Key Takeaways

  • Software companies operating their own global infrastructure have lower non-GAAP gross margins than typical SaaS firms due to depreciation costs.
  • Substantial capital expenditures, like Cloudflare’s 11-14% of revenue, directly reduce free cash flow, tempering cash generation even in growth phases.
  • High valuation multiples for infrastructure-reliant software depend on clear, modeled paths to future operating leverage and new market expansion.
  • Evaluating these businesses requires projecting "act two" and "act three" scenarios beyond current market penetration.

The Reality of Infrastructure-Heavy Software

Founders often chase the promise of "software margins." However, Sam Eden, analyzing Cloudflare, highlights a different picture for companies building and owning global physical infrastructure. Cloudflare reports non-GAAP gross margins around 75-78%. Eden points out, "They're a software business, so they non-GAAP gross margins are about 75 to 78%... you have to keep in mind that they own and operate their own physical infrastructure and the depreciation of this equipment is included in the reported cost of goods sold." This means their gross margins are lower than pure-play SaaS companies, which often hit 80-90% or higher. For builders contemplating infrastructure ownership, this cost structure presents a critical lesson.

Capital Expenditure: The Unseen Drag

The financial model of companies like Cloudflare involves substantial capital expenditure (capex). Eden notes, “The capex has consistently been around 11 to 14% of revenue.” This isn't optional; it's the cost of maintaining and expanding a global network. This spending directly impacts a company's free cash flow. Cloudflare's free cash flow margins hover around 10%, a figure lower than many high-growth software peers. For founders, this demonstrates that chasing scale through physical assets comes with a constant need for capital, even for successful companies.

Valuing Future Operating Leverage

Cloudflare is a highly valued company, trading at around 25 times next twelve month (NTM) revenue at the start of the year. This valuation multiple demands high future performance. Eden explains, “To get comfortable with the valuation, you have to model out two things. You have to model out the act two, how quickly they can catch up and perhaps surpass the incumbents in that space. And the trajectory is very solid there. But also, you need to model out what the act three scenarios could look like.” This means investors aren't just paying for current growth; they are betting on Cloudflare’s ability to achieve substantial operating leverage and expand into entirely new, high-margin markets. Management's long-term guidance aims for free cash flow margins over 25%, implying a substantial shift from current levels.

What to Do With This

When building your own financial models or evaluating potential acquisitions, go beyond simple revenue multiples or headline gross margins. Explicitly account for infrastructure capital expenditure as a mandatory cost of revenue if your business model requires physical asset ownership. Project your free cash flow trajectory by modeling out future capital needs and the precise points at which operating leverage truly kicks in, rather than assuming it scales linearly with revenue.