Investment Thesis
In our previous article, we took the opportunity to remind investors of Cloudflare's (NYSE:NET) tremendous scalability potential. Also, we explained the misconception of its widely perceived Content Delivery Network (CDN) features.
Cloudflare is heading into Q2 earnings on Thursday (Aug 5), following a series of relatively tepid Q2 releases from Amazon (AMZN) and Facebook (FB) as they warned of slower growth amid tougher comps ahead.
We think the expectations for Cloudflare to perform well are also likely to be high as investors pushed the stock to a new ATH recently, piling up optimism for the company to overdeliver yet again.
This article highlights some salient metrics for investors to pay attention to as we head into earnings.
Cloudflare Often Crushes Revenue Estimates
Cloudflare's mean revenue consensus (quarterly) estimates. Source: Seeking Alpha Premium
Cloudflare is heading into Q2 earnings with amazing momentum, and also with expectations running high as the Street anticipates that Cloudflare would post YoY revenue growth of 46.5% to reach $146.1M in Q2'21, which is largely in line with the company's guidance of $145.5M to $146.5M.
Quarterly revenue beat/miss. Source: Seeking Alpha Premium
The company has also consistently outperformed the Street's estimates, and we see little reason to think otherwise. In the subsequent sections, we would be highlighting the key metrics to closely monitor in our hope to present a basis for our readers to evaluate Cloudflare's report card on Thursday better.
Watch for Developments on Magic Transit
We would be closely watching the company's progress in its Magic Transit business, where the company has been focusing on trying to disrupt the on-premise security players that Cloudflare has highlighted as a huge multi-year opportunity that would likely be highly instrumental to Cloudflare's revenue growth moving forward, as Cloudflare emphasized that “the MPLS spend is a significant dollar item in the budgets of [Cloudflare's enterprise] customers.”
While Cloudflare has been using the land-and-expand model to acquire and grow its customers' revenue over time, Magic Transit is designed to be mainly a land strategy, as "it's a comprehensive cloud-based network-as-a-service solution that is designed to be secure, fast, reliable, but it replaces, this patchwork of appliances and wide area network technologies that companies have."
Therefore, investors could consider this a "complete" solution set that Cloudflare has brought to the market to disrupt the on-premise security leaders' business model with its cloud-native solution designed to be a lot more scalable. This is highly important as Cloudflare added that
Those customers tend to spend a lot of money managing, in a lot of cases, even outsourcing their wide area network infrastructure. And because of that, it's a significant opportunity...MPLS connections are expensive connections for companies to run their WAN infrastructure. [Cloudflare] offering a very disruptive technology also from a pricing perspective allows for superior returns. ROIs are usually significantly less than 1 year.
Therefore, investors should pay attention to the updates provided on Magic Transit and carefully evaluate the management's guidance on its expected progress moving forward.
Screen for Updates on Workers and AWS
While we think the company's flagship DDoS product segment would continue to play a critical role in its land-and-expand strategy, the company's undisputed leadership in the DDoS protection segment with an 81.4% market share likely means that it would also need to leverage on other products to create more opportunities to acquire new customers to its network.
DDoS and bot protection software market share worldwide as of Apr 21. Data source: Datanyze
One of the key areas that we think Cloudflare is likely to continue capitalizing on is the highly competitive Cloudflare Workers product. This product forms the fundamental basis for its edge computing capability, which is supported by "the Cloudflare global anycast network, [spanning] over 200 cities in more than 100 countries."
Workers are Cloudflare's primary offering against AWS Lambda (AMZN), and Cloudflare has also run tests that demonstrate the superior latency performance of Workers against Lambda across several key functions.
Recently, Cloudflare also launched an offensive highlighting "AWS's egregious egress," where the company took the opportunity to present AWS's "unreasonable" charges for egress bandwidth which alleges that "AWS stands alone in not passing on savings to [mutual Cloudflare] customers."
While such developments on AWS are not new, we think that Cloudflare has taken the opportunity to highlight the pricing practices of the largest global hyperscaler to try and level the playing field against AWS Lambda.
We also noted that Amazon responded in reply to The Register that clearly refuted Cloudflare's assertions as the company emphasized:
Major cloud providers charge similar amounts for transferring data out of their clouds. However, not all clouds are the same. It’s important to note that data transfer costs are more than just bandwidth. In addition to bandwidth, our costs reflect the extreme levels of redundancy that our customers get in our data center and broader networks and the value of a purpose-built backbone that reduces latency and improves throughput.
As the battle heats up between Cloudflare and Amazon as Cloudflare is trying to challenge the Tech behemoth's hegemony, Amazon is astutely leveraging AWS's massive scale and size of its walled garden to reduce Cloudflare's advantages for mutual Cloudflare customers significantly.
To further rub it in, Amazon clearly apprised its customers on how they could enjoy even more savings, as the company emphasized: "...And, the majority of our heavy data transfer workload customers use Amazon CloudFront (AWS’s Content Delivery Service) to enjoy even more significant cost savings."
The battle between David and Goliath is expected to intensify moving forward. We think this clearly demonstrates the immense control and power that Amazon has over its customers, which we think the e-commerce bellwether would continue to capitalize on to try to neutralize the competitive threat posed by Cloudflare.
One positive development is that Cloudflare has managed to build a strong alliance since 2018 with other Cloud service providers, which the company calls the "Bandwidth Alliance," which has "committed to discounting [mutual Cloudflare] customers data transfer fees." While AWS still retains about 40.8% of the global public cloud IaaS market, it's, after all, not the market, which should provide Cloudflare sufficient opportunities to acquire new customers outside of AWS's walled gardens.
Enterprise Segment Should Become Increasingly Important
Total paying customers. Data source: Company filings
Large customers. Data source: Company filings
While Cloudflare has amassed a total of 119K paying customers in Q1'21, its enterprise customers total was a much smaller 945. Importantly the number of both the paying and enterprise customers has continued to grow rapidly. In particular, enterprise customers accounted for about 50% of Cloudflare's current revenue base, and the company has also highlighted that they are landing even larger deals now as their largest cohorts of $1M+ customers have grown even faster, "growing north of 70% consistently over last the 7 quarters.”
In addition, as the company's Magic Transit product is also primarily focused on enterprise customers, we think Cloudflare's key revenue driver would be attributed to its enterprise segment moving forward and encourage investors to keep a close watch on this growing customer segment.
Monitor the Scale of its Global Expansion Plans
Revenue by region. Data source: Company filings
Cloudflare has a globally diversified revenue base, which lends strong credence to its high scalability and massive global adoption, as the US market accounted for about 51.6% of Q1'21 revenue. Recently, Cloudflare also announced its expansion in Brazil as the company expanded its presence in Brazil to 25+ cities.
Expected e-commerce sales growth in 2021. Source: eMarketer
As we could glean from the country's e-commerce leadership, Brazil is an important market as it's expected to notch the second-highest growth rate in 2021 with a YoY growth of 26.8%. We are encouraged to know of Cloudflare's increasing relevance to companies worldwide, and we would expect to see that the company's share of the revenue from the US is reduced over time. Investors are encouraged to monitor Cloudflare's global revenue share in Q2 closely and evaluate whether its worldwide revenue has been growing faster than its US revenue.
Watch for any Unexpected Gross Margins Impact
Gross margins (quarterly and LTM). Data source: S&P Capital IQ
Cloudflare has consistently delivered on its gross margins, which the company thinks is highly instrumental in its quest to achieve FCF profitability as Cloudflare emphasized: "So the strength certainly is in the gross margin. We always said we want to get to [FCF] breakeven reasonably fast."
We expect Cloudflare to continue delivering on this aspect, even though back in Q1'21, the company highlighted some supply constraints, which the company eventually sorted out. Investors are encouraged to continue monitoring this, to determine whether the company is expected to face semiconductor supply challenges moving ahead and evaluate the impact if any.
Unlevered FCF margin and unlevered FCF margin forecast. Data source: S&P Capital IQ
Importantly, we expect the company to achieve FCF profitability sometime in 2022 and await further clarity on this matter. We think this is important as NET is currently trading at a premium valuation of 59.5x, based on its most recent EV / Fwd Revenue multiple.
EV / Fwd revenue. Data source: S&P Capital IQ
Cloudflare EV / Fwd Rev 1Y mean
This also places NET at about 57% above its 1Y EV / Fwd Rev mean. The Street's mean target price of $104.6 values NET at an implied EV / Fwd Rev of about 52.4x, at about a 12% discount to the last closing price. Thus, we think NET is carrying a lot of optimism heading into earnings. For investors who are not convinced with its business model or do not have a long-term horizon, the current price may present an opportunity to remove some risk from the table.
Price Action and Trend Analysis
Source: TradingView
Moreover, while we continue to maintain our high conviction in NET's undisputed medium-term and long-term uptrend bias, we note the over-extended price action and think the price action concurs with the stock's valuation at the moment. Therefore, while we do not encourage long term investors to bail out of NET as we continue to maintain our belief in this stock, we encourage investors to set aside some exposure to add into NET if the opportunity presents itself post-earnings in the event any of its metrics fails to meet the Street's expectations, leading to profit-taking and creating potential opportunities to add on weakness.
However, at this point, we think the risk is skewed to the downside and do not encourage investors to add new exposure to NET right now.
