Cloudflare as a leader in AI? + Q2 Results

For the past six months, the investing world has been on the hunt for investible stocks with AI exposure. Surely, they ask, there must be something other than Nvidia benefitting from all this AI spending? The large cap semis universe offers varying degrees of “AI-ness” from AMD with its new M100 GPU, to Intel who maybe has something, to Qualcomm with lots of AI capabilities but no clear way to monetize them. There are also all kinds of wafer fabrication equipment (WFE) and small cap names with AI exposure, all of which are covered well by Fabricated Knowledge and Semi Analysis (seriously, go subscribe to those). But in the end, this is not a big list.

Recently, Josh Wolfe of Luxe Capital appeared on Bloomberg’s Odd Lots podcast. Buried deep in an interesting conversation he mentions that Cloudflare is an unsung winner in AI. This piqued our interest as Cloudflare is one of those companies that we have been keeping an eye on for many years. They seem to sit at an important spot with their globe-spanning network, with equipment in over 200 cities, coupled with a compelling growth engine that seems to be executing incredibly well.

Cloudflare provides a huge array of services for connecting websites, data stores, workers and customers all over the world. They essentially provide a networking service sitting between data centers/the Cloud and all the users at the edge. We will save a deeper dive into their business for some future post, but the more we look at the company the more interesting it seems. Their services are immensely useful in connecting all the pipes that make up the Internet. In fact, one of the most surprising things about Cloudflare is that no one else built their business before them. For those who remember the Bubble of the 90’s, a number of companies, like Akamai and Limelight, arose to provide functionality to distribute content closer to the eyeballs on the Internet. Translate those terms from 90’s speak to modern day terminology and those companies all had early versions of what Cloudflare offers today. But somewhere along the line, those companies faded away or went far off course, leaving room for Cloudflare to fill the gap just at the time when everyone moved their workloads to the Cloud. If nothing else, Cloudflare is worth following for all the insight they provide into how the Internet actually works at a fairly tactical low level.

The company reported earnings yesterday, and their results were fairly healthy. Q2 revenue of $305 million hit consensus and EPS of $0.10 was three cents ahead. They guided revenue to $330.5 million ahead of consensus of $329.4 million and EPS one cent ahead of $0.09 expectation. They also bumped up their full year estimates to reflect the good quarter. One interesting facet of the company’s reports is that they guide revenue very precisely, Q3 was guided to $330 million to $331 million, the full year was guided to $1.283 billion to $1.287 billion. Anyone who guides with that tight a band has a deeply recurring revenue base, but even other SaaS companies have a guidance range that is an order of magnitude larger than Cloudflare’s.

One of the confounding things about Cloudflare is that they do not neatly fit into industry categories. They provide software, but they are not really a software company. Most of their competitors are actually hardware companies selling point solutions for specific functions like security or application acceleration, and they are definitely not a hardware company. Probably their truest comparables are AWS, Azure and Google Cloud, but no one likes to say that out loud as it makes their position seem untenable. Despite this, the company plugs some important holes and solves some significant problems for anyone building globally accessed software.

That all being said, what interested us most on their call was management’s commentary about AI. First, we appreciated their modesty about the term AI which has seen multiple generations of definitions. More critically, they spoke about AI as an important opportunity for the company, echoing Wolfe’s comments above. As we have noted, the big opportunity for anyone touching AI will be the inference market, and Cloudflare has a compelling story here. Like us, they note that the only way for the economics of AI inference to work will be to distribute a significant portion of the workload on to edge devices (i.e. users’ computers and smartphones). This means there will be a significant need to move a lot of data around the network. Enterprises building their own AI models will need to distribute those models close to the workers actually running inference queries against it. Consumer devices will need to receive regular updates as models improve. All of this will probably work best when run over Cloudflare’s network, which can keep all the data synced up and secure. Moreover, the big motivation for enterprises running their own models will be to allow them to keep control of all that data, the notion of data sovereignty. Cloudflare is probably one of the leaders in providing such sovereignty and is a critical aspect in their competitive differentiation from the hyperscale public cloud providers.

All of which is to say, we think there is a lot of credence to positioning Cloudflare as one of the larger beneficiaries of AI. If this happens, it will still be several years in the future. A lot can change before then, models and usage patterns can change drastically before that happens, but in most cases we think Cloudflare could end up as the common denominator in all those scenarios.

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