort of follow-up to John's question. I was wondering if you could just provide any color around maybe your pipeline of renewals for Q4 because I assume Q4 is usually pretty big in terms of renewals. I'm wondering if you perhaps changed how you're handicapping the likelihood of those renewals closing in Q4 given the lengthening sales cycles you're seeing. And I have a follow-up.
spk04: Yeah, I don't think – again, we have not seen an uptick in overall churn.
spk02: across the business, that has continued to hold very, very strong. And so we haven't changed how we've handicapped the renewal forecast.
spk01: Okay, thank you. And keep in mind, most of our revenue still gets built monthly and not annually, so we don't have this massive renewal quarter in the fourth quarter either, at least not yet.
spk07: Got it. Okay. I just want to also just dive a little deeper on the security and how security demand is holding up. We heard, obviously, over the last few days, Fortinet talking about how they're seeing more normal spending patterns from customers where they're not placing orders for firewalls 12 months in advance because the supply is starting to free up. I suppose you could view that negatively as a change in the overall security spending environment, but Could you also view it as a positive for CloudFlare because now customers aren't making sort of irrational purchase decisions and buying firewalls, whereas now they can actually evaluate and deploy a smarter solution like CloudFlare 1? Just wondering kind of how you view that change that the firewall vendors are talking about.
spk02: I mean, I think that there's, you know, I think that you've had a series of head fakes from the hardware space for quite some time, going back to the Trump tax cuts that moved forward, a lot of incentives on CapEx spending, the beginning of COVID where everyone was just scrambling to keep the lights on, and then the supply chain crisis, which again made people place orders just to get in line for products that they may not eventually even want to have. So it is In the grand course of history, you can't solve the problems of a distributed workforce. You can't solve the problems in the cloud by shipping a box or a virtual box. It just doesn't work. And so I think that anything that gets the market back to being rational without any kind of sort of artificial incentives to continue to invest in hardware is definitely beneficial for for Cloudflare and other cloud-based security solutions.
spk04: Great. Thank you.
spk09: Up next is Fatima Bulani, Citi.
spk10: Oh, thank you for taking my questions. Matthew, one for you, and then Thomas, one for you as well. Matthew, I wanted to ask you about a pricing strategy, pricing philosophy question that we heard a lot in your preparedness commentary about the downshifting of customers or trade down from customers to some of your free solutions, which of course have better TCO in this environment. I'm wondering what's the rationale for you to maybe not, I guess, raise the floor on that so you can hold on to these paying customers. I'm just curious about how you're sort of thinking about that thing. And then I had a follow up for Thomas, please.
spk02: First of all, our pay-as-you-go business is a relatively small portion of our business. It's much less than 20% of revenue. I think that what we see as the value from that pay-as-you-go business is that those customers, whether they pay us something or not, end up being our biggest advocates and our biggest champions inside whatever large organization that they operate at. So if you look at who are our largest customers and you go down in the top 10 customers, almost all of them came to us originally because some technical leader inside that organization used Cloudflare's pay-as-you-go services, fell in love with us, understood us, and was able to adopt us as part of that. And so I think that that benefit is so substantial to us that we always want to make sure that we're treating those customers well. And so as Thomas said, well, they may go from paying us $20 a month to not paying us something because gas prices went up. That isn't something that we're trying to optimize for. What we're trying to optimize for is that those customers love us, they understand us, and they take us to work. And so as they do, that's how we've been able to close so much of the Fortune 500. Behind almost every one of those Fortune 500 wins is a pay-as-you-go customer who advocated for us internally, and that is our secret sales force.
spk10: Fair enough. Appreciate you sticking to your ethos on that. Thomas, on the dollar net expansion rate discussion, I appreciate you kind of shared some of the granularity as to where you know, some of the pressures are coming from there. But I'm curious from a product pillar perspective, if you can shed light on, you know, are you seeing expansion levels moderate within the application services bucket or the network services bucket? Just kind of curious to get a sense of, you know, what feature functionalities across your portfolio are more prone to that, you know, expansion velocity dynamic. Thank you.
spk01: I think the first statement to make is for us, it's a very true number. It's an all-in number covering our pay-as-you-go business, our mid-market, and our enterprise. And as we just discussed over the last 15 minutes, different segments behave differently. We just talked about pay-go customers churning off and becoming free customers. That is something that hinders across the cohort expansion. We have seen... exchange rate headwinds from a billing and contracting perspective in overseas accounts. So that is something that would be reflected in an expansion number. And then we talked about prolongated sales cycles at the very high end in the very large cohorts. And that is, if you go back to the KPIs we shared where a lot of growth dynamics are happening. Those cohorts are growing in general significantly faster than our average growth rate. So any movement we have in terms of sales cycles in the very large cohorts is impacting DNR in the current quarter. But this does not take away from the opportunity that is in front of us. And it falls into the logic that we always had when we talked about DNR. You know, we see a path forward to get north of 130%. But there will be movement around that number. It will not be a straight line that gets us there.
spk09: I appreciate that. Thank you.
spk04: Thanks, Fatima. Operator, can we take a question from one last analyst, please?
spk09: Absolutely. Our final question will come from James Breen, William Blair.
spk13: Thanks for taking the question. Can you just talk a little bit about the M&A environment? I know you talked about getting to $5 billion organically. It seems with valuations coming down and given the cash you have, are there going to be opportunities out there to maybe add product or some scale in certain divisions around other companies?
spk04: Thanks.
spk02: Yeah, Jim. You know, I think our different companies are built in different ways. And so if you look at Cisco, they were very much an M&A, an acquisition machine. Whereas if you look at an Apple, you know, they do M&A, but it's usually for core technologies. It's not for products. I think we are much more like an Apple than we are like a Cisco. We've watched as some of the competitors in the space have really tied themselves up in knots, building what is effectively a Frankenstein-type solution through a series of M&A, and they don't get the same level of efficiency that we do. And so I think that we will always be biased against M&A, and we will always have a very high hurdle rate to do any sort of a transaction, which isn't to say we won't do transactions. When we find great technologies, great teams, great ways to integrate like we did with Area 1, we will jump on that. And as the valuations and multiples, especially in some of the private market, continue to fall, we look at lots and lots of deals. But I don't think that that has changed that relative to other companies, I think we're going to maintain a very high hurdle rate. We have very much optimized around internal development. And as Mark said in his responses, we believe we can get to $5 billion without having to build or buy any new products or companies that are out there. We think we've got the right products in the bag today. It's just a matter of us continuing to execute on the go-to-market side.
spk03: Great. Thanks.
spk09: That does conclude our question and answer session. I'd like to hand things back to Mr. Matthew Prince for any additional or closing remarks.
spk02: Just want to thank everyone on Cloudflare's team for delivering what has been, again, another strong quarter. We're proud of the fact that we're protecting the U.S. elections and we're standing by to make sure that they go off smoothly. I also want to specifically thank Chris for his nearly 10 years of service at Cloudflare and appreciate all that he's doing to transition and get Mark on board, and to wish Jason good luck in his new role as CFO, signing all of those SEC statements. Hopefully we won't keep him up too much at night, and I know that he's going to do an amazing job going forward.
spk04: Thank you all for being investors. Look forward to talking again next quarter.
spk09: Ladies and gentlemen, that does conclude this conference. Thank you all for your participation.
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