Cloudflare: Turning Bullish Now, Though Volatility Likely Remains

Apr. 25, 2022 12:03 PM ETCloudflare, Inc. (NET)5 Comments4 Likes

Summary

  • Cloudflare continues to impress each quarter, consistently beating and raising despite revenue growth at 51% CAGR over the past five years.
  • The stock has pulled back nearly 60% as investors rotated out of high-valuation names, though Cloudflare's financial metrics remain very strong.
  • Valuation is currently ~18x my 2024 revenue estimate, which is pretty similar to other fast-growth technology companies' forward revenue multiple.
  • Long-term investors should look to build a position in the name, though expect volatile trading to occur over the coming quarters.

Exterior view of Cloudflare headquarters

Sundry Photography/iStock Editorial via Getty Images

Cloudflare (NYSE:NET) has pulled back nearly 60% from all-time highs as investors quickly rotated out of high-valuation technology companies in favor of those who may benefit more from higher interest rates. Nevertheless, the company's financial metrics have only continued to improve as the need for top notch IT security solutions remains very relevant.Cloudflare price chart

Data by YCharts

I have previously been quite neutral on the name given high-valuation, with Cloudflare trading at over 90x forward revenue during the high-point. However, the significant pullback was driven by investors rotating out of technology stocks as a whole, rather than anything Cloudflare-specific.

With the company likely to report earnings in late-May, I believe they will report another beat and raise quarter, consistent with their historical pattern. In addition, I continue to believe their revenue guidance for the year to be conservative, and wouldn't be shocked to see another year of 50%+ revenue growth.

Valuation remains a sticking point for many investors, but when looking out a few years, the stock currently trades ~18x 2024 revenue, which is in line with other fast-growth peers who trade ~15-20x forward revenue. In other words, investors are paying a similar multiple for Cloudflare on 2024 revenue, when growth will decelerate closer to their peer group.

I believe long-term investors would be wise to pick up some shares ahead of earnings, though I would expect the stock to continue to trade in a volatile fashion for many quarters to come.

Who Is Cloudflare?

For those who are unfamiliar with Cloudflare, they provide cloud security, web security, CDN, and identity access management solutions. In the past, the company has described themselves as a "Cisco-as-a-Service", giving enterprises the ability to purchase cloud-based network-related security solutions, rather than using the traditional hardware solutions.

The global pandemic definitely accelerated companies' shift to the cloud and with employees continuing to be in a "work-from-anywhere" mode, the need to have strong IT security protocols remains essential.

Cloud-based security solutions are much easier to implement and change compared to legacy hardware solutions. In addition, storing applications in the cloud enables companies to ramp-up or ramp-down usage very quickly.

Cloudflare TAM Opportunity

Cloudflare

The company estimates their TAM to be around $100 billion by 2024, which would represent nearly 3x increase from 2018 level of $32 billion. Also, the TAM is largely being driven by Cloudflare Zero Trust and Cloudflare Network Services, both of which are new solutions since the beginning of 2020. Thus, I believe their TAM will only continue to get bigger as the company expands into more adjacent solutions.

On top of that, the current war going on in Russia/Ukraine has shed even more light on the need to have top of the line security solutions. Knowing there is a potential risk of foreign counterparts to hack into a company's servers, it would appear that companies are more than willing to invest in the right protocols.

Cloudflare Customer Growth

Cloudflare

Cloudflare utilizes a freemium model, which I believe attracts a very large span of customers. In essence, customers are able to use certain Cloudflare solutions for free, but in order to be most effective, enterprises will need to upgrade their solutions. The upsell/freemium strategy is quite common throughout the industry and Cloudflare has been able to expand their large customers, as defined as having >$100k of annualized revenue, to 1,416.

Their continued focus on not only attracting as many customers as possible, but driving growth from their large customers will continue to drive overall revenue growth for years to come.

Financial Review

Cloudflare's revenue model is 100% subscription-based, meaning it is highly recurring and highly visible for the company and investors. From 2016-2021, revenue has grown at a 51% CAGR, which is driven by both the acceleration of cloud-based IT security solutions and Cloudflare expanding/upselling their customer base.

Cloudflare Non-GAAP Financial Trends

Cloudflare

Over the past eight quarters, Cloudflare has shown extreme consistency in both revenue growth and profit expansion. Revenue has grown sequentially each quarter, which can be difficult to do for many companies. As to be discussed later on, the company's valuation has largely been driven by the balance of revenue growth and profitability.

The company is guiding to 41-42% revenue growth for the full year and 48-49% growth for Q1. This means that revenue growth will decelerate throughout the year, which I believe will end up being conservative. The company has a nice history of beating and raising expectations and I see no reason to believe this will change, especially as the overall IT security market remains very bullish.

From a profitability standpoint, the chart above does a great job showing that non-GAAP operating income has improved from a $14 million loss just eight quarter ago, to over $2 million profit. While there continues to be a lot of room for profitability improvement, it does solidify the belief that as the company continues to scale, they will generate higher profitability margins.

Cloudflare FCF and Metrics

Cloudflare

To further demonstrate the company's continued improvement, FCF margin has improved quite significantly. At the beginning of 2020, Cloudflare had a FCF margin of -34%, which has significantly improved to a 4% margin in the most recent quarter. Again, this remains barely in the positive territory, however, it demonstrates that the company's scale will lead to increased profitability and FCF.

One of the biggest drivers of improved profitability comes from increased scale. The number of paying customers has consistently grown of 25% for the past several quarters, with the number of paying customers >$100k of annualized revenue growing above 70% for the past four quarters. Clearly, Cloudflare customers are seeing the benefit of their products, which is causing significant upsell opportunities as demonstrated by their dollar-based net retention rate of 125% during the most recent quarter.

Long-Term Model

Cloudflare

Many quarters ago, investors had feared that the path to profitability was lost and Cloudflare could generate losses for many years to come. However, this theory has started to unfold and I believe that over the next several quarters, profitability will only continue to improve.

The company's long-term growth model, as shown above, demonstrates a clear path towards improvement. Even when looking back at the prior four years, investors can see improvement across non-GAAP gross margin and non-GAAP operating margin.

What's interesting to me is the company expects long-term non-GAAP gross margin to be 75-77%, which would actually be a tick down from the 78-79% seen over the past several years. In my opinion, this gives the company another leverage point in terms of margin expansion. If non-GAAP gross margin remains closer to 80%, we could see non-GAAP operating margins either improve quicker or have a higher base.

Valuation

Despite the financial improvement and success, the stock has pulled back nearly 60% from all-time highs. This type of pullback has been quite common for many high-growth, high-valuation companies, as investors became more uncomfortable with valuations.

The fears of difficult growth comparisons from pandemic-driven acceleration as well as the Federal Reserve raising interest rates, valuations across the technology sector have been hit quite hard.

CLoudFlare vs peers in EV to revenues
Data by YCharts

As previously mentioned, valuations across many fast-growth technology companies have taken a massive hit in recent months, and Cloudflare has seen their valuation pullback from over 90x forward revenue to ~32x forward revenue.

For 2022, the company is guiding to revenue of $927-931 million, which I believe will end up being conservative. The company has a history of nicely beating revenue guidance each quarter, and even if we only assume a small beat each quarter, it's very reasonable to think revenue could reach $950 million this year.

For some back of the envelope math, if we assume revenue growth decelerates to ~40% in 2023 and further decelerates to ~35% in 2024, we could see 2024 revenue of ~$1.8 billion.

The company has a current market cap of ~$32.5 billion and with ~$700 million of net debt, they have a current enterprise value around $33.2 billion. Using my 2024 revenue estimate of ~$1.8 billion, this implies a 2024 revenue multiple of ~18x.

Yes, this does not screen as a cheap revenue multiple, however, Cloudflare's revenue growth could easily remain above 40% for the next few years and with profitability improving each quarter, they are likely to be a Rule of 40 company for the foreseeable future. In addition, many other fast-growth technology companies already trade around 15-20x forward revenue. This peer groups tends to have lower revenue growth than Cloudflare, so it seems reasonable that in when looking at 2024 revenue, Cloudflare could trade at a similar multiple as where peers are trading today.

For now, I believe long-term investors should look to start building a position in the name. While the revenue multiple will surely come down over time, the prospects of very strong revenue growth and non-GAAP operating margins expanding towards 20% gives me confidence at current prices.

I believe the biggest risk to my bullish thesis is rising interest rates, which tend to cause high-valuation stocks to contract more than the broader market. Investors who are looking to get out of high-valuation names to protect themselves from higher interest rates may look to sell Cloudflare. In addition, if revenue growth were to decelerate or profitability were not to come through, investors may look to sell the stock.

This article was written by

Individual investor with hands-on experience in the equity markets. Largely focusing on Tech companies or major mispricings in the market.
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Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. 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.

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