Cloudflare: Macro Headwinds Significantly Impeded Its Momentum
Summary
- Cloudflare is an expensive but high-growth Cloud SaaS stock. The company has also executed well consistently.
- However, given the macro headwinds, we think NET stock's significant growth premium has hampered its momentum recently.
- We discuss why we retain our Buy rating on NET stock, heading into its Q1 card on May 5.
- I do much more than just articles at Ultimate Growth Investing: Members get access to model portfolios, regular updates, a chat room, and more. Learn More »
Sundry Photography/iStock Editorial via Getty Images
Investment Thesis
Cloudflare, Inc. (NYSE:NET) stock has continued to consolidate within a considerable range as dip buyers remained tentative over its significant growth premium. NET stock is also the most expensive Cloud SaaS stock in our coverage. It displaced Snowflake (SNOW) as the market digested SNOW's growth premium.
Although Cloudflare has consistently executed well, its stock was also impacted by the intensifying macro headwinds. Recent commentary by the Fed had affected investors' confidence, as they became worried over a more hawkish rate hike cadence. Therefore, we believe the market has been trying to price in potential 75 bps rate hikes, further impacting the momentum for high multiple stocks like Cloudflare.
As a result, we believe that the macro headwinds could continue to hold NET stock back in the near term. However, investors should also note that the company remains well-positioned to leverage growth in cloud computing and cloud security. In addition, its leadership position with telcos networks, hyperscalers, enterprises, and SD-WAN vendors has strengthened its ability to expand its TAM.
CEO Matthew Prince & Team is scheduled to release its Q1 earnings on May 5. In addition, management also highlighted an Investor Day follow-up on May 12. Cloudflare's previous Investor Day presentations have consistently introduced new market opportunities, further expanding its TAM. Hence, despite the recent headwinds, we think long-term investors can consider adding NET stock on weakness.
Nevertheless, we must caution investors to space out their purchases, given its high growth premium. Accordingly, we reiterate our Buy rating as we head into its Q1 card.
NET Stock Growth Premium Hampered Its Momentum
NET stock 2M performance Vs. peers (Koyfin)
NET stock NTM revenue Vs. peers (TIKR)
As mentioned earlier, NET stock is the most expensive Cloud SaaS stock (NTM revenue multiple: 32.7x) in our coverage. However, given its robust execution, the market has consistently rated NET stock highly despite its premium. Nonetheless, we believe its growth premium has also led to its underperformance against its peers over the past two months.
For instance, NET and Zscaler (ZS) have much higher NTM revenue multiples over CrowdStrike (CRWD) and Palo Alto (PANW), as seen above. Notably, NET and ZS underperformed against CRWD and PANW over the past two months. The cybersecurity leaders have been re-rated, given the increased focus by enterprises and governments on cyberwarfare moving forward. It was also the most critical spending category of CTOs in a recent Bloomberg survey.
Furthermore, a Gartner report released in April corroborated the secular growth in cloud spending, including security. Gartner estimates that global public cloud spending would increase by 20.4% to $495B in 2022E, after 2021's 20.4% increase. Furthermore, it expects spending to reach $600B by 2023E, implying a further 21.2% increase from 2022E's estimates. Therefore, we are confident that Cloudflare and its peers remain well-positioned to capture the continued digitization despite the recent macro headwinds. These are multi-year secular growth drivers that near-term headwinds should not impact markedly.
Cloudflare's Continued Gains In Operating Leverage Are Critical
Cloudflare RPO and deferred revenue metrics (Company filings)
Readers can observe Cloudflare's remarkable consistency in the growth of its remaining purchase obligations (RPO), undergirded by strong deferred revenue growth. For instance, Cloudflare's RPO increased by 62.7% in FQ4, surpassing FQ3's 59.5%. The company also recognized deferred revenue of $116.55M in FQ4, suggesting a massive backlog of $507.4M.
Cloudflare's implied annualized recurring revenue (ARR) growth remained impressive at 54% in FQ4, above FQ3's 51%. Therefore, we think that's one of the critical factors why the market has been willing to ascribe a significant growth premium to Cloudflare. The company has continued to execute consistently well with no marked reopening drop-off in growth. Given the continued increase in cloud spending, we believe Cloudflare's well-diversified cloud portfolio should benefit tremendously.
Cloudflare consensus estimates % (part 1) (S&P Capital IQ)
Cloudflare consensus estimates % (part 2) (S&P Capital IQ)
In addition, the company is also expected to reach and maintain its FCF profitability over the next two years, as seen above (part 2). However, investors should note that Cloudflare remains unprofitable on a GAAP net income basis.
Therefore, Cloudflare must demonstrate significant growth in operating leverage to justify its premium moving forward. Consensus estimates suggest that Cloudflare's adjusted net income could increase by 164.5% in FY22 and 200.8% in FY23. Hence, we think it's critical for Prince & Team to surpass these estimates to maintain its growth premium.
Is NET Stock A Buy, Sell, Or Hold Now?
NET stock is one of our core cloud SaaS holdings. We think it's uniquely positioned to leverage several growth drivers across cloud computing, storage, cloud security, and CDN infrastructure. But, management must continue to execute well.
NET stock consensus price targets Vs. stock performance (TIKR)
We concur that the recent macro headwinds could further impede its recovering momentum and re-rating. Nevertheless, NET stock last traded near its most conservative price targets (PTs), as seen above. These PTs have also proved to be solid support zones over the past year.
Still, we encourage investors to consider adding in phases as NET is a highly volatile stock.
We reiterate our Buy rating on NET stock as we head into its Q1 card.
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