Cloudflare: Excellent Company, But Risky Stock At Current Levels
- Cloudflare has been one of the most successful stocks in the market since going public in late 2019.
- Revenue has grown at a 50% CAGR since 2016 and will likely continue to remain north of 25% for many years to come.
- The company is still working towards non-GAAP profitability, but as it scales and better leverages the expense base, there is light at the end of the tunnel.
- Valuation is the biggest pushback, with the stock currently trading at nearly 60x forward revenue.
- I am cautious at current levels, though would be opportunistic on any post-earnings pullbacks or when high-valuation names turn out of favor like the group did in May 2021.
Cloudflare (NYSE:NET) has caused many investors over the past few years to really question if valuation matters. Yes, the company has superior technology and a great business strategy. However, with the stock currently trading at 60x forward revenue, I have become cautious heading into their upcoming earnings.
Since going public in September 2019 at an IPO price of $15 and the first opening trade at $18, the stock has been a clear winner for many investors. There has been some volatility along the way, but those who have been willing to stick it out have been rewarded handsomely.
I'm not here to argue that Cloudflare's business model is not working or their long-term strategic goals are unachievable, however, I do believe the stock's valuation has reached a point where investors should start to question, "who is buying shares at these levels."
Cloudflare is a fantastic company. The stock seems to be a little lofty right now. It wouldn't shock me to see some investors take a profit after the company's upcoming earnings, though I would look to optimistically pick up shares on a dip.
Cloudflare can be classified as many different types of businesses, though the company likes to view themselves as a Cisco-as-a-service, given that they have solutions in many areas. Rather than a company using several providers to secure their network, Cloudflare does it all including cloud security, web security, CDN, and identity access management. They eliminate the need for enterprises to buy firewalls, routers, VPNs (and more).
Source: Company Presentation
The chart above does a great job showing exactly where Cloudflare thinks the enterprise stack will evolve to. Clearly, they believe they can become the leading all-in-one network provider, eliminating the need for enterprises to do business with several legacy vendors. Cloudflare essentially sells the full network that enterprises can plug into and not worry about anything else.
While the global pandemic has caused many tragedies, one of the biggest takeaways is enterprises needing to shift their operating models to become more digital, cloud-enabled, and agile. The days of operating with legacy hardware, on-premise solutions are long gone and those that invest in digital and cloud innovation will surely reap the long-term benefits.
In 2018, Cloudflare estimated their TAM to be $32 billion, largely focusing on areas such as application delivery controllers, WAN, CDN, DDoS, IDP, and firewalls. Over time, the landscape of cloud-based security and the proliferation of security spending has only accelerated. While these applications are essential for enterprises to run a secure network environment, Cloudflare has expanded their solution set to Cloudflare One, which includes zero trust services and network services.
Fast forward to today, Cloudflare sees their current TAM at $72 billion and further expanding to $100 billion in 2024. A majority of this TAM opportunity is being driven by Cloudflare One solutions, which include areas such as VPN, content filtering, remote browser isolation, data loss prevention, access management, smart routing, and firewall-as-a-service.
With 9,500 interconnects throughout the world, Cloudflare boasts their network is located within 100 milliseconds of 99% of the internet-connected developed world population. I believe this gives the company a lot of room for further penetration, both within the developed and underdeveloped parts of the world.
Source: Company Presentation
While Cloudflare's freemium model is not unique to the software market, the company places a high degree of focus on attracting new customers, then trying to upsell them to premium paid services. As discussed later on regarding their financials, this is partially why the company may be under-earning right now. Their extreme focus on getting a large customer base will likely pay dividends for the company long-term.
With a 100% subscription-based revenue model, Cloudflare has high visibility into their recurring revenue. Given the strong market growth and Cloudflare's success in the market, it's not surprising to see them growing revenue at a 50% CAGR from 2016-2020. This success continued into Q1 with revenue growing another 51%.
As their TAM continues to expand, Cloudflare has opportunities to experience growth from new customers and penetrating existing customers. As touched on in the section above, Cloudflare focuses on expanding their user base, albeit most of these users take advantage of the freemium model. This does however give Cloudflare a lot of room when it comes to upgrading their existing customer base to premium paid services. In addition, by developing new products, entering new markets, and extending their serverless platform strategy, I believe the company could easily grow revenue 25%+ for the next several years.
Paying customers continues on a nice upward trajectory, with that figure reaching nearly 120k at the end of Q1, up nearly 35% compared to last year. However, I believe there is a big opportunity for Cloudflare to focus on large customers. They have ~17% of the Fortune 1000 as paying customers and combined with 945 large customers with >$100k of annualized revenue (up significantly from just 197 three years ago).
As enterprises use Cloudflare and as Cloudflare expands/continues to improve their solutions, it's likely that more paying customers will end up becoming large customers.
These customers are typically much stickier and highly recurring, thus giving investors an even greater confidence in Cloudflare achieving continued strong revenue growth.
In addition, Cloudflare's dollar-based net retention rate has consistently been above 115%, meaning existing clients are very willing to spend more with Cloudflare.
Source: Company Presentation
While Cloudflare's TAM and revenue growth opportunity are clearly very positive, my biggest financial contention is around their margins. Yes, it's very common for high-growth SaaS-based companies to experience non-GAAP operating losses as they ramp their customer base and accelerate revenue growth.
As previously discussed, Cloudflare's freemium model is not a new concept, however, it appears this model has been causing quite significant operating losses. Their ability to convert these free users into premium paid subscribers will be instrumental for Cloudflare to generate a consistent, strong profit margin.
Gross margins are very healthy near 80%, which is quite typical for leading SaaS-based companies. Over time, the company expects their operating expense base to be better leveraged, enabling them to achieve non-GAAP operating margins of 20%+ over time.
In the meantime, I will continue to watch the slow progression towards profitability, which investors will ultimately expect Cloudflare to achieve over the long term.
With the stock up nearly 60% so far this year and nearly 3x in the past year, it's clear Cloudflare has become a crowd favorite. Yes, the company has great long-term growth potential on top of strong gross margins, which could ultimately lead to good profitability. However, investors should take a closer look at valuation heading into the upcoming earnings.
The above peer group demonstrates some companies which can be considered leaders in their respective markets. The two biggest standouts are Cloudflare and Snowflake (SNOW), which both have valuations well above other leading software players. Cloudflare's near 60x forward revenue valuation is a bit excessive.
Cloudflare has a current market cap of ~$36.85 billion and with ~$640 million of net cash, the company has a current enterprise value of ~$36.2 billion.
Per Yahoo Finance, consensus currently expects 2022 revenue of $815 million, which represents a ~33% growth compared to 2021. Using this estimate for 2022, this already implies a 2022 revenue multiple of nearly 45x. If we were to assume another 30% growth in 2023 and 2024, this could result in 2024 revenue of nearly $1.4 billion, which represents a 2024 revenue multiple of 26x.
I think the company will continue to execute well, though investors should be cautious putting new money to work right now. Over time the stock has been a little volatile and can fall out of favor if the market turns its' back on high-valuation software names. Just like the market did in late April and throughout May, high-valuation names were under pressure and Cloudflare saw their stock drop nearly 25% during those few weeks.
Buying on dips and any self-correction is my preferred way to play this name. Valuation at nearly 60x forward revenue makes me question who is currently buying at these levels.
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