Why Cloudflare Is A Buy Despite The Premium Price
Summary
- Cloudflare's stock price is up 270% over the last year and it introduced more than 550 new products and features in 2020.
- Cloudflare's mission statement "to help build a better internet” has been the guiding star for the company.
- Cloudflare has built itself a huge total addressable market through disruptive innovation. It has learned this from the best: Clayton Christensen, the father of innovation.
- Cloudflare rolls out free products that it makes better through the feedback of its customers and then it starts charging.
- The stock is priced at a premium price but compounding earnings beats and continuous innovation make it a buy for long-term investors. The numbers confirm the story.
- This idea was discussed in more depth with members of my private investing community, Potential Multibaggers. Learn More »
Introduction
On Thursday, May 6, Cloudflare (NYSE:NET) reports its Q1 2021 earnings. The stock has been on fire over the last year. Let's start with the stock price, up almost 270% over the last year:
The company's innovation even more than doubled that, though. Cloudflare has introduced 550 new products and features in 2020 and its CEO Matthew Prince (see picture above the article) has said on the recent Investor Day that he expects to even accelerate that pace of innovation in 2021. This article shows you why innovation is one of the main reasons why I think Cloudflare is still a buy, despite the premium valuation.
A Noble Mission Provides A Big Business Opportunity
Recently, Cloudflare released two Innovation Weeks. The first week was called “Security Week 2021” and was kicked off on March 21st by a blog post written by Matthew Prince, founder and CEO of Cloudflare. If you want to read the full blog post, you can check it out here.
In the blog post, Prince reiterates something he likes to talk about a lot - the fact that the internet was not originally designed for what it has become. This is also something that Cloudflare harped on in its S-1, as you can see from this quote:
The Internet was not built for what it has become.
Originally conceived as a decentralized, wired network to interconnect academic institutions, the Internet has evolved into a global platform for business and communications, hosting a wide variety of often mission-critical applications. While the Internet was brilliantly architected to deliver fault tolerance and robust connectivity, it was not designed to deliver the security, millisecond performance, and reliability required now that it has become the lifeblood for business and the primary vehicle of commerce and communication for humanity.
The internet was originally just supposed to be a vehicle for connecting academic institutions. It wasn’t supposed to be the world's main medium of communication and commerce, but it is. As Prince writes in his blog post:
A lot of what we do is about security. Approximately half our products are security related. And that makes sense because some of the Internet's deepest flaws are that it specifically did not engineer in security from the beginning.
This gap in the original design of the internet has actually created a huge opportunity for Cloudflare and is a big part of the reason that it is now a $23B publicly traded company. It has grown to this size by following its mission statement:
“Our mission is to help build a better internet.”
This may seem a bit too bold, a bit overachieving, reaching for the stars, whatever you want to call it, but that is what a lot of great companies do. It’s a mission that has guided Cloudflare to get to where it is today and is driving its decision-making for the future. As such, we shouldn’t be surprised to see the level of investment it's putting into cybersecurity, a big part of building a better internet. Cloudflare also showed what it means by building a better internet on its recent Investor Day:
And Cloudflare makes the internet better every single day. On the Investor Day presentation, it shared the huge number of cyber threats it blocks every single day:
Cloudflare's huge TAM
Fast and continuous innovation is what has brought Cloudflare to where it is today. Just look at how it has been able to expand its TAM (total addressable market) over the years, more than doubling it from $32B in 2018 to $72B in 2020 and expected to be $100B in 2024:
Innovation is at the very core of CEO Matthew Prince’s mindset. This is evidenced by some interesting anecdotes he has recently shared on Twitter. First, look at this Tweet:
It’s interesting to see Prince citing the philosophy of Clayton Christensen, who I later found out was actually one of Prince’s professors at Harvard.
It’s obvious that Christensen was a big influence on Prince, as Prince ended up hiring Christensen’s former co-author and research assistant, James Allworth, as the Head of Innovation at Cloudflare.
Christensen followed Prince’s career closely until Christensen passed away in January of 2020. On Twitter, Prince shared a note that Professor Christensen had written to him:
Clayton Christensen should be a familiar name for every growth investor. He's the great theorist on innovation, who coined the term disruptive innovation.
(Clayton Christensen in 2013, source)
Christensen's theory of disruptive innovation has proven to be the most influential business theory of the 21st century. Christensen was a professor at Harvard Business School. The course he taught at Harvard Business School was called Building and Sustaining a Successful Enterprise.
He wrote his first article on disruptive innovation in 1995 and published a milestone book in 1997: The Innovator's Dilemma. It received the Global Business Book Award.
(Source)
It is amazing how Christensen could foresee in 1995 what was about to happen. Christensen was a huge influence on the people that have changed our daily lives: Jeff Bezos, Reed Hastings and Steve Jobs, to name a few. In typical Bezos style, The Innovator's Solution, another book by Christensen, was one of the 3 books that Amazon's executives were forced to read.
I could write a whole article on Christensen and his vision, but let's keep our eyes on the road here: Cloudflare. We will take a few of Christensen's concepts and ideas and apply them to Cloudflare.
The first really important element is that disruptive innovation is always a process and never a product or a service in itself. And, very important here, the disruption comes from the fringe, from the margin, and it moves slowly to the mainstream. The origins are in the low-end or new markets, where customers are not so demanding.
It's not that the incumbents don't see the disruption, but they consider it as low quality, low margins and not a big market. It's only when the quality of the new players, of the disruptors, starts to catch up, that these legacy players start reacting to it.
In the very best scenario, the legacy players can survive, as Walmart (WMT) does in the online market versus Amazon (AMZN). But does anyone believe that Walmart will ever beat Amazon in e-commerce? If Amazon will ever loses market share, it will be because of a newer innovator, Shopify (SHOP), for example.
The opposite of disruptive innovation is sustaining innovation. It sounds much more rational than disruptive innovation. It means that you keep launching small incremental improvements to your current product, serving the needs of customers that bring in your big profits. You can think of Apple (AAPL) here.
(Source)
Disruptive innovation often comes from reducing friction, which can be done with simple products or services, that are easy to use and that often appeal to a market with low demands. Look at the low-cost airlines, for example. They were the laughing stock when they started out but they have become industry-leading companies. I'm old enough to remember that people laughed at the idea of using your credit card on the internet in the 90s. Amazon was a gimmick to them.
This is a schematic representation of disruptive innovation, the same as above, but with more data points
(Source)
You see that the disruptor starts out later then comes at innovation parity and then takes the market lead. I think that Cloudflare is close to innovation parity now. You can see that in the fact that it attracts more and more big customers. From the Q4 2020 earnings release (my bold):
Our paid customer count grew to more than 111,000, with our largest customers continuing to be our strongest growth area.
And, from the Q4 2020 earnings call:
We ended the quarter with 828 large customers which we defined as paying customers with greater than a $100,000 in annualized revenue representing an increase of 57% year-over-year. We added 92 large customers sequentially and over 300 in 2020.
And you can see that this was not a coincidence or Covid-related. If one thing, the virus will have been a headwind.
(From the Investor Day presentation)
A Method to the Madness
As Prince said in his Tweet, Cloudflare aims to be a disruptive innovator instead of a sustaining innovator. A sustaining innovator just launches small incremental improvements to its existing products. A disruptive innovator will expand, look to resolve unaddressed frictions in the marketplace, and try to create solutions for unaddressed problems of potential customers on the market.
To do this requires the rapid release of lots of different products that seek to solve unaddressed frictions in the market a company operates in. Cloudflare has the luxury of being able to experiment with different product releases because of its proprietary network and its unique architecture. As Cloudflare states in its S-1:
This architecture allows us to add new products and features across our platform without significant additional operating costs.
Then, as Matthew Prince said in his Tweet, Cloudflare’s strategy is to “release products fast” and “improve them rapidly based on feedback, usage, and data”. Essentially, Cloudflare can trial a product or feature with a certain subset of its customers (either based on size, region, etc.) and then get customer feedback to guide the company on the enhancements it needs to make.
Cloudflare often does this by releasing an early product to all of its customers for free. In that way, it gets a ton of feedback and users don't mind that the quality is not top-notch yet, a free tool is always good to have. It's an inherent element of Cloudflare's strategic plan (see step 3):
(From the Investor Day presentation)
Sometimes, Cloudflare will learn that the product is not appreciated or needed by customers and that will cue them to withhold any further investment. You may think that it cost them money, but it actually saves money. One big product launch that flops is much more expensive than dozens of small launches. Either way, Cloudflare wins as it gets feedback on what customers need and don’t need.
To fully understand the approach of the company, this quote from Cloudflare’s S-1 is key:
Feedback from our diverse, global customer base helps us expand into new, adjacent product areas. Since our customers’ traffic is already passing through our network, our serverless architecture means we can add products on our platform to solve new network challenges without significantly increasing our incremental costs. This allows us to provide new products at competitive prices and further expand the overall market.
Is Cloudflare a buy right now?
The answer to the question if you should buy Cloudflare's stock right now, has the same answer as most of the interesting questions in our world: it depends.
If you are a short-term focused trader, I'm not able to help you. I don't trade. My marketplace here on Seeking Alpha is called Potential Multibaggers and the name already says what I do: I try to find stocks that have the potential to go up 10 times and more over the next decade. You need time on your side to perform its magic for this.
That also means that valuation is less of a concern to me. I made Shopify (SHOP) a Potential Multibagger pick at $77 in May of 2017. It was called extremely overvalued at the time and it still is called extremely overvalued today, after it has become a 14-bagger. Amazon (AMZN) got the same label for a few decades, until very recently. As long as great companies keep performing, they can look overvalued for very long stretches.
With a ttm EV/revenue of almost 60 and a forward P/S of 33, Cloudflare is definitely not cheap.
The strange thing about this category of stocks is, though, that their growth is exponential, not linear. Linear growth often looks more level-headed on the surface and it will often look better over the short term, but over the longer term, exponential growth leaves it in the dust by miles:
(Source)
You can see this difference in charts of stocks as well. This is Apple (NASDAQ:AAPL) versus Berkshire Hathaway (BRK), for example:
Of course, there are plenty of other examples. If you would take the charts of Amazon or Shopify over the same period, the exponential growth would be even higher (although Shopify only had its IPO in 2015). but you get the picture: linear growth seems rational, exponential growth is what you look for if you want multibaggers.
What is often misunderstood about growth stocks is how compounding earnings beats can really be the fuel for exponential growth. It can really totally change the valuation picture. Just like stock gains, earnings beatings compound over time and quite often, the market price is more adapted to that than people realize, making 'overvalued' stocks not as overvalued as they seem.
Let me give an example to illustrate what I mean. Company A has a revenue of $100M and it is expected to grow its revenue by 25% for 10 years. This is what you get then:
From $100M to $931.3M. If the valuation doesn't change, you will have a 9 bagger over that decade. Not too shabby, right? A lot of value investors will argue that it's irrational to think that the valuation won't drop. OK, let's continue.
Suppose that this company beats the revenue expectations by 7% each year, which the best companies definitely can, you get this:
Instead of $931.3M, the company's revenue now comes in at $1.6B and it's a totally different world. Even if the valuation goes from a P/S ratio of 30 to 10, which would be an extreme cut for a company with 77% gross margins, but not impossible, you would have an eight-bagger.
That's the power and importance of compounding earnings beats. That's why growth investors are willing to pay a premium price for companies that have proven that they can beat the estimates over and over again.
Cloudflare is still a young stock on the public market, but it has beaten the revenue estimates each and every time since its IPO:
The average beat? 6.7%, pretty close to our theoretical example of 7%.
The reason why I picked Cloudflare at $39 as a Potential Multibagger was edge computing. A better, faster product that is also cheaper for its users? That has always been and will always be a winning combination.
If you look out far enough into the future, mass adoption of edge computing. The edge computing market is expected to grow at an annual rate of 41% or 43% in the next 5 years or 37.4% annually until 2027. That's about ten times the current level. And of course, it won't stop there. Just as the core cloud (AWS, Azure...) is still growing at high rates, 15 years after AWS was launched, the edge cloud will continue its growth for a very long time too.
That's why Cloudflare is still a great company to buy now. It's still very early, and despite the fact that edge computing is only starting, you can see that Cloudflare's numbers really show that the company is working towards its long-term model fast:
Because Cloudflare trades at a premium price, you don't have to withhold from buying the stock. After all, we never know what the stock market will do. That's why I always advocate scaling in slowly over time. If the stock surges, good that you didn't wait, if it drops, great that you didn't have a full position yet.
Of course, to be able to hold a stock through the market's inevitable ups and downs, you should build conviction. If Cloudflare drops 50% now, I wouldn't mind, because I know how great this company is, how well it is positioned to capture a huge market. Volatility only equals risk if you don't have enough conviction.
Conclusion
Cloudflare has disruptive innovation at the core of its company culture, learned directly from the prophet of innovation, who coined the term disruptive innovation. Although the stock may seem expensive, it is perfectly placed to become the leader in edge computing and therefore it can be 'overvalued' for very long. Scaling in slowly looks like the best strategy.
In the meantime, keep growing!
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This article was written by
From Growth To Value is an individual investor with a long-term perspective. He targets high-quality disruptive businesses who have early multibagger potential. His rigorous research process provides him and his readers conviction in these companies.
He invests personally in the ideas he shares and leads the investing group Potential Multibaggers. Features of the service include: best buy list, access to his personal portfolio and watchlist, 5+ articles of individual stock coverage, weekly review regular webinars, overall quality scores, and a vibrant chat for discussions. Learn more.Analyst’s Disclosure: I am/we are long NET, AAPL, AMZN, SHOP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
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Comments (104)
I'm opening a position with 100 shares tomorrow.
Thank you. I'm not sure how big your portfolio is, but usually, I advocate going in slowly.
To each his/her own, though.
Keep up the good work.
Thank you for your kind compliment.
What I mean is that I scale in slowly. If I would want a 2% position, I would only buy a 0.2% position right now and go to 2% over the course of the next months/year.
ttm EV/revenue actually looks back to 2020. With the fwd P/S, I look at 2022. Of course, you are right here, traditionally, this is seen as 2-year forward P/S.
You see, that's the problem with putting too much emphasis on valuation. If you have a very high-quality company and you are a long-term investor, valuation is much less important than most people think. Why? A few reasons:
1. You write "analysts growth rate (usually optimistic long term)" If you look back on estimates of a few years and you look at the analyst projections of the very best companies, they are ridiculously undervaluing growth rates.
2. Beatings compound in a huge way. If you have a company with $100M in revenue and growth expectations of 25% and it does 32%, beating just by 7%, that means that revenue is after ten years is $1.6B instead of $900M. Huge difference.
3. In this case, what makes you think Cloudflare's growth falls off a cliff? Just that $1B in revenue? Look at what FAANG does. Scalability is much easier nowadays, don't look over your shoulder. Look ahead.
Of course, if growth falls dramatically, the stock would plunge, and that's why it's very important to know the company very well and to just have the very best of the very best. Cloudflare is in that category, believe me. I have written dozens of articles and updates about it for my subscribers.
If you don't believe me, that's ok, I'm only here to help.
Easy short, in this environment it'll be 50$ in a few days!
If you call Cloudflare garbage, you make yourself ridiculous.
Market timers always sound confident but most lose money. But just like the rest, you'll probably claim you are the exception, right?
But let's see, time will tell!
Thank you very much for your kind words!
Thank you for your kind words and well done!
Thank you. I have read The Innovator's Dilemma and I really liked it.
GLTU and keep growing!
Looking back, it never is, but in 2017 many commenters like you said it was extremely overvalued. And it has been down at least 30% in every single year since I bought it. I don't care. As long as you keep great companies for long enough, you'll have huge winners.
Thank you and yes, you are right. I think most people underestimate the company and its products. The real killer product will be edge computing, imo.
GLTU and keep growing!
Thank you for reading and your kind compliment. I think it's still very early for Cloudflare. Edge computing will probably be the killer product. So, there is still time to double that position. But, as I write in the article, I would do it slowly.
GLTU and keep growing!